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China’s Currency And The Three Options For Renminbi Policy

China's Currency And The Three Options For Renminbi Policy by Worth W. Wray featuring guest contributions from George Magnus & Chen Long Evergreen Gavekal

"The dollar may be our currency, but it’s your problem."

- US Secretary of the Treasury John Connally in 1971

Summary Of EVA's Key Points

  • China’s decision to devalue its currency—for reasons we still do not fully understand—has set a dangerous series of events in motion which are already disrupting global financial markets. In fact, it was China allowing its currency to drop a seemingly minor 3% against the US dollar last month that triggered the recent bout of extreme asset price volatility—mostly of the downward variety—since then.
  • In our first guest selection, GaveKal’s Chen Long outlines three possible paths for the renminbi (RMB), China’s currency, arguing that the most likely outcome is a gradual, managed depreciation, which admittedly risks encouraging further depreciation expectations.
  • However, Chen also points out there is a decided risk of something less controlled—and more threatening to the planet’s economies and markets. GaveKal has estimated that the People’s Bank of China is expending $10 billion (US) per day to prevent the RMB from falling further—possibly much further.
  • In our second guest selection, the formidable George Magnus explains that a struggle is taking place within the Chinese Communist Party. It is escalating into a brutal battle between the reformers who want to restore China as a great power—in part by transitioning from an investment-driven economy to a consumption-driven economy—and the vested interests who want to protect their personal holdings by pressing on with a nearly-exhausted growth model.
  • We cannot know which direction the RMB will ultimately move in the coming months because we do not know which group will eventually prevail within the Party. However, a major fall in China’s currency would be a serious shock to the world: (1) essentially stealing growth from its export competitors (like Germany, Japan, and South Korea), (2) dragging inflation to dangerously low levels across the developed world (which would make debts more difficult to service), and (3) reducing the longer-term structural demand for government bonds, including US Treasuries. We believe this is one of the gravest risks facing the global economy and financial markets.
  • In light of all this uncertainty—and a number of other serious threats—our investment committee at Evergreen GaveKal is remaining defensive, waiting for clarity, and preparing to take advantage of the dislocations that will likely follow should China’s currency fall further.

China’s Currency, Our Problem

Please allow me to take you halfway around the world to the People’s Republic of China (PBOC), the curious epicenter of the latest global financial panic attack… which I still believe is more of a fear-induced, computer-trading-driven overreaction as opposed to a legitimate financial crisis.

As I wrote in mid-August (“What Happens When a Dragon Flaps its Wings?”), the 3% devaluation we have seen in China’s onshore currency market in recent weeks is not the kind of global deflationary shock that it appeared to be on August 11th and 12th. While the People’s Bank of China has technically moved the onshore yuan (CNY)* into a more market-oriented structure, Beijing continues to intervene in the open market to defend the appearance of stability.

Nonetheless, Beijing’s surprise CNY “reform” set a series of events in motion that are starting to destabilize global financial markets at a time when the imminent threat of further Federal Reserve tightening already hangs over every liquid market in the world.

It doesn’t take an expert to see the connection between the sudden un-anchoring of what had been Asia’s most stable currency and the swift break-down in sentiment that has torn through global markets in subsequent trading sessions. For what it’s worth, this isn’t the first time that a macro-economic surprise has triggered a sharp break in sentiment and confused the high- frequency trading programs that have become so pervasive in today’s markets. If relatively small surprises can have big consequences over time in our highly leveraged, highly interconnected, and increasingly automated global financial system, major shocks can change everything in a flash.

I hope you’re paying attention, because if a 3% devaluation in China’s currency can trigger a global rush for the exits—as it did last week—a 20% drop could shake the world. A major devaluation would (1) essentially steal growth from China’s export competitors (like Germany, Japan, & South Korea), (2) drag inflation to dangerously low levels across the developed world (which would make debts more difficult to service), and (3) reduce the longer-term structural demand for government bonds like US Treasuries.

With a potential shock of that magnitude now on the horizon, we have to carefully consider what is happening in China today and what it means for the renminbi (RMB) going forward if we have any chance of understanding the rapidly evolving global macro outlook. That’s why this week’s Guest EVA is so important.

In our first selection, GaveKal Dragonomics Research’s Chen Long outlines three possible paths for China’s currency. I won’t try to steal Chen’s thunder since his report is brief, but he does a fantastic job articulating the three possible paths for the RMB in the coming months. As you may already expect, the risks are high in all three cases as (1) maintaining RMB stability in the face of massive capital outflows “is not a viable course of action” over any meaningful period of time, (2) a large one-off devaluation may curtail further depreciation expectations at the risk of a diplomatic disaster, and (3) a gradual, managed depreciation could heighten expectations for further depreciation.

In our second selection, the ever-brilliant George Magnus—one of the most influential economists and investment strategists in the world today—cuts through popular hyperbole and refocuses the conversation on the ongoing power struggle playing out within the Chinese Communist Party.

Contrary to the increasingly popular “hard landing” narrative—and consistent with my note in last week’s EVA Exchange (“Don’t Panic… Just Yet”)—George explains that China’s economy is in trouble, but it is not collapsing. Unquestionably, “old economy” sectors like mining, construction, and low-value-added manufacturing are floundering as credit growth slows and a number of state-owned and state-favored firms are facing the unfamiliar prospect of bankruptcy. On the other hand, “new economy” sectors like retail, services, and technology are compensating for some, but not all, of that decline. Thus, China’s overall economic growth is slowing dramatically, its financial system is struggling under the weight of bad—but officially performing—debts, and the medium-term risks of a Thai-style collapse or Japanese-style malaise are rising in the absence of meaningful economic and financial market reforms.

“There is little question,” George explains, “that [President Xi Jinping] and his senior colleagues understand they have to implement deep and meaningful economic reforms to unlock

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new sources of economic growth and productivity.” Yet at the same time, that agenda is not moving ahead quickly enough. While Xi’s long-running anti-corruption campaign has brought down a number of “tigers” (high-ranking Party members) and “flies” (low-ranking Party members), Xi’s government still faces “resistance to reforms on an unimaginable scale” from vested interests at all levels of government who stand to lose a great deal if those reforms proceed. In fact, the Nikkei Asian Review reported in June that Xi has been the target of nearly twenty assassination attempts since taking office. Moreover, that report was published BEFORE his administration’s credibility began to crumble in the wake of its failed stock market intervention.

Considering their recent failures, Xi Jinping and his reformers may not be losing their resolve, but they are almost certainly...


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