Last Sunday (31 January) Zero Hedge ran an article drawing attention to the big names in the hedge fund community who are betting heavily that the yuan will suffer a major devaluation any time between the next few months and perhaps the next three years.
The impression given is that this view is universal, almost to the exclusion of any other.
A market cynic would point out that when everyone is short, there is no one left to sell, so it is a good time to buy. This may indeed be true, and gives the Chinese authorities the opportunity to squeeze the bears mercilessly should they so choose. However, as Zero Hedge points out, some bear positions are in the form of put options rather than naked shorts, so hedge fund losses in this case would be limited to option money if the trade goes wrong. Instead, whoever sold the options to them will ultimately absorb the losses to the extent they have not hedged their corresponding positions in turn.
The advantage of buying long-dated OTC put options is that you can wait for a financial strategy to come right. The motivation for buying them is therefore less to do with market timing, and more to do with economic expectations.
At its simplest, the common view appears to be that China is suffering from the debt problems that follow an excessive expansion of bank credit, the unwinding of which is expected to lead to crippling deflation. This view is variously informed by the findings of Irving Fisher in his analysis of the 1930s depression, and perhaps the Austrian school’s description of credit-driven business cycles thrown in. To these can be added the experience of modern credit bubbles, particularly the aftermath of the sub-prime crisis of 2007/08, which remains fresh in hedge-fund managers’ minds. It amounts to a rag-bag of impulsive thought, and consequently it is assumed a large devaluation will be required to reduce the prices of China’s exports, so that China’s labour force will remain competitive and employed.
There are many empirical examples that disprove the idea that devaluation is the route to export success, so it is something of a mystery why it should be seen as a certain outcome for the yuan. The root of the idea that devaluation for China is an economic cure-all is the supposed improvement it gives to the balance of trade. And here the mystery deepens, because the fall in prices for imported commodities has actually increased China’s trade surplus, so much so that the trade surplus for all of 2014, which was $382bn equivalent, was exceeded by just the last seven months of 2015, while at the same time the economy was supposed to be collapsing. The total trade surplus for 2015 at $613bn was a record by a very large margin. A devaluation is definitely not required on trade grounds.
Instead, China’s trade surplus is a secure platform from which to pursue market-based reforms. And here the objective is more about permitting the population to build personal wealth, increasing the numbers of the middle class instead of destroying it. This is an alien concept to western macroeconomists, leaving them uncomfortable with their anti-market, pro-interventionist ambitions. They have a monetarist and Keynesian notion that devaluation counters the price deflation they think China faces, encourages moderate inflation, and stimulates animal spirits. This depends on the broad question as to whether or not a retreat into monetary manipulation actually solves anything, and more importantly, whether or not the Chinese authorities also believe in these theories.
The Chinese authorities appear to show little interest in fashionable macroeconomic suppositions. Instead, the leadership’s motivation runs counter to western political thinking. China is made up of over forty different ethnic groups, which without a strong central government, would probably be at each other’s throats. Western-style democracy would simply lead to civil war and a disintegration of the state, as evidenced elsewhere in Iraq, Afghanistan, Egypt, Libya and now Syria. It is for this reason that the state communist party ruthlessly suppresses all political discord.
The Chinese leaders know that political oppression can only work if it is not in the masses’ economic interest to oppose their government. For this reason, they use the market to enhance individual wealth, and are acutely aware that a failure to better the people’s condition risks fomenting dissent. Economic factors align the leadership’s interest with those of the people, not democratic representation.
This is what drives economic policy. The leadership is mercantilist in its approach, rather like the East India Company when it ruled India. Individuals working with John Company, as it was known, had the opportunity to accumulate great fortunes, and if they survived the diseases and fevers, these nabobs returned home to Britain and became landed gentry. The elite in China is motivated in a similar fashion and are conditioned on loyalty to the state and its commercial objectives.
This forms the basis of the cycle of five-year economic plans, which can be regarded as the equivalent of business plans, something unknown in western politics. The thirteenth version commences with the year of the monkey on Monday, the full details of which are due to be released in March. We already know that it will tell us how production will be directed to improve the earnings and the standard of living of the lowest paid workers. Greater controls will be imposed on pollution and the use of water resources. The internet will be accorded greater economic resources within the “Internet Plus” project. Social insurance will be increased and extended towards better healthcare and pensions. And lastly, financial reforms will continue to liberalise markets.
