For a moral compass, many look to the Bible. For political directives, Machiavelli’s succinct and direct The Prince. But for matters of war, the Chinese have a lock; they’ve literally raised the wisdom guiding generals engaged in battle to an art form. Here is a but a sampling from the Top 500 List of quotes from Sun Tzu’s fifth century masterpiece, The Art of War:

“Appear weak when you are strong, and strong when you are weak.”

“Strategy without tactics is the slowest route to victory. Tactics without strategy is the noise before defeat.”

“The best victory is when the opponent surrenders of its own accord before there are any actual hostilities… It is best to win without fighting.”

“The general who advances without coveting fame and retreats without fearing disgrace, whose only thought is to protect his country and do good service for his sovereign, is the jewel of the kingdom.”

“All warfare is based on deception.”

“Speed is the essence of war. Take advantage of the enemy’s unpreparedness; travel by unexpected routes and strike him where he has taken no precautions.”

The Art of Trade Warfare

Trade Warfare

The essence of the last two quotes is what has many market watchers on tenterhooks as Inauguration Day and the Chinese yuan sporting a seven-handle fast approach. For those of you following the Vegas odds, January 20th is sure to mark both Trump’s taking office and the yuan falling to 7-something, as if they’re somehow in simpatico and synched at the hip.

Does this psychological threshold suggest that China is on a pre-ordained path to freely floating the yuan? That’s certainly where Wall Street’s sell-side sides, especially if Trump swiftly moves to impose trade sanctions. In that event, odds for a free float are 50-50 this year. If Trump’s freshly announced Trade Czar Robert Lighthizer holds off on immediate measures, count on a free float becoming reality in 2018.

If ‘speed is the essence of war,’ a freely floating yuan is a surefire way for the Chinese to counter sanctions. That said, the disruption caused would trigger a global recession and catalyze a concomitant correction in dearly valued risky assets. The attendant insult would arrive in the form of China’s wealthiest citizens’ increased impetus to ferry their fortunes overseas.

“There’s no arithmetic or economic reason Beijing would make that decision which means the only reasons they would float the currency would be out of sheer panic or because they were locked in a trade war and just said, ‘What the hell,’” said Leland Miller, president of China Beige Book (CBB) International, a research firm that produces a private survey on the Chinese economy.

At the most fundamental level, China lacks sufficient funds to take adequate precautions on the heels of 2016’s carnage; last year the yuan suffered its steepest annual decline in more than two decades. Managing that devaluation was anything but free of charge. Estimates suggest China’s foreign reserves will hold at $3.01 trillion when the latest batch of data are released January 7th. Still, that’s down a cool trillion to a five-year low. More to the point, it’s going to continue to be costly to continue to defend the yuan given the trajectory of the currency’s sickly slide. That’s saying something considering some estimates suggest $2 of the $3 trillion are inaccessible — $1 trillion earmarked to construct the Silk Road and another $1 trillion that’s illiquid.

That math is the main reason the “float” argument is reserved for headline writers. So said Neil Azous, founder of Rareview Macro LLC, a Stamford, Connecticut-based research firm. “Professional investors have three concerns,” Azous explained. “The first of these is the pace of foreign exchange reserve outflows, specifically how many months it will take to draw down China’s USD-related holdings. The second is the funding stress in the interbank lending market; the cost of funds and a key measure of counterparty risk has set higher for 53 consecutive days. The third is whether Chinese debt surpassing $18 trillion in 2017 (vs. the current $17.3 trillion) will be a precursor to a more pronounced credit crunch that exports deflation to the rest of the world”

The good news is our new head of Trade is no negotiations newbie and will be highly cognizant of all the moving pieces. In the spirit of not taking any chances, Trump literally reached back into Reagan’s cabinet for his nominee who served back then as a trade representative. Lighthizer surely has a vivid recollection of the recession that greeted Reagan shortly after he took office. Treading lightly will presumably be at the forefront of his mind despite his vociferous aversion to the very imbalances emanating from previous trade agreements that got us to point blank range.

And then there’s the delicate business of those other dithering deals to consider. All you capitalists out there, close your eyes and envision the most formidable foursome the antitrust forces on the DOJ, FTC, Treasury and FCC could combine to conceive. Throw in propaganda perfected and you get to acrimonious acronym MOFCOM, or the Ministry of Commerce for the People’s Republic of China. Of late, this auspicious agency has put the red back in China, as in red tape, dragging out the approval of three major deals that, on a relative basis, swept through its international counterparts’ gauntlets. Call that strategy with tactics intact in the subtle message department even as Chinese firms pursue deals abroad with abandon.

As for the deception aspect of this tentatively tenuous trade war, look no further than the basket the China Foreign Exchange Trade System (CFETS) uses to “manage” the exchange rate of the yuan on a trade-weighted basis.  Manage is in quotes as the basket is but one factor deployed to set the rate. Brute force is the other, as in onshore swings in the spot price of two percent in either direction are simply not permitted. It’s no coincidence that the basket was born in December 2015 as the Fed was raising interest rates for the first time in nine years. The driving force behind the establishment of the basket was the creation of a mechanism by which the yuan can eventually decouple from the dollar.

Where does the deception come in? At birth, the dollar’s weight within the basket was 26.4 percent. Bear in mind, it’s only been three months since the IMF granted China entry into the special drawing rights (SDR) club of big boy currencies; the yuan joined the dollar, the euro, the yen and the British pound. Hence the market’s surprise at the CFETS’ December 29th announcement that the original basket of 13 currencies would be expanded by an additional 11 currencies. Oh, and the new and improved basket’s dollar weighting would be reduced to 22.4 percent.

The stated motive for the move is to better maintain stability against the dollar, which is on a tear and against which the yuan sits at an eight-year low. In telling fashion, a good number of the basket’s new additions are currencies over which China holds great sway. Of course, China can also take more traditional routes to exert control such as relaxing its banks’ Loan-to-Deposit ratio and cutting the Required Reserve Ratio.

“China has many counteracting levers at their disposal to fend off bomb-throwers,” Azous added. “What professional investors have learned over the years is China can remain irrational longer than they can remain solvent trying to fight them. It’s more prudent to hedge tail risk and monitor

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