China’s artificial peg is starting to crush its own economy. For a long time China has lived by the sword of its undervalued currency. But now things have changed. The foundations on which it was built rising commodity prices, falling dollar, a growing global economy are all are crumbling.
As I noted back in JANUARY of this year, the Yuan’s artificial peg would create a feed back loop between China and its trade partners. It goes like this: As china slows down, its trade partners like Australia and Canada will also suffer a slowdown. As a result Australia and Canada’s currencies will fall but the Yuan won’t because it’s pegged to the rising dollar. So the disparity between China’s currency and that of its trading partners will continue to grow decreasing demand for Chinese goods which will in turn only worsen China’s economic situation.
To make matters worse, the Fed is threatening the first rate hike in over nine years. Which is what I believe led China to start the process of devaluation. Technically the Chinese haven’t devalued, they are merely lowering the level of support they’ve previously given to the Yuan. And yet, they’ve still managed to burn through $100B in US treasuries in the past 2 weeks alone. There’s some irony here because the Chinese don’t want the Fed to hike rates but via their long term treasury liquidation the Chinese are forcing long term interest rates higher.
What is most interesting about this whole scenario is that the PBoC is doing everything in its power to defend the yuan’s peg to the dollar. Which begs the question why? Why waste important resources (FX reserves) defending what seems like an indefensible position? Why not just let the market take over? Well the obvious answer here is pain, not just for the average Chinese person whose wealth would evaporate in an instant but to the Chinese corporations that have borrowed over $1 trillion to finance their operations. That trillion isn’t in yuan, it’s in dollars, meaning the Chinese corporations have to pay back their debts in dollars which unfortunately is not the currency they operate in. Any significant devaluation would send most of these companies into default and the country into a recession. Obviously this is not something the Chinese government wants.
So for now the PBoC seems content with selling long term US treasuries to defend its peg. It is important to consider the knock on effects of such a strategy. The most obvious is in the short term, higher US interest rates, which for those holding long term treasuries will certainly make you a little queasy. Higher long term interest rates will hurt the middle to lower end of the housing market since it will be harder for people to get mortgages. I’m not sure how much this matters as the high end market seems to be what really matters. Especially as foreign money continues to funnel in the US. But with the US economy growing at 3.7% in the 2nd quarter it seems like there’s a good chance (>50%) for the Fed to hike rates in mid September.
Will it happen? The Fed has a history of being gun shy and three weeks is a long time for things to go wrong, especially in this environment. If the Fed is insistent on hiking rates, the global equity and bond markets which are already on a knife’s edge will suffer in the run up. I’ve already stated that if the Fed does hike, the world will quickly fall into a recession. So let’s assume they don’t hike which is what a lot of people are assuming (praying). Will it be enough to out shine the shadow of a Chinese collapse? Short answer is no, but I think there will be a strong but short lived rally due to the intense anxiety market participants have over the upcoming decision. That’s it for now.