Yuan Falling After Inclusion: Coincidence?

It took a while, but 15 years after China’s inclusion in the WTO, China was able to add another notch on its geopolitical belt with the inclusion of the Yuan into the SDR and its official acceptance as a reserve currency. One can assume that this event will strengthen the Yuan, but over what time horizon? Barring, the dissolution of China, there is little doubt that the Yuan will be an important currency in the decades to come, however, we are investors and do not have the luxury of such time scales.

To just say, the Yuan’s reserve currency status will lead to a marginal increase in short term demand, is not out of the question. But once again, fails to see the forest through the trees. Certain funds, and foreign demand may rise slightly in the short term, and all else being equal, the Yuan would strengthen. But is it wise to assume “all else being equal” given a historic paradigm changing event?

I would think not. China has been artificially holding the Yuan steady to “prove” to the world that its currency is stable. Now that they have done that, and received their prize, the incentive to continue doing so, no longer exists. Well now that’s not entirely true, but all else being equal… Just kidding.

In all manner of seriousness, there are certain costs and benefits to holding the Yuan steady, and while the SDR inclusion was on the table, the benefit outweighed the cost, I argue now, that is no longer the case. The SDR inclusion was a big carrot, and with that gone the scales have tipped towards devaluation, and volatility.

For one, the big item of the day, is Chinese exports, which fell quite dramatically in September, 10% YoY. In essence, because China has been holding its currency up, it has allowed other nations to eat its growth. With the financial and economic situation as dire as it is in China, the authorities will no longer tolerate such policies.

Let’s not forget the key threshold of 6.70 USDCNY that Beijing had held since the Brexit. Before the 6.70 threshold, the PBOC targeted liquidity conditions, keeping O/N SHIBOR below 2.06%. The fact that they allowed liquidity conditions to tighten in favor of holding the Yuan steady, just shows how important a stable currency was to them. SHIBOR was certainly spiking quite sharply, and the authorities had to do something, but the fact that they waited till after the Yuan’s inclusion in the SDR tells us a lot.abook-oct-2016-china-shibor-cny

However, China’s problems don’t end with the Yuan. Even with liquidity drying up, the Chinese property bubble pushed higher, further confounding regulators who felt powerless to stop this potential systemic crisis. To show you how serious Chinese regulators are, they have teamed up Avengers style to stop the problem:

“The event included a phalanx of speakers in addition to Wang: People’s Bank of China Deputy Governor Fan Yifei, State-owned Assets Supervision and Administration Commission Vice Chairman Meng Jianmin, Assistant Finance Minister Dai Bohua and National Development and Reform Commission Vice Chairman Lian Weiliang.

Such multi-agency coordination is one of the bright spots of the initiative, according to Ming Ming, head of fixed income research at Citic Securities Co. in Beijing. “Regulators of banks, SOEs, and industries are all parties with a stake, and should work together to solve the problem,” he said. “Otherwise deleveraging can never be truly realized.'”

With all these problems in China bubbling back up to the surface, it important to remind everyone that the Chinese capital flight story although dormant in the minds of investors never truly went away. According to a recent report by Goldman Sachs, China’s capital outflows this year may be 50% larger than “stated” by the PBOC.

As the market’s fears about a Chinese debt crisis come back to the forefront, any Yuan weakening will force the market into a risk off scenario. The irony of a risk off scenario is the strengthening of the Japanese Yen which has its own set of problems, confounding its own central planners.

It would be interesting if the PBOC was successful in forcing Japanese investors to stay in JGBs, which is exactly what the BOJ does not want. The BOJ with its yield curve target, would not be able to buy certain bonds, and may even have to taper its purchases altogether. Obviously this would be a tightening of sorts, possibly strengthening the Yen even further. Let’s not forget the havoc this would cause to the Japanese banking system.

If we go back to Brexit, the two countries most concerned about the Brexit were actually China and Japan. These Asian nations seem to be the only major countries that have a realistic grasp on the systemic nature of the global debt bubble. The free falling pound has proven their worst fears and to anyone thinking this series of events are actually unrelated coincidences fails to see the forest through the trees.



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