• Risk sentiment and commodity prices bode ill for AUD in the event of a Chinese slowdown. Effects on other G10 currencies are more ambiguous: A reduction in global liquidity and redressing of global imbalances will likely be positive for USD, but the ultimate effect will depend on the strength and timing of the respective policy responses.

The impact of a slowdown in Chinese economic activity will likely make itself felt in FX space via three channels: 1) a turn in risk sentiment; 2) a decline in demand for commodity inputs and hence a disinflationary drop in commodity prices; and 3) a slower pace of reserve accumulation, a reduction in global liquidity and in global imbalances. The importance of each additional factor rises with the severity and extent of the Chinese slowdown.

Given the market’s current febrile reaction to any lower-than-expected activity release from China, an adverse shift in risk sentiment is likely the first reaction. This implies selling pressure on currencies perceived as being risk-related and offering a meaningful positive rate differential, chiefly CAD, AUD and NZD. The commodity price effect is likely to hurt exporters (as above) and benefit importers such as the U.S., Europe and Japan. But industrial metals will likely be hit hardest as they are tied to heavy industry/investment, where the sharp point of the slowdown will be concentrated. On the other hand, oil imports will likely prove more resilient as they are more directly linked to transportation. Food imports should also hold up, considering that incomes will continue to rise and water tables fall. As a result, AUD is the most exposed to a slowdown in China, a fact well understood by the market and evidenced by the close association of AUD/USD with 1y CNY forwards (see Figure). Having risen sharply beyond the improvement warranted by the terms of trade and its equilibrium value, AUD/USD is likely to drift toward and—as the slowdown deepens—through parity. CAD and NZD are likely to ease against G3, but benefit vis-à-vis AUD. 

But the eventual result will critically also depend on the trade implications and the policy response. U.S. imports of both consumer goods and commodities would decline as Chinese exports and commodity prices drop, but so would U.S. exports. The net effect would likely be positive for the U.S. external balance. It would likely be negative for the eurozone (EZ), which is a greater exporter to China and EMs. In turn, this will be negative for EUR/USD. But, it would take place against a backdrop of still-large internal U.S. imbalances, which would not be helped by a Chinese and/or global growth slowdown. If U.S. monetary authorities are again more proactive than their G10 counterparts in their policy response and engage in additional QE, this would drag long-end U.S. yields back down and detract from USD value.The effects of a deeper and/or more prolonged slowdown play out at a more fundamental level. For one, China’s export-led growth model would be impaired. All else equal, this implies a slower pace of CNY appreciation (if not depreciation) and stalling reserve accumulation (if not decline). Such a redressing of global imbalances could also mean a halt or reversal of the USD’s decade-long decline that has accompanied its rising current account deficits. So far, some 10 percentage points of the broad dollar’s 37% decline from its 2002 peak have been unwound during the course of the financial crisis. What is more, a decline in global liquidity—and associated recycling of funds—could imply greater (relative) demand for USD, adding additional upward pressure.

Japan, already besieged by regional competitors benefiting from weaker exchange rates, would feel the additional squeeze; this could prompt further official FX intervention to weaken JPY.