Everyone's Favorite China Bet: A Cheaper Yuan
Gordon G. Chang ,
Where are they going?” Tom Keene asked Geoffrey Yu of UBS Wealth Management on Bloomberg Surveillance late last week, referring to the Chinese central bank. “I can’t get a handle on that.”
This year, Beijing has adopted every currency policy in the book, pushing the renminbi stronger, driving it lower, and trying to hold the line.
As Keene’s comment suggests, there has been some confusion in the market as to what Beijing ultimately wants for its beleaguered currency.
Yet there is a consensus slowly emerging that the People’s Bank of China, the central bank, is willing to let the yuan weaken, so it will probably fall during the remainder of this year. Beijing thinks it can control the descent, but that appears optimistic.
One thing is clear. The central government is trying to reassure. Embattled Premier Li Keqiang has, this year as in the past, said China would keep the currency at a “reasonable” level.
This month, Vice Finance Minister Zhu Guangyao, speaking to CNBC, said China had no reason to devalue. “With strong economic fundamentals, we believe the renminbi will continue to keep stability,” he said.
Zhu’s words were not especially comforting, however. As evident from Q2, China’s fundamentals are weak. The official National Bureau of Statistics reported 6.7% growth for the period—the same rate as Q1—but underlying numbers suggest a far weaker expansion.
Tellingly, electricity consumption, still the single most reliable indicator of Chinese economic activity, rose only 2.7% in the first half according to official data.
Imports and exports, figures harder to fake because they can be cross-checked, tumbled. For the first six months of this year, exports fell 7.7% and imports 10.2%.
For an economy that grew fast, there was almost no price pressure. The Producer Price Index, measuring factory-gate prices, was down 2.6% in June, the 51st-straight month in the red. The Consumer Price Index was up 1.9% last month, but if it were not for food the measure would have been flat.
Moreover, the indefinite suspension of the China Minxin Purchasing Managers’ Index, tracking small- and medium-sized businesses, is an indication that Beijing has become extraordinarily sensitive about the direction of the economy.
Capital Economics estimates 4.5% growth last quarter, but even that number could be high. In any event, the highly respected firm has hinted China’s lack of volatility is suspicious. As Mark Williams, its chief Asia economist, says, “The country’s official growth rate has been uncannily stable from quarter to quarter and the speed of growth that it points to is increasingly hard to believe given the clear structural drags that the economy is facing.”
So if fundamentals are as weak as they appear, Zhu’s apparent confidence is misplaced. When he says Beijing “will continue to reform the exchange regime of renminbi to reflect the market situation,” he could be signaling the currency will fall.
That’s what an increasing number of analysts think. As Bloomberg notes, “bears argue that China’s leaders are growing more comfortable with yuan weakness after a 3.3% slump since March failed to spark a repeat of January’s market turmoil.” Jason Daw of Societe Generale believes Beijing policymakers are now emboldened “to push the limits of depreciation.”
How far will the redback fall? David Woo of Bank of America Merrill Lynch, whose favorite trade is betting against the renminbi, predicts seven yuan to one dollar by the end of this year. “Seven is going to be a psychologically important level for households,” UBS Wealth Management’s Yu told Keene.
On Friday, the yuan in China closed at 6.6350 to the greenback.
As the currency approaches seven, we can expect the central bank to step up support to avoid a breach of that level.
Yet Beijing, when it begins its support efforts, will then face a dilemma. Unprecedented debt creation this year has not triggered the growth the economy needs, and this failure has forced Beijing to let the currency fall to jumpstart an expansion.
Yet a falling currency will undoubtedly cause even more capital outflow as holders of renminbi, both domestic and foreign, rush for the exits. To staunch the outflow, the central bank will have to go back defending the currency.
There are, however, limits to what Beijing can do to support the currency, at seven or at any other number. Defending the renminbi means buying it with dollars or other foreign currencies. In either case, the result is monetary tightening. Tightening could lead to lower growth—or none at all.
“I don’t think they can afford any more policy mistakes and they know that because the margin for error is just basically non-existent anymore at this stage of rebalancing,” Yu told Bloomberg’s Francine Lacqua, referring to Chinese currency policy.
Yu’s right, of course. China is now boxed in: every stimulative move carries greater risks than potential rewards. So letting the renminbi fall is potentially dangerous, but that is what Chinese technocrats are in fact doing. In June, the central bank appears to have intentionally drove down the yuan, and now it is letting the market do the rest.
Bloomberg says the central bank has ended its “war” with the “Yuan Bears,” so now we will find out if holders of the Chinese currency will, as I expect, convert to dollars and send money abroad.
Why should Beijing worry about accelerated capital flight? In the first quarter, there was $123 billion of net capital outflow according to Goldman. In May, outflow amounted to only $25 billion. Yet the technocrats should be concerned because the flow outbound almost doubled in June, reaching $49 billion according to the bank’s figures.
Citigroup Global Markets estimates net capital outflow amounted to between $281.7 billion and $286.6 billion in the first half.
Citigroup also predicts full year outflow of $573.2 billion. A little dose of pessimism, caused by a perception that the PBOC has made a bet and is no longer defending the currency, could balloon second-half outflows.
This could, therefore, be the last bet that the People’s Bank of China ever makes.