In a recent article, Cam Hui asks "What if the Renminbi were to Fall?" Actually, this is exactly what I expect to happen, and it cuts to the heart of the ugly catch-22 facing China (FXI). It also exposes why the idea that there will be a "soft landing" might be somewhat optimistic.
While Cam's article suggests that the falling renminbi might hurt the US (I disagree with this contention, but more on that later), the more important question is how it might harm China. My contention is that the renminbi (CNY)(FXCH) is at the heart of China's massive bubble, and will also play an integral role in its collapse.
Around late 2009, Jim Chanos first introduced the thesis that China was in the midst of a massive real estate bubble that would eventually crash. Chanos argued that fixed asset investment was at extraordinarily high levels, and that growth of the Chinese economy was entirely dependent upon fixed asset investment.
This fixed asset bubble has been fueled by numerous flawed policies that promote construction in China whether it's needed or not. Some examples of these policies include:
(1) China's artificially low interest rates at the state-run banks. By keeping interest rates artificially low, China has promoted debt-fueled growth for a long-time. Loans are like any other good or service; if you price them too high, you get too few borrowers; if you price to low, you get too many. The other problem here is that access to money at the state-run banks is controlled by political connections. The result is that those who are well connected can borrow at these low rates, and then re-lend out in the shadow banking system at black market interest rates. If you aren't well-connected, then you have to borrow at those sky-high black market interest rates.
(2) Local government reliance on land sales for funding. The local governments in China are heavily reliant on land sales to fund their operations This creates misaligned incentives, with the local governments constantly promoting construction. These efforts might not be nearly as successful in a market oriented economy such as the US or UK, but in an economy dominated by state-owned enterprises, it's an entirely different matter.
(3) The Dollar peg. There are numerous issues with the Dollar peg, but at the heart of the matter is that China has largely left the peg unchanged over the past several years, while the Yuan has dramatically appreciated. This has created a situation where the Yuan is artificially undervalued, providing exporters with a massive subsidy for their goods. This creates, in Sorosian terms, a self-reinforcing cycle.
As the RMB appreciates on an intrinsic basis, the value of the export subsidy increases. As the export subsidy increases, the exporters become more profitable. As the exporters become more profitable, more foreign capital flows to China. As more foreign capital moves into China, the Yuan appreciates. Unfortunately, the thing about self-reinforcing processes like this is that they eventually reverse. This is the nature of boom / bust cycles.
What Would You Do as a Chinese Citizen?
All the policies mentioned above coalesce to create a lot of inflation in China. Since the interest rates for depositors are held artificially low and depositors earn negative real returns, Chinese citizens search for alternatives where they can make reasonable returns in spite of the inflation. There are two obvious options for this; the first is gold. While gold is an imperfect inflation hedge, it is still generally expected to increase with inflation. It has worked well as a hedge in China over the past 8 years. It's also no coincidence that gold's rapid rise happens at about the exact same time that China's fixed asset bubble started developing.
The other more direct option as a Chinese citizen is to invest in real estate. There's no asset more directly tied to inflation than real estate. In a sense, inflation is real estate price appreciation, since real estate is typically the largest expense component for the average middle income individual. Not surprisingly, Chinese citizens have invested an overwhelming large amount of resources in real estate.
Of course, the Chinese weren't the only ones who jumped in. Wealthy citizens in places like the US, Australia, Canada, Japan, South Korea, and many other liberal democracies saw opportunities for big returns in China. Accordingly, foreign capital flooded in.
So what's the problem? If real estate assets are not actually needed, then they will earn returns below their costs of capital over time. And that's exactly what's happening in China. If we all invest in a residential high-rise and we demand a 10% return for that investment, what happens when we get a 5% return instead? Or how about a 2% return? Or maybe a -5% return? Eventually, we realize that we're throwing our money down the drain, and we begin to invest in other opportunities.
Unless, of course, there's some market distortion or irrational behavior that prevents us from making this realization. If instead of renting out our high-rise condos and making sub-optimal returns, we instead decide to flip it a few months later to the next sucker, then everything looks great on paper. And there's a long line of suckers waiting around to buy real estate with floods of money they borrowed. But the real returns are still low or negative. At some point, the line of suckers ends, and someone is left holding the bag.
Why it Will All Collapse
The reason it all eventually has to collapse is because someone is on the short end of the stick already; and I don't mean the "last sucker" who can't find another buyer for his real estate properties. I'm talking about another group of people entirely: Chinese laborers.
If you are a Chinese factory worker, and you spend 6-7 days per week working 10+ hour days to support your family, inflation hurts you a lot. High inflation means you can't buy enough food. It means you can't achieve the Chinese dream of buying your own home in the city. It means your standard of living is falling, even though you're working harder. So you slowly get squeezed, until you can be squeezed no more.
