About China’s currency devaluation, Hubert Marleau of Palos Mgt. Montreal

 

About China’s Currency Devaluation: The Renminbi (also called the Yuan) is very different today than it was a generation ago. Twenty years ago, foreigners used special exchange certificates rather than local currency and only in selected stores, hotels and restaurants. Today, foreigners can use local currency at anytime and anywhere. Moreover, some 20% of China’s merchandise trade is settled with the Renminbi.

In this connection, the People’s Bank of China (PBOC) has been pushing the IMF to accept the Yuan for official reserve status and to join the dollar, euro, yen, pound and the loonie in the basket of currencies that make up the fund’s Special Drawing Rights. Since 2005 when the Chinese government fixed its currency to the US dollar, the Renminbi has appreciated more than 30% even though the monetary authorities gradually backed down their intervention in the foreign exchange market.

The holdings of US treasuries peaked at $1.65 trillion at the end of April 2014. Since then China slashed its reserves stake in US debt by $180 billion. Three major developments have occurred over the past few months. Firstly, the IMF insisted, a few days ago, that if the Renminbi is to be considered as a reserve currency it must be freely usable and allow the market to play the role of pricing.

The IMF delayed a decision to endorse the Yuan as a reserve currency. Secondly, over the last few quarters, a lot of capital has left China as a result of turbulence and volatility in the financial markets. The nation’s foreign exchange reserves decreased no less than $350 billion. Thirdly, Chinese exports are sliding fast. Last month exports decreased 8.3% creating concerns that the 7.0% growth factor for 2015 may not be met. Yet, China’s trade surplus, in the first seven months of 2015, aggregated to $306 billion. This is what everyone thinks is important over the short term. In this connection, China made the sound decision to devalue the Yuan and strengthen the function of the market in determining exchange value as a rational, single and remedial cure to all of the above problems.

On Tuesday last, the central bank cut the Yuan’s daily fixing by a record 1.9% to Rmb6.2298 against the dollar and told market makers, who submit prices for the PBOC’s reference rate, that they need from now on to consider the previous day’s closing spot rate rather than the opening rate, foreign exchange supply-demand equation and major currency rates. These are broad changes that reflect real market levels and signal the possibility of a new currency regime.

Bloomberg Intelligence wrote in a quick research note that a 1% depreciation in the relative effective rate could boost export demand by 1.0 percentage point and trigger $40 billion in capital and money outflows with a lag of three months. If these numbers are indeed the case, the risk of a capital flight is real but a blow-out could be handled by the PBOC who has $3.69 trillion of currency reserves. Beijing has a long standing preference for gradualism.

We do not believe that the Chinese would opt for a rapid, abrupt and massive depreciation for it could bring about a wave of defaults on companies that have dollar denominated debts. Certainly, the PBOC will sell dollars on an as needed basis to smooth variations in the exchange rate. In fact, it was reported that the central bank sold some U.S. Dollars on Tuesday and Wednesday. All the major central banks around the world intervene from time to time in the foreign exchange in order to smooth variations. It’s one of the main reasons that they hold huge amounts of currency reserves. What are the Market Risks?

The Yuan might be allowed to slowly fall further to release pressure on exports. The trade balance was not the primary motive for the currency move. It appears to be related to capital outflows and a delayed IMF decision. The movement to more freely traded Yuan could lead to a favorable IMF decision. This decision may symbolic but it could put a stop to the capital outflow. The Chinese might be seeking a more flexible exchange rate to solve classic monetary-policy dilemma. It’s very difficult to allow monetary policy divergence and independence to take place when currencies are fixed.

If the currency is permitted to fall low enough, a reversal of capital back to China is possible. Despite everything going on, China is still one of the fastest growing economies in the world. It is good for dollar bulls and oil bears reflecting the greenback’s ascendancy. Yet, the price of both gold and the dollar could move up simultaneously, it could intensify currency wars in Asia but could ameliorate US-China currency debate. This latest move will liberalize the Chinese economy by implementing a less hands-on approach in managing the Renminbi. The IMF welcomed the move. It could delay the US interest rate liftoff to December for the Chinese move poses a challenge to the Fed.

If Chinese foreign reserves are allowed to erode, a selling of US treasuries would ensue causing rates in the US to rise more than the Fed may be prepared to accept. However, the immediate implication on economic activity in the US is small. But, should the devaluation process be persistent, it would become a serious drag on US growth. More worrying is that the devaluation works against the much needed rebalancing of the Chinese economy from manufacturing and exports toward services and domestic demand.

What Did Palos Do? Palos has no direct exposure to China. We increased our gold position because we anticipated that China, a major country, was leaning toward more monetary stimulus. We increased our exposure to the US dollar space by reducing hedge positions. We reduced exposure in the energy sector. We are buyers of Canadian companies whose revenues are concentrated in the US.