Short The Renminbi Yuan

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Includes: CY, CYB, FXCH
by: Kurt Dew

Summary

There has been some recent weakness in the Chinese economy.

This weakness is not a recession. It’s the result of a major change in China’s policy objectives.

The recent devaluation is insufficient to eliminate the continuing effect of the new policy on markets.

Expect further devaluation of the Renminbi Yuan.

In January, I wrote an article "2016: The Year of the Financial Tectonic Shift" for SA. I argued that the current dominance of the dollar and relatively stronger US economic growth should come as no surprise. It's a return to the global status quo.

The article placed less blame for the Crisis than others do on the popular culprits: US governmental housing obsession and US financial institutions' greed and hubris. It put more of the blame on a largely passive foreign financial and economic system which bases its investment decisions on US advice and its economic policies on imitation of US decisions.

The point was simply this: Yes. The US financial system was disastrously wrong in the lead-in to the Crisis. But the reason that fact was so important is that the US financial system functions with no serious completion. The US financial system is composed of humans. Its occasional failure is therefore a foregone conclusion. And if there are no foreign alternatives to US plans, two things happen.

  1. All US investment decisions are multiplied through foreign imitation.
  2. There are no alternatives to the US-driven strategies.
  3. In the absence of new US ideas, the old ones will be pursued well past the point of profitability.

The return to the status quo ante of US dominance eight years after the Crisis corroborates this discouraging conclusion.

My Simple Story. My basic view of the functioning of the global financial system since World War II applies Occam's Razor. Or to reference the current slang version: "Keep it simple, stupid." Especially when making a case for a big change in financial values or prices, a good case should be based on a few assumptions.

My simple story has a single objective, three moving parts, and a safety valve.

The objective is the maximization of global wealth.

The three moving parts:

  1. Execution of US corporate, governmental, and multinational corporate decisions, driven by US financial institutions that gather and invest global funds.
  2. Global foreign investment planning: Which US investment decisions and financial institutions to imitate?
  3. US monetary and fiscal (?) policy to recover from past errors in the US, or foreign surprises.

The safety valve: currency price changes. Currency price changes are necessary to balance the global balance sheet, but they also provide valuable information. They are useful as signposts and signals. Telltale signs of a country pursuing two inconsistent objectives; or government plans inconsistent with real production of goods and services.

Of course, the real world is infinitely more complicated than this model, but thinking of all the world's complexities never leads to actionable conclusions. You may not agree with my assumptions. If you don't, make changes and reach conclusions of your own.

In my simplified world, I now ask what will drive the yuan in 2016.

This new article deals with a new event in this otherwise smoothly functioning process. China has announced its intention to change its plan. The Chinese have concluded there is a need for a shift in production. As market forces internal to China begin to drive up the Chinese unskilled wage rate, and the demand for construction expenditures abates, the new plan has Chinese production shifting, to meet the rising demand for domestic Chinese consumption goods, and especially services.

This change in plan has long been anticipated and supported among China experts.

And there is nothing in this plan that would conflict with the smooth functioning of the simple global system described above. US consumption and production in particular are only slightly affected. Growth in Chinese imports may slow and exports to China increase - but neither of these will change dramatically, at least in the short run. Most of the effect is internal to China.

In China, there will be a need for some sacrifice among both investors and consumers. As resources are shifted from production to costly, sort-run-unproductive education, and as old-economy industrial firms give way to new-economy firms, real growth will slow.

As with any well-considered investment, there is a reward to this slowing growth. The planners see greater long-term benefits to the country than with the current plan. Indeed, the cheap immigration from the countryside upon which the old plan was based is exhausted, suggesting some new plan is essential.

But in this story of Chinese adjustment so far, there is no need for a yuan devaluation. The issue of the value of the yuan arises only if the planners think that the sacrifices need disguising. What if it is desirable to maintain the appearance of government provided well-being without sacrifice?

For example, the Chinese stock market is notoriously volatile. There has been a substantial sell-off, and apparently some capital flight, in response to an apparent slowing in Chinese economic growth. But there is no reason for these factors to affect the value of the yuan.

Click to enlarge

And this has shown the government's hand.

The Chinese devaluation also shows how gullible the IMF and the Sinophile community, more generally, are. Calls within the IMF and the US government for the Chinese to "clarify" Chinese intent are embarrassing. The intent could not be more obvious. The welcoming of the renminbi yuan into the SDR has only poorly disguised the Chinese monetary authority's intent to devalue the currency.

The question this article asks is "Are we finished with the devaluation?" The answer is no. Expect (NYSEARCA: CYB), (NYSEARCA: CY), and (NYSEARCA: FXCH) to fall from here.

Why? The event to which the currency is responding is not, according to our simple model, a recession. Therefore, the change in Chinese economic growth is not temporary. It will last for several years. If the Chinese government intends to disguise it, the government will need to make a great display of taking action to restore prosperity. And that will include further devaluation.

However, rumors of a role for hedge funds in affecting the renminbi yuan are not reasonable. If you do the arithmetic, it is pretty clear the hedge funds are not big enough to be a factor in a Chinese decision to devalue again. They are miniscule by comparison to Chinese reserve resources. But in the long run, not even the Chinese reserves are inexhaustible.

Ultimately, the Chinese government will have no alternative but to confront its population with lowered expectations for a period of several years. I expect this confrontation to be peaceful. I doubt that fears of forced regime change, and the like, are credible. The government's large military presence, counter to popular Western belief, exists to defend the Chinese elite from their own people, not to threaten its neighbors.

What to Make of China's Problems in the United States? The mandate of US monetary and fiscal policy does not include saving the world. Nor should it, for two reasons:

  1. We are not that powerful.
  2. The rest of the world already fails to take responsibility for its own fate. The global press is filled with explanations of the US' responsibility for the current global economic weakness.

Current monetary and fiscal policy in the United States, quite rightly, ignores the effects of policy on Asia and Europe, or even the major capital outflows in commodity-based economies. Obviously, Asia, Europe and commodity-based economies are not something the United States can repair, unless these economies themselves take some responsibility for their fate.

The US have proven that it cannot police the world. How can we possibly take sole responsibility for world prosperity?

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.