Evergreen Virtual Advisor – China: What Happens When A Dragon Flaps Its Wings? by Evergreen GaveKal

“The world economy is like an ocean liner without life boats.”

– Senior HSBC economist, Stephen King.

What Happens When a Dragon Flaps its Wings?

Have you ever heard of the butterfly effect?

It’s the idea in chaos theory that small events in a complex system can result in big changes over time. A butterfly flapping its wings over the Puget Sound can supposedly set a series of events in motion that ultimately hurls a Category 3 hurricane onto the shores of South Louisiana. Or a flock of seagulls flying over the beaches of Brazil can trigger a freak snowstorm in Tel Aviv. In other words, events that appear trivial can change the course of history.

China: What Happens When A Dragon Flaps Its Wings?

The idea that seemingly small events can have big impacts is particularly relevant in financial markets. As the Bank of England’s Chief Economist, Andrew Haldane, outlined in a recent speech, the global financial system is not a classic complex, adaptive network. It’s a complex, adaptive “system of systems” with an entirely different risk distribution.

As a result of all that complexity, extreme events tend to occur far more frequently than most investors expect. “A four-standard deviation event—a true catastrophe—would under a normal distribution be expected to occur roughly every 15,000 years,” Haldane explains. “Under the estimated distributions for economic and financial systems, such an event would occur every 10 to 15 years.”

Contrary to our recent experience in what my friend Ben Hunt calls the “Golden Age of the Central Banker,” it doesn’t take much to upend the markets in a highly leveraged, highly interconnected “system of systems”… not to mention a system of systems which have all been distorted by years of easy money. Don’t get lulled into complacency, my friends. The fact that it’s been nearly seven years since the last true financial panic should make us more—not less—vigilant about the growing risks. The illusion of stability can’t and won’t last forever. It just takes the right catalyst—the likes of which often seem insignificant until months or years down the road—to usher in a new era of profound instability.

With all that in mind, let’s get back to the butterfly. If a flock of seagulls or a tiny insect can cause such a ruckus, what happens when a dragon flaps its wings?

I think we’re about to find out…

The People’s Bank of China (PBoC) shocked the world last week when it abruptly devalued its currency and introduced an ostensibly more market-driven protocol for guiding the exchange rate over time. Chinese currency policy may seem like an insignificant or overly-esoteric topic to discuss in this week’s EVA, but please bear with me. The un-anchoring of what has been Asia’s most stable currency may be the most important macro event of 2015, and it could have enormous implications for your portfolio.

Beijing has kept a firm grip on the USD/CNY (US dollar/Chinese onshore yuan) exchange rate in recent years by forcing the markets to trade within a narrow band around a midpoint set each day by the PBoC without respect to market forces. For all practical purposes, this protocol has kept the Chinese government in control of the onshore exchange rate (CNY). That perceived stability has generally kept speculators at bay despite significant deviations from the market-driven offshore exchange rate for the Chinese currency (CNH).

As a quick aside, Beijing launched the offshore yuan (CNH) in 2004 as part of an early effort to internationalize China’s renminbi (RMB), which includes both the CNY and the CNH. In addition to a growing list of Hong Kong-offered financial services denominated in the freely-traded CNH, the marked-driven offshore yuan has become the backbone of the rapidly deepening “dim-sum” bond market. This rising demand is keeping interest rates low relative to mainland rates and also encouraging foreign borrowers to finance their operations in yuan, facilitating its widespread adoption as a trade currency.

Beijing eventually plans to reunite the offshore and onshore currency markets into a freely-floating RMB which, within the next few years, will hopefully boast enough global demand to function as both a trade and a reserve currency. In theory, such acceptance would grant the PBoC the exorbitant privilege of expanding its balance sheet in line with growing demand… a huge advantage for a debt-burdened country that needs to finance a Eurasian version of the Marshall Plan (the New Silk Road Economic Belt & 21st Century Maritime Silk Road) in order to boost its potential GDP growth in the coming years. Of course, it would help if the International Monetary Fund (IMF) would lend a little credibility to that cause by including the RMB in its Special Drawing Rights (SDR) basket of reserve currencies sooner rather than later.

That’s why last week’s announcement was so important. While Western media outlets continue to obsess over the multi-day fall in the CNY’s value (admittedly the largest since 1994, but still quite small compared to the recent moves in other currencies), the big story is the new protocol governing the CNY exchange rate.

Rather than arbitrarily fixing the onshore currency’s midpoint each day at a level of its own choosing, the PBoC now anchors each day’s trading band in line with the previous day’s closing price. While daily moves in the USD/CNY are still limited to 2% in either direction, Beijing is sending a message to the world that the market now plays a decisive role in determining the exchange rate’s ultimate direction… as long as you keep in mind that Beijing is often the most dominant player in the CNY market.

Considering PBoC official Zhang Xiaohui’s comments last Friday—that “the one-time total depreciation of around 3% is largely finished” —it would be easy to think that the CNY slide is over. But there is no guarantee that Beijing will continue to intervene indefinitely in the CNY market as it did last week. China has decisively moved toward a more market-oriented structure at a time when outflows have been accelerating. Moreover, considering Beijing’s confidence-killing response to its falling stock market last month, it’s unlikely that foreign capital will pour in anytime soon to offset domestic money already headed for the door.

With $3.6 trillion in foreign exchange reserves, the PBoC certainly has the resources to hold the line on China’s onshore exchange rate. But who knows what will happen if and when capital outflows accelerate? A major depreciation over time is certainly possible. Yet, even if Beijing chooses to maintain CNY stability in the face of tremendous outflows (which would only empower President Xi Jinping’s critics within the Chinese Communist Party), the mere possibility of further depreciation in China raises the probability of more competitive devaluation somewhere in the world (in fact, this week we’ve seen exactly that in Vietnam and every tourist’s favorite vacation spot, Kazakhstan). This could occur at the very moment that the Federal Reserve looks to raise interest rates.

Make no mistake, China has just changed the game in a thousand ways that are not entirely straightforward. While a 3% devaluation in the USD/CNY exchange rate is not the kind of global deflationary

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