What will not be mentioned in these plans, which are for domestic consumption, is geopolitics, the financial war between China and America. It is this aspect of China’s future about which the hedge fund managers seem woefully ignorant. And it is a bad mistake to ignore the importance of geopolitics to both China and America, because it has the potential to have a far larger effect on the CNY/USD exchange rate than anything else. If there is any doubt in the reader’s mind that there is a financial war being waged, it is worth reading in its entirety a speech given last April by Major-General Qiao Liang, the Peoples Liberation Army strategist. There is a translation here. Of the many quotes available the best one to show why financial power is seen by the Chinese to supplant military power is the following:
“A few strokes on a computer keyboard can move billions or even trillions [of dollars] of capital from one location to another. An aircraft carrier can keep up with the speed of logistics, but it can’t keep up with the flow of capital. It is thus unable to control global capital.”
It is appropriate at this juncture to make a simple observation: you do not win a financial war by undermining your own currency. Instead, you should undermine the enemy’s currency.
This is precisely what China is doing to the dollar. Last year China elevated her currency’s standing on the world stage by forcing the IMF, against America’s will, to include it in the SDR basket. This year she plans to establish gold and oil contracts priced in yuan, two key commodity markets which Chinese demand now dominates. China has also established the Asian Infrastructure Investment Bank to act as the financing arm for an Asia-wide industrial revolution, to be spearheaded by China. She has successfully replaced, for the purpose of this trans-Asia project, the various multinational organisations set up in the wake of the Bretton Woods agreement.
So 2015 was the year when China did the groundwork to replace the dollar throughout Asia, the Middle East and North Africa, as well as sub-Saharan Africa, which she also dominates commercially. 2016 will be the year when the dollar finds its hegemonic status is increasingly confined to the Americas, Western Europe, Japan, diminishing parts of South-East Asia and western financial markets.
This brings us to another consideration ignored by the US-centric hedge fund community: the dollar itself is likely to take a big hit in 2016. Besides the damage inflicted by the internationalisation of the Chinese currency and the loss of hegemonic status that it imparts to the dollar, deflationary forces are increasing in America’s domestic economy, because it is suffocating under a debt burden now too great to bear. The analysis hedge funds are applying to China would be more appropriately applied closer to home, and in this case the Fed will probably seek ways to devalue the dollar to counter a gathering slump. And unlike China, which has a record trade surplus, the US has an increasing trade deficit.
American monetary policy is failing, and the Fed is on the back foot. China meanwhile has a plan, and that is to redeploy labour currently making cheap price-sensitive goods for America and elsewhere. The low-end of the labour force will be retrained and re-employed into both higher-value production and in the development of infrastructure on an Asia-wide basis. Asian development will be spearheaded by the yuan as the common currency for cross-border settlements.
In summary, a significant devaluation for the yuan is neither necessary nor desired by the Chinese authorities. The announcement that China will start targeting the yuan against a basket of currencies and not the dollar is consistent with the strategy of undermining the dollar’s value. With dollar reserves accumulating at a record rate because of the trade surplus, China should have no problem maintaining a yuan rate of her choosing. If anything she will seek to dispose of dollars on the basis they are over-valued relative to the commodities she needs for the future. China will sell her dollars not to protect the yuan, but to dispose of an overvalued currency.
A most interesting take, Alisdair and in terms of the Chinese leadership’s intent, I suspect you’re about right. The larger question may be whether their best intentions will be run over by events.
It seems to me they face two related challenges. Firstly, as has often been written about here, the unprecedentedly rapid increase in debt has left China with achingly large imbalances and structural fragility, neither of which is easily solved. Secondly, the economic ructions likely to flow from these handicaps could easily fracture whatever internal consensus and confidence exists. Capital flight, if sufficiently motivated by fears of the future, won’t be easy to control and attempts to do so seem likely to conflict with China’s desire to internationalise the yuan.
Perhaps the Chinese leadership can defuse these two booby-traps, while at the same time enabling the necessary change from a mercantilist investment driven economy to a more balanced one. If they do, without first having to endure a period of chaotic retrenchment, it will surely rank as an historic tour de force.
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