Our Take On The China’s Currency Move: More About Rebalancing Than Devaluation by Bryce Coward, CFA, Gavekal Capital
China has seen better days. Its economy, while far from falling off a cliff, is in the midst of a generational rebalancing act whereby it must simultaneously cut the rate of investment growth and raise the rate of consumption growth. If it fails to do the former it will find itself in an unmanageable debt situation. If it fails to do the latter then the level of GDP growth will fall to far and China will have the dreaded “hard landing”. Most of the high frequency data suggest that the economy is slowing and is much weaker than its been at any point since the Great Recession. The just released retail sales, industrial production and trade numbers were categorically on the weak side. While loan growth continues at a rapid pace (up 15.7% YoY), a higher number than we’d like to see given the need to reduce the growth rate of hard asset investment, actual completed growth in fixed assets is at the lowest level since the early 2000s, which is actually a good thing (charts 1 and 2). Rebalancing an economy the size of China is a monumental task, and there of plenty of winners and losers. One of the necessary side effects is a lower growth rate of the economy as a whole, and this is what China is trying to manage at the moment.
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Given all that, it seems almost obvious that China would want to devalue its currency in order to provide some relief from the painful process. Indeed, competitive devaluation would be a sure fire way to juice the industrial and export sectors and create some much needed inflation in the process. We ourselves pointed out in February the almost irresistible incentive devaluation in China. However, other than the fact that China wants a seat the table with the US, UK, France, Germany and Japan and it knows that competitive devaluation will delay that day for long time, China also knows that competitive devaluation is counter productive to its stated goals of rebalancing its economy and liberaizing its financial system. There are at least three reasons for this:
First, China has already made process towards reducing the share of investment and increasing the share of consumption in its economy and a competitive devaluation would undo much of that progress. As of the end of 2014, China had successfully lifted consumption as a share of GDP from a low of 36% in 2010 to 38%. Investment as a share of GDP fell from 48% in 2013 to 46% in 2014. While there could be a decade left of further adjustment, this is definitely progress and it was hard earned. In this respect a competitive devaluation would have the effect of suppressing consumption as a percent of GDP, and reversing the progress that’s been made.
Second, Chinese companies in aggregate have a lot of debt and a good chunk of that debt is denominated in US dollars. Estimates for the amount of US dollar denominated debt vary, but one prominent firm just put the number in the $1.1tn range. A massive devaluation would make that debt harder to repay and would decimate industrial/cyclical companies who have piled on the leverage over the last few years at a far faster rate than consumer, health care, or technology related companies. In an ironic way, the very sectors that would benefit the most by a devaluation from an income statement perspective are the same ones that would be hurt the most from a balance sheet perspective. To help illustrate this, the next two tables show the aggregate annual sales growth of CSI 300 companies broken out into industrial/investment/energy related companies and consumer/tech related companies. In the first table showing the industrial/investment/energy related companies we can see that the liabilities have continued to pile on even as the rate of sales growth has slowed, implying a lot of leverage buildup. In the second table showing the consumer/tech related companies, we see that liabilities and sales have grown in lock step over the last decade, implying not much leverage buildup.
Third, one of the key ingredients to creating a truly open and accessible financial market is having a semblance of a freely floating currency. Without a fair price for the external cost of money (currency rate) that companies and investors use to determine asset allocation decisions, misallocation of capital is inevitable and will continue indefinitely. China has already made a number of small – but significant in aggregate – steps in the last year to improve the allocation of capital within the country. These include the liberalizing of domestic interest rates and the opening up (if even to a small degree) the local stock market to foreign investors. Competitive devaluation would make these reforms all for naught.
Instead, what China appears to have done with its currency this week is undergo another small, but symbolically reform that when combined with further action may well lead to real change. The yuan’s initial fall versus the US dollar should not be a red flag (pardon the pun) for investors. After all, the yuan has appreciated markedly versus pretty much every major currency over the last year as its link to the US dollar dragged it higher. And this at a time when the Chinese economy has both slowed massively and continued its lengthy process of adjustment. Local interest rates have even been cut multiple times in China this year while the Fed is talking about raising rates and foreign exchange reserves have been declining, implying capital wants to leave China. If anything, we should expect the yuan to fall versus the dollar based on economic fundamentals alone, and a lot more than 4%. The mere fact that the PBOC has regulated that decline thus far implies its intention is not a 30-40% competitive devaluation a la Japan or Europe, which is what would be needed to give China a real shot in the arm, but rather a slow adjustment toward a more market oriented rate, and that is good news, both for China and for investors.
The trick as an investor is to embrace this further evidence of reform rather than trying to fight it tooth and nail. This means making intelligent allocations that overweight companies likely to benefit from the Great Chinese Rebalance and underweighting those likely be hurt from it. To achieve this most likely requires straying from typical market capitalization weighted investment products or products that focus on dividend yields in favor of products that have overweight allocations to the fastest growing areas of the economy including the consumer areas, health care, tech, and high end manufacturing. The Gavekal Knowledge Leaders Emerging Markets Index and the Gavekal Knowledge Leaders Developed World Index do both of those things.