For several months now, I have been hearing stories about the risk of capital flight and capital outflows out of China. At the same time, perhaps as a result of these outflows, traders have recently been trading CNY/USD at the upper end of the 2% band instituted by the People’s Bank of China, suggesting acute renminbi devaluation. Now that the PBoC has decided to institute a new currency regime that takes these market forces into account, a substantial depreciation in the Chinese currency is virtually guaranteed.
As I wrote yesterday, the Chinese have had tight control of their currency via a fixed but crawling peg to the US dollar. They have set a daily rate that has steadily seen the renminbi appreciate significantly in value versus the US dollar. In fact, Albert Edwards estimates the real effective exchange rate of the renminbi has appreciated 50% over the past ten years. This has created a problem for the Chinese. For simplicity, let’s call the problem a Lewis Turning Point, the point at which the supply of excess rural labour is exhausted and wage pressure mounts. Here is a recent FT article on this matter.
I first broached the Lewis Turning Point topic in 2010, writing that, “from a Chinese domestic perspective, the Lewis Turning Point will crater productivity levels as wage rates rise. The corollaries of this increase in wages and lower productivity are slower GDP growth, higher consumption, lower savings and a deteriorating external balance of payments aka current account deficits.” At that time, China was in full-on reflation mode, taking over the role as the global marginal buyer of last resort from the US and the threat was wage and price inflation. Arguably the wage and price inflation did come to pass, acting as a major factor in the worsening terms of trade for Chinese exporters and helping the real effective exchange rate to appreciate significantly.
By late 2011, Chinese wages were uncompetitive and the country was losing out as a low-cost manufacturer. Yet this trend continued. The BBC noted late last year that wages in China were rising the fastest in Asia at 9% annually, even as Asian wage growth outpaced the rest of the world. The result has been two-fold. First, there is a great need to rebalance the economy above and beyond the desire to reduce malinvestment from excessive reliance on export- and infrastructure investment-led growth. The low-cost manufacturing trick was no longer viable given the wage pressure. Second, the increase in the real effective exchange rate eroded growth rates, something now exacerbated by rising non-performing loans and reduced credit growth. Given these factors, a downward shift in China’s balance of payments and pressure on the currency was inevitable.
At this point, capital outflows have reached an annualized level of nearly $1 trillion. In a sense, this is a balance of payments crisis – as Albert Edwards puts it in his weekly note from earlier today. And a balance of payments crisis means that the impossible trinity of a relatively fixed exchange rate becomes incompatible with China’s goal of a more liberalized flow of cross-border capital and an independent monetary policy. The fact is China’s monetary policy stance is at odds with the Fed stance. Thus, without currency depreciation capital outflows will continue and increase.
As a result, the renminbi has been consistently bumping up against the weak side of the daily FX fix band, meaning traders are signalling that the Chinese currency is overvalued. Yesterday I wrote that the PBoC has finally taken these signals onboard in devaluing the currency. But the PBoC is doing something far more significant; it is now saying that it will always take market forces into account regarding the daily fix. And we saw what that means just today because the currency pressure has persisted, forcing the PBoC fix 1.6% lower, even after a 1.9% decrease the day before. This is clearly a major paradigm shift – one that suits the Chinese of course – as it means a move from a relatively fixed exchange rate to a depreciating one, given the overvaluation of the Yuan.
Moreover, the PBoC had indicated that the devaluation move was a one-off move. We now see this simply isn’t true except in the strictest sense. The PBoC can claim the first move was a devaluation and every subsequent move is a price fix adjusted to accommodate market signals. But given the likely one-way movement in the Chinese currency, we should consider the possibility that we are about to see a major competitive currency devaluation – something in the order of magnitude that the South Korean Won, the Euro and the Japanese Yen have seen i.e. 10-15% or more.
This would put us in a serious currency war as Asian exporters are already hurting. Malaysia, which is leveraged to energy exports, has seen its foreign reserves fall from about $140 billion to only $100 billion. The Ringgit is thus near a 17-year low as the impact of an emerging markets slowdown takes hold. The prospect of China joining the currency depreciation party is going to put pressure on that economy and create problems for corporates indebted in US dollars.
The most relevant questions at this point are:
- How do the Fed and other political and monetary actors respond?
- What kind of economic and market stress will we see?
- What kind of policy space do we have to deal with that stress?
The Fed could stop its hiking campaign if the Chinese move leads to enough market stress. It’s not clear the Fed will do this. Even so, policy divergence will remain in place to a degree since the Fed would still have a tightening bias.
And then we should expect more downward pressure on commodities, emerging markets and energy high yield. Oil and commodities are already in bear markets. And EM currencies are at 15-year lows. EM equities are now officially in a bear market as well. And now the energy high yield rout is metastasizing into an overall high yield market downturn with average yields ex-energy now above 6% for the first time this year. Given this already difficult environment in several different markets, the potential for a crisis is heightened. And in a crisis, the weak sell what they can, meaning often unrelated but liquid assets go up for bid, creating contagion.
The big problem is that we are already at zero in the US. Even if the Fed doesn’t raise rates, it can’t lower them. And in a crisis, the US dollar is a safe haven asset that rises. That means lots of pain for those with dollar liabilities and insufficient dollar income, forced deleveraging and a crisis in Emerging markets at a minimum. The deflationary impulse from China will make this a lot worse. Currency swap lines from the Fed can help but not that much in that kind of scenario. So, I believe policy space is limited. The hope has to be that the downward pressure on the troubled asset classes eases relatively soon.
One last point: China’s policy options are limited here. Given the already high levels of capital outflows, they are loath to reduce interest rates any further as doing so would invite yet more capital to leave China. The currency really is the release valve here and I believe they will use it.