FXStreet (Delhi) – Jane Foley, Research Analyst at Rabobank, suggests that the recent weakness of both the AUD and the ASX has been a direct response to concerns that the Chinese authorities could be prepared to allow the CNY to weaken, which could involve a heavy cost to Australia’s external sector. Key Quotes “Measured on a 12 mth view the near 6% fall in the value of the CNY vs the USD is far more modest vs the 11% drop in the IDR or the 20% plunge in the MYR. The CNY has not just been losing ground vs. several Asian currencies but since the start of last year it has lost 4.76% vs the EUR and 8.75% vs the AUD. Last month the PBoC pointed out in a publication that the market should be less focussed on the value of USD/CNY and should be paying more heed to the value of China’s effective exchange rate. As a consequence of the PBoC’s de-facto USD peg, the value of China’s effective exchange rate has been dragged higher by an appreciating USD. This has no doubt been contributing to China’s slowing growth and weakening price pressures. Now that the Fed’s tightening cycle has started, there is risk that China’s currency could be dragged even higher vs. a basket of other currencies. By allowing USD/CNY to move higher, the PBoC may be attempting to reverse some of the recent gains in its effective exchange rate. The PBoC may also be attempting to reduce the cost of propping up the value of the currency. China’s FX reserves dropped by a record USD108 bln in December, far greater than the market had expected. If China has decided to allow its currency to weaken, this is likely to be viewed as another development in the currency war. The question now is whether China’s trading partners will retaliate by extended their easing cycles to prevent their exchange rates from appreciating vs the CNY. For some time we have been arguing that risks associated with slowing growth in China is likely to lead to further easing from the RBA, potentially as soon as February. Australia’s external sector has suffered heavily from multi-year lows in coal and iron ore prices. This is linked with over supply of steel and China’s position as the world’s producer of half of the world’s output of the metal. Although shipments of iron ore from Australia has remained high, the weakness of unit prices is feeding back into the Australian economy as lower incomes to mining households and reduced tax revenues. Although Australian exporters have been offered some protection by the sharp fall in the value of AUD/CNY since 2011, AUD/CNY is been bias moderately higher since the middle of last year and this trend is now threatening to extend. Although on a national level, Australian employment has held up well in the face of the pressures on commodity markets, the weakness of wage inflation in Australia may in part be a function of high paid mining jobs being replaced by lower paid service sector openings. We see heightened risk of further RBA easing and remain bearish on AUD/USD, looking for a move towards 0.66 medium-term.” For more information, read our latest forex news.