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 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 losing support within the Party. From that perspective, George explains that “it is only possible to understand [recent] economic, exchange rate, and equity market developments in the context of the [anti-corruption] campaign.” Why? Because, contrary to popular belief, economic and financial market reform in China is not a foregone conclusion, and as George aptly points out, “the latest developments… may imply that those most enthusiastic about reforms are now on the back foot.”
Beijing may have just taken a legitimate reform-oriented step toward RMB internationalization; however the same move may ultimately prove to be an anti-reform step toward further “Fed-induced” devaluation in the wake of a US rate hike. Fortunately (or perhaps, unfortunately) the enormous cost of maintaining RMB stability under the current structure implies that we will know a lot more about Beijing’s intentions sometime this fall. While the People’s Bank of China can keep burning through $10 billion a day to prop up its currency for several years, Party politics will likely force Xi to make a more decisive move in one way or another before too long. If Beijing’s eventual response to its collapsing stock market is any indication, they may soon throw up their hands and let the RMB fall. At that point, China’s currency becomes our problem.
At Evergreen GaveKal, we see this as a good time to be defensively positioned, to wait for clarity, and to prepare to buy into the deep dislocations that are now virtually inevitable in some corner of the world.
The Three Options For Renminbi Policy
Chen Long, GaveKal Research
In the three weeks since its abrupt -3% devaluation, the renminbi (RMB) has reverted to a remarkably narrow trading range against the US dollar. However, this rediscovered stability does not reflect any market belief that the renminbi is now appropriately valued following its modest fall. On the contrary, it is the result of heavy intervention by the People’s Bank of China (PBOC) to keep the onshore spot rate steady at around CNY6.4 to the US dollar. In the near term, this fits with policymakers’ assertions that China’s exchange rate adjustment is complete (last week Premier Li Keqiang reiterated this stance, telling a delegation from Kazakhstan that the renminbi will not see “sustained depreciation”). In the longer run however, repeated intervention to maintain the currency’s stability is at odds with the “more flexible exchange rate mechanism” the central bank announced just three weeks ago. This contradiction casts doubt over the PBOC’ s intentions: whether it is serious about moving to a more flexible currency regime, or whether it has simply re-imposed a de facto peg at a different level against the US dollar. As we see it, the central bank has three options:
- Continued intervention to maintain exchange rate stability. The objective of this strategy would be to reduce market expectations for further deprecation, as participants betting on further renminbi weakness capitulate in the face of the PBOC’s superior firepower. If successful, the PBOC could scale back its interventions, allowing the renminbi more leeway to float freely. The risk for the PBOC would be if its interventions fail to overcome depreciation expectations. In that case, it would have achieved little or nothing by last month’s move, which would neither have advanced exchange rate reform, nor introduced the greater degree of volatility the International Monetary Fund is demanding as a condition for the renminbi’s inclusion in the Special Drawing Rights basket. What’s more, failure would be expensive. With China’s capital account more open than in the past, and the central bank easing policy at home, intervention to maintain exchange rate stability is getting increasingly costly. As daily turnover in the onshore spot market has shot up from US$15bn to US$50bn over the last few weeks, traders estimate that the PBOC and its agents have spent between US$100 and US$150bn of China’s foreign reserves to maintain the renminbi’s exchange rate. Of course, with US$3.7trn in reserves, in theory the central bank can go on intervening for years to come. However, policymakers will gain little by running down China’s reserves at a pace of US$150bn a month. As a result, while the PBOC may adopt a strategy of continued intervention in the near term, say through President Xi Jinping’s visit to the United States later this month, it is not a viable course of action over the long term.
- Cease intervention and allow a sizable devaluation. A large one-off move could have the merit of curtailing expectations for further depreciation. Following a -10% or -15% fall, significant renminbi buying interest would emerge, avoiding the feedback loop of capital outflows that would accompany a gradual depreciation. However, the costs entailed by such a strategy would be considerable. China’s leaders have repeatedly rejected the notion of competitive devaluation, so a large one-off depreciation would be a diplomatic disaster, wrecking Beijing’s currency credibility. Moreover, a big one-off devaluation would inflict severe damage on the balance sheets of those Chinese companies, including many state-owned enterprises, which have borrowed in US dollars without hedging their exchange rate risk.
