Tensions In The Yuan Are Intensifying

| About: iShares China (FXI)

Summary

PBOC has rushed to overhaul its yuan trade-weighted index in order to calm market nerves about the intensifying pressures on its peg with the US dollar.

In another pre-active move, China announced a huge infrastructure spending plan of half a trillion dollars, in order to stem a generalized credibility crisis and a subsequent mass exodus of.

Still, the yuan seems extremely vulnerable as the level of reserves in relation to the inflating domestic money supply are dropping like a stone. An “accident” could be closer than.

Soon after we discussed how stressed the China's foreign exchange policy has become, due to its peg to the almighty US dollar (NYSEARCA:UUP), PBOC did its miracle again; it announced that it will dilute the weight of the US dollar in the calculation of its benchmark currency basket the CFETS RMB Index, by adding an additional eleven new currencies in the mix. This decision comes amidst extreme tensions in the USDCNY exchange rate (NYSEARCA:CYB), faster than anticipated depletion of foreign exchange reserves, and massive capital exodus from the country. Most importantly, it flags a desperate attempt by the Chinese to move ahead of the market and lay the ground for a potential one-off devaluation of the yuan against the dollar, in case capital flight becomes excessive. In reality, what this policy action, as well as a bunch of other sobering indications, communicate is that the chances for a yuan misstep in the foreign exchange market have increased enormously. The world has gotten too close to a yuan accident, and investors need to brace themselves accordingly.

Fragile Chinese Foreign Exchange Dynamics

One of the key indications that the defense of the yuan has become extremely vulnerable is the precipitous fall of the ratio of foreign exchange reserves over M2 money supply, i.e. currency in circulation and all types of deposits. The larger the M2 is, the bigger the amount of money which theoretically could escape the country becomes. As more capital is available to flee the yuan, more foreign exchange reserves are required to defend it. The drop in the ratio of reserves over M2 shows that less and less foreign currency, mainly US dollars, is left in PBOC coffers to be spend against an increasing demand for US dollars. Two years ago foreign exchange reserves amounted to about 20% of domestic money supply, while currently they can hardly cover 13.5% of M2.

Reserves to M2

Source: tradingeconomics.com

This coverage ratio exhibits a pretty much steady downward momentum throughout the last two years, without managing to find a plateau even in the last few months. This is quite ominous since during this recent period some of the biggest trading partners of China are seemingly rebounding and also Chinese macroeconomic activity indices are gaining upward momentum. This means that China has possibly lost its ability to generate enough surpluses from its international trade to counteract the demand for capital exodus. In order to regain such ability, China will need to let its currency depreciate substantially. China is approaching fast a point where the available reserves will be insufficient to defend the selling pressures on the Chinese currency, prompting an attack on its currency.

Erratic Policy Moves?

The yuan's ominous macro dynamics seem to drag the PBOC into erratic policy action, such as the announcement of an overhaul of its CFETS RMB Index, a trade-weighted basket against 13 important currencies. Under the new rules to be implemented in 2017, eleven new currencies will be added to the index and the weight of the US dollar will be reduced accordingly. This is a move to signal that China is caring less about its bilateral exchange rate with the US-dollar, trying to detract market attention from the growing USDCNY tensions.

CFETS RMB Index

Source: CFETS

Still, the tensions are there. For example, the trading volume in yuan surged above the usual seasonal activity in December, potentially indicating accelerating capital flight. Also, the gap between the prices of off-shore and on-shore yuan has reached its lowest level in almost a year, indicating extreme selling pressure on the currency.

CNY-CNH

Source: tradingview.com

In another pro-active major policy move, China announced a huge infrastructure spending plan of half a trillion dollars, in order to expand its high-speed rail network between its biggest cities. This fiscal initiative came in response to an escalating credibility crisis which is directly linked to the mass exodus of capital from the country. The Chinese need to desperately boost global confidence in their economy and avert the escalation of a currency crisis, which would be devastating for the global economy. Fiscal stimulus works towards that direction.

Of course PBOC's capital controls are a powerful weapon against a massive capital flight, and the latest policy initiatives show that the authorities have become extremely concerned about the situation. However, global market forces are always stronger than any individual economy and China is no exception. It is no coincidence, for example, that its trade surplus began to shrink lately, after an expansionary cycle in the years which followed the Great Financial Crisis. The yuan is not cheap enough to restore competitiveness and the peg to the dollar doesn't help in that direction. Chinese exporters (NYSEARCA:FXI) are overleveraged and suffer from a loss of long-term competitiveness, especially if we take into account inflation differences between China and its trading partners. In fact, the