At some point, you decide you've had enough and you demand higher wages. You might not have a lot of good options, but it's simply not possible to work 8-9 days and 140 hours per week. Essentially, all that "easy money" the Chinese government provided access to was at your expense. You were the loser, and manufacturing capitalists, well-connected party officials, and foreign investors were the winners.
So you demand more or you threaten to walk. And while they don't like it, the manufacturing capitalists are forced to raise your wages. Only problem: once they raise your wages, the horrendous economics behind the entire enterprise start to become exposed. The only reason some of these manufacturing facilities are profitable to begin with is because the Chinese government is subsidizing them through the undervalued Yuan (via the Dollar peg). If laborers demand more money, then those subsidies get offset to a certain extent. Eventually, the entire operation becomes unprofitable. And once things become unprofitable, those foreign investors start to leave.
Now that some of our foreign investors are leaving, a problem is starting to develop. So long as foreign money continues to flow in like the Yangtze River, the Yuan can maintain its high value. And it's only through this high value that the Chinese government is able to subsidize exporters. If the value of the Yuan were to fall, the subsidy would begin to disappear. Once the subsidy begins to disappear, the thin profit margins of those exporters become even more vulnerable; which then scares off more foreign capital. The more foreign capital is spooked, the weaker the Yuan becomes. Once again, we have a self-reinforcing cycle, except this one moves in the opposite direction.
We still have real estate. But the real estate appreciates because of the cheap credit and negative real interest rates for savers. And with less foreign capital coming in, the credit becomes more difficult to obtain and expensive. It may not necessarily show up in terms of interest rates; rather, it could manifest itself via weaker purchasing power. This eventually leads to real estate struggling, as well. As real estate prices suffer, those dismally poor interest rates that depositors earn start to look more attractive. And as deposits become more attractive, there are fewer buyers for real estate. We have yet another self-reinforcing cycle.
Of course, as real estate sputters, more foreign capital begins to flee, and the Yuan continues to depreciate. Eventually the Yuan depreciates so much that its intrinsic value falls below the Dollar peg value. And that's when we suddenly have a giant problem on our hands.
If the intrinsic value of the RMB falls below its pegged value to the USD, China will either have to de-peg or deal with incredibly tight credit conditions that send its export sector into a freefall. This is the catch-22.
If China de-pegs, this spooks foreign investment more, signaling to the world that the Yuan is not a safe currency and China is not a safe place for foreign capital to invest. On the other hand, if China leaves the peg in place, confidence in the Yuan might not collapse immediately, but certainly, its economy will suffer massively and enter into a huge depression, which will likely cause foreign investors to flee regardless.
The only real choice is to de-peg and suffer the consequences. And that's exactly what I believe will eventually happen. But once China de-pegs, it is suddenly exposed as a paper tiger and the "hard landing" ensues.
Where this all will lead after that - I have no clue. It could create more pressure for liberal reforms in China, focusing primarily on the state-run banking sector. It could create a massive wave of popular discontent that could threaten the very viability of the Communist Party in China. But I don't feel comfortable making any predictions beyond the economics.
Even if I end up being wrong (and I don't think I will), my hope is that this crisis will increase pressure for reforms that ultimately allow the Chinese economy to be more sustainable; and that the benefits of a healthier economy flow to the more general populace, rather than to a select few individuals. That's my hope.
But what about the US?
Contrary to the popular consensus, I believe a Chinese hard landing would be beneficial to the United States (SPY). It could create some amount of short-term pain, but it will be very beneficial to the US in the long-run.
Remember that the Dollar peg has been a significant cause of the US massive trade deficit. However, let's be more precise - the issue isn't the Dollar peg itself, rather than the fact that the Dollar peg is set at an unsustainable level. If the Dollar peg were set close to the Dollar's intrinsic value versus the Yuan, there would not be an issue.
This is where I disagree with Cam Hui - Hui focuses on how a depreciating Yuan might harm the US. The real harm comes not from a falling Yuan, but from a mispriced Yuan. The distinction may be subtle, but it's very important.
A mispriced Yuan results in the US importing too many goods from China, and exporting too few. If the Yuan floats freely, we don't have to worry as much about this issue, because the market will begin to correct itself.
The most obvious result of a falling Yuan is that China will begin selling Dollar assets. This will also cause the US Dollar to weaken. A weaker US Dollar will act as a form of stimulus on the US economy, and could result in greater demand for US exports, thereby helping the economy recover. This will also likely end up benefiting the struggling US housing market (XHB).
For these reasons, I don't foresee a Chinese "hard landing" or a falling Yuan harming the United States at all. Rather, it will allow market distortions to correct, which will then stimulate the US economy.
Disclosure: Author is short and owns long-dated put options on FXI. Author is long US homebuilders and real estate, including PHM, TOL, and HHC.