Daily Management Review

Is China preparing to maximum devaluation of yuan?


China is a relatively open economy. In recent years, it has been striving to realize the "impossible trinity", receiving quite predictable results.

Since 2008, China has tied its rate to the US dollar. Also, the country implements free flow of capital, which allows free exchange of RMB for dollars. In addition, China prefers an independent monetary policy.

The problem is that the "impossible trinity" implies that you cannot have all three factors at once. This model has been tested several times since 2008, as China faces a number of exchange rate fluctuations, writes James Rickards, financial expert and writer, author of "The Road to Ruin". In the past, he successfully predicted the Fed's policy.

The impossible trinity (also the trilemma of international finance) is a hypothesis in the international economy that it is impossible to simultaneously achieve:

Fixed exchange rate
Free movement of capital
Independent monetary policy

For example, China tried to do the impossible in 2008 with a peg to the dollar of about 6.80. All abruptly ended in June 2010, when China broke the currency peg and allowed it to rise from 6.82 to 6.05 by January 2014.

This exchange rate revaluation was partly explained by the US Treasury Secretary’s complaints on the "currency manipulation" of China due to the artificially low level of pegging to the dollar in the period 2008-2010.

After 2013, China changed course and continued the gradual devaluation of the yuan from 6.05 in January 2014 to 6.95 by December 2016. At the end of 2016, the Chinese yuan returned to the point at which it was once accused of "currency manipulation."

Now, however, there is a new figure pointing a finger at China. The new American critic is no longer a quiet US Treasury Secretary, but annoying Donald Trump.

Trump threatened to declare China a currency manipulator throughout his campaign from June 2015 until the Election Day on November 8, 2016. As soon as Trump was elected, China tried to smooth the growth of tension in the flaring currency war.

China actually maintained its currency with a soft peg. The trading range was particularly narrow in the first half of 2017, around 6.85.

Unlike the 2008-2010 bindings, this time China avoided the "impossible trinity" by partially closing the free flow of capital and raising rates along with the Fed, thus abandoning its independent monetary policy.

This also ran counter to China's behavior when its attempts to reach the "impossible trinity" failed for the first time. In 2015, China did not reach the "impossible trinity", not closing the free flow of capital, and abolishing the currency peg.

In August 2015, China provoked a sudden devaluation of the yuan. The dollar rose 3% against the yuan in two days, as China devalued the currency.

The results were catastrophic.

In a few weeks, US stocks fell 11%. There was a real threat of the global financial crisis and a full-scale liquidity crisis. The Fed managed to prevent the crisis and decided to postpone the "take-off" of US interest rates from September 2015 until next December.

China conducted devaluation from November to December 2015, only covertly this time.

The results were just as disastrous as in August of the previous year. American stock indexes fell by 11% from January 1, 2016 as of February 10, 2016. Again, a larger crisis was prevented only by the decision of the Federal Reserve to postpone planned increases in interest rates in the US in March and June 2016.

By mid-2017, the Trump administration again complained about the Chinese currency manipulations. In part, this was due to the fact that China did not support the US in the argument about North Korea’s nuclear weapons.

For its part, China did not want to unleash a trade or currency war with the US on the eve of the National Congress of the Communist Party of China, which begins on October 18. President Xi Jinping played a soft domestic political game and did not want to rock the boat in international relations. China reassured the US once again, allowing the exchange rate to rise from 6.90 to 6.45 in the summer of 2017.

China escaped the Impossible Trinity in 2015, devaluing its currency. China once again avoided the "impossible trinity" in 2017, using a hat trick partially covering the free flow of capital, raising interest rates and allowing the yuan to grow against the dollar, thereby violating the binding of the exchange rate.

The problem for China is that these solutions are unstable. China cannot continue to close the free flow of capital without prejudice to the extremely necessary inflow of capital. Who will invest in China if there is no way to get their money?

China also cannot maintain high interest rates, because interest costs will bankrupt insolvent state enterprises and lead to an increase in unemployment, which is a socially destabilizing factor.

China cannot maintain a strong yuan, because it damages exports, infringes on export-related jobs and leads to deflation by lowering import prices. Artificially high currency also depletes the foreign exchange reserves needed to maintain the peg.

Given that the Impossible Trinity is really impossible in the long term, and China's current decisions are unstable, what can China do to realize the problem?

The most obvious course that can be implemented is the maximum devaluation of the yuan to about 7.95 or lower.

This will stop the outflow of capital, as these outflows are caused by devaluation fears. As soon as the currency’s value falls, there will be no need to get money from China. In fact, an influx of new money is needed to benefit from much lower prices in local currency.

There are early signs that this devaluation policy is already being implemented. The yuan fell sharply in the last month from 6.45 to 6.62. It looks like a hidden devaluation at the end of 2015, but somewhat more aggressive.

The geopolitical situation is also ripe for China's devaluation policy. As soon as the National Congress of the Communist Party of China ends at the end of October, President Xi will support his political ambitions and will no longer deem it necessary to avoid rocking the boat.

China clearly did not have a big influence on North Korea's nuclear ambitions. Against the background of the approaching war between North Korea and the United States, neither China nor the US will have so much incentive to cooperate with each other on bilateral trade and currency issues.

Both Trump and Xi prepare a "no-gloves" approach on the eve of a trade war and a renewed currency war. The maximum devaluation of the yuan is the strongest weapon of China.

Finally, China's internal contradictions. China must resist an insolvent banking system, a bubble in the real estate market and Ponzi's $ 1 million asset management scheme that begins to fall apart.

A weaker yuan will give China some political space in terms of using its reserves to solve some of these problems.

Less severe devaluations of the yuan led to failures in the US stock market. What is the new forecast for the maximum devaluation for US stocks? We can get the answer pretty soon.

source: dailyreckoning.com