3. Scale back intervention and allow a gradual depreciation. Chinese policymakers prefer to move gradually whenever possible. Both interest rate liberalization and capital account opening were pursued one step at a time, and when the consensus argued that the renminbi was deeply undervalued, the central bank only allowed a gradual appreciation. A gradual depreciation now would avoid inflicting a major shock on the economy, and so would be politically acceptable. However, there would be risks. A slow and protracted slide in the currency could heighten expectations for further depreciation to come, so fueling self-reinforcing capital outflows—the opposite of the inflows attracted by the renminbi’s long years of slow appreciation. Each strategy has risks. The current “peg and intervene” approach can work for a month or two, but can only be a stop-gap policy. The best outcome for the PBOC would be if its interventions allayed depreciation expectations and renminbi buyers re-emerged. However, that looks farfetched. Of the other two options, a gradual depreciation looks more likely than a one-off devaluation, not because of its economic merits, but because it is politically more acceptable and because experience argues for a gradualist approach. The risk is that it will just reinforce depreciation expectations. What the PBOC really needs at this point is a weaker US dollar, but that of course, is beyond the reach of its policymaking.
Why does that matter? Because high volatility is consistently associated with periods of market weakness. As CNBC’s Bob Pisani breathlessly observed on Monday, “We saw an entire year’s worth of volatility play out in half an hour.” Similarly, my ever-observant partner Louis Gave noted that the S&P swung by a cumulative 4500 points during Monday’s session. Consequently, it’s safe to say something is definitely different about this market. It’s called fear and it’s been MIA for a very long time.
In my opinion, this newfound angst isn’t misguided. Yield-oriented securities have been flashing red for months and, as I’ve conveyed to numerous Evergreen clients, credit market-related issues typically lead the stock market. If MLPs are any indication, this market’s rabbit hole goes deeper than 10%.
China’s Economy: No Collapse, But It’s Serious, & So Are The Politics
George Magnus, Oxford University China Center
For the sake of clarity, repeat three things after me:
- China’s economy is not collapsing
People who have become China experts in the last few weeks, point to the sharp falls in power consumption and freight traffic—two of the three indicators in the now famed Li Keqiang index—but these and other industrial indicators don’t tell us anything about what’s going on in the services or tertiary sector, which accounts for about half of the economy. Even if producers are having a tough time at the moment, consumers of household goods and services and buyers of real estate haven’t gone to ground. Retail sales were still up by over 10% in July, and property sales registered pretty robust year on year increases of over 13% in the second quarter and 19% in July. The government is going to continue to support the economy with infrastructure spending, monetary easing, and fiscal and debt initiatives.
In August, even though the Caixin and NBS PMI data were down, some of the high frequency data could ‘look’ better in year-on-year terms, largely because of flattering base effects following from declines this time last year. The official data are likely to continue to show the economy growing around 6.5-6.8% in annual terms in the next few quarters.
- What’s going on in China is serious
The economy is the fourth year of a structural slowdown that shows no signs of ending and is becoming increasingly insensitive to the government’s stimulus measures. This chart of the manufacturing, services and total PMI indices in August captures the situation well, and points specifically to the fact that the services component, which still shows expansion, isn’t doing enough to offset the decline in manufacturing.
FIGURE 1: CAIXIN CHINA OUTPUT PURCHASING MANAGERS INDEX
Source: Markit, Caixin
As the second half of 2015 unfolds, we should expect the services sector to weaken, largely as the drag from the financial sector (following the stock market plunge) permeates the economy. This could take around 0.5% off GDP growth. The contraction in heavy industry, including metals, chemicals, cement, and power generation, may already have tipped some provinces in the north-east and west of China into a ‘recession’, defined as growth below 4-5%. Manufacturing investment will remain weak not least as a consequence of persistent excess capacity, deflation and debt in the industrial part of the economy.
In spite of the summer recovery in property sales and prices, mostly in Tier 1 cities, and the implied erosion of the overhang of housing inventory, there is next to no prospect that the trend fall in real estate and construction investment will stop. Infrastructure spending and other policy easing stimuli in the first seven months of 2015 may have amounted to about 1.3% of GDP, and so even if we think the official growth data of about 7% are right—which is increasingly questionable—the underlying pace of economic expansion is a ‘high 5’ percent, not 7%.
This graph, showing the decomposition of fixed asset investment, shows that even though infrastructure investment, which is about a fifth, is holding up, it’s not enough to hold up the entire component. And this, after all, is the kernel of rebalancing: a fall in the investment rate that allows the consumption share of GDP to rise—but in the context, of course, of a slower overall growth rate.
FIGURE 2: GROWTH RATE (% YEAR-OVER-YEAR 3 MONTH AVERAGE)
Source: CEIC, UBS Estimates
We don’t know what’s really going on in the Chinese labour market, but the employment component of the PMI has been falling for several months and registered 48 in August, indicating a decline in employment levels. The International Jobs Report, published in January by the IMF in conjunction with the Economist Intelligence Unit estimated that China’s unemployment rate was nearer 6% than the 4% at which official data have been stuck for over a decade. The data are an apparition anyway, because a large proportion of the urban population are migrants who do not have hukou, or urban registration entitling them to social benefits, and the registration for unemployment benefit is in any case thought to be low because the level of benefits is. Given what has happened to investment and construction this year, one could imagine that the unemployment rate has climbed since the end of 2014. This is way more important than GDP from a policy and political perspective, and the more policy is eased, the greater the concern will be about labour market conditions.
- Political tensions are making things worse
What has really set the cat amongst the pigeons this summer is the juxtaposition of a weakening economy, and the cack-handed manner in which the authorities managed the mini-devaluation of the yuan and the frantic attempt and failure to prop up the stock market. I’ve written about this most recently in the Financial Times here, and in the Times here.
The bottom line is that it is only possible to understand these economic, exchange rate and equity market developments in the context of the campaign waged by President, Xi Jinping to bolster the Communist Party’s authority and control. Specifically, the anti-corruption campaign, and the effective displacement of government ministries by so-called ‘small leading groups’, which are Party agencies, which are anything but small.
The benign view is that to strengthen the Party, increase compliance among cadres in the Party and in SOEs and local governments, and get reforms going to correct the imbalances in the economy, Xi had to amass power and centralise it. There is little question that he and his senior colleagues understand they have to implement deep and meaningful economic reforms to unlock new sources of economic growth and productivity.
The risk, as they know even better, is a loss of control. And they fear this more than anything. President Xi’s anti-corruption campaign is weeding out high profile Party misfits, but simultaneously stifling growth and initiative. It is also making an example of so called ‘tigers’—top Party officials—but it is impossible to go after all the ‘flies’—lower level officials, whose misdemeanours (or worse) have a real effect on peoples’ lives. Think only of the recent appalling chemicals explosion in Tianjn, where 11 local government and port officials have been accused of negligence and a beach of regulations, so far.
Xi has also substituted Party small leading groups for government institutions in broad areas of decision-making, undermining the authority of those charged with implementing reforms, and solidifying opposition among vested interests in the Party, SOEs and local governments. During the recent annual leaders’ get-away in the resort of Beidahe, State media reported that the government was facing resistance to reforms on an unimaginable scale. This expression of frustration was indicative not so much of the determination to press ahead regardless with market-oriented reforms and the creation of inclusive institutions, but of factional struggles and the influence in particular of retired leaders and senior Party officials. To all intents and purposes, meaningful reforms of SOEs, and local government finance functions and structures, and a retreat of the State from the commanding heights to make way for the private sector and markets, had already run aground. So, the latest developments are not promising, and may imply that those most enthusiastic about reforms are now on the back foot.
This is what markets and commentators may finally have realised. In this context, though, I was amused to read a current piece by Mohamed El-Erian in the FT’s Exchange blog (China needs to learn how to talk to markets). Specifically the part where he says that as that China ‘engages further on the road of economic liberalisation and broader market-based reforms’, it will have no choice but to become ‘more sensitive to short-term market positioning’ and better at communicating policies and ‘managing market expectations’.
El-Erian is no intellectual slouch, and a very experienced investor, but this is a bit parallel universe. I’m sure he meant to say that China’s mini-devaluation and stock market management were bungled, damaged the credibility of policy-makers, and in future, they need to take more care. Yet, the idea that Chinese policy-makers simply ‘got it wrong’ out of haste or lack of thought doesn’t really square with what’s going on in China. And the notion that leaders will have no choice but to learn about markets and treat them with more respect as they advance with fortitude down the path of economic liberalization is, to put it bluntly, other-worldly.
Our Current Likes And Dislikes
There were no changes this week.
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