UBS Predicts ‘Limited’ Yuan Drop; Morgan Stanley Sees 10% Loss

By Paul Panckhurst and Kim Kyoungwha

Dec. 3 (Bloomberg) -- China has “very limited scope” to allow sustained declines in the yuan next year because of the risk of a backlash from trading partners, UBS AG said. Morgan Stanley predicted a drop of as much as 10 percent.

“Depreciation would likely invite criticism that China is adopting a beggar-thy-neighbor type of policy, leading to possible protectionist responses from China’s major export markets,” Wang Tao, a Beijing-based economist for UBS, wrote in a note today. The report came on the heels of a forecast by Stephen Jen, Morgan Stanley’s global head of currency research in London, that the yuan may weaken 5 to 10 percent next year.

The government this week allowed the biggest drop by the currency against the dollar since the end of a fixed-exchange rate in 2005, triggering speculation that policy makers favor a weakening currency to support exporters. President-elect Barack Obama called for an end to “manipulation” of the yuan on Oct. 24 as the U.S. trade deficit with China ballooned to a record $27.8 billion in September.

China’s government has shifted focus from stemming inflation to sustaining growth, after the world’s fourth-biggest economy expanded 9 percent in the third quarter, the weakest pace since 2003. A record contraction in manufacturing last month signaled that the slowdown is deepening, raising the risk of surging unemployment and social unrest.

‘Competitive Devaluation’

Depreciation “could also lead to a round of competitive devaluation in neighboring economies, which would result in little material gain for China,” wrote Wang at UBS, the world’s second-biggest currency trader.

The yuan may weaken to 7 against the dollar this year, then strengthen to 6.8 by the end of 2009, she predicted. The currency traded at 6.8845 as of 1:29 p.m. in Shanghai, near the lowest in more than five months. Morgan Stanley, the 10th biggest currency trader, reversed its forecast for no depreciation.

“Beijing could very well permit modest and temporary depreciation of the yuan,” Jen wrote. “That Beijing would hold the line on dollar-yuan parity was too demanding a call, given the economy reality China faces.”

Standard Chartered Plc., a U.K. bank that makes more than three-quarters of its profit in Asia, said today that investors should buy yuan put options as the Chinese currency is set for further weakness.

“We have had a break of the recent range that means the market started to panic more about the idea of a change in policy,” David Mann, a senior strategist with Standard Chartered in Hong Kong, said in a phone interview. “We are anticipating some weakness anyway in the first half of next year and it seems that’s coming sooner than later.”

To contact the reporter on this story: Paul Panckhurst in Beijing at ppanckhurst@bloomberg.netKim Kyoungwha in Beijing at kkim19@bloomberg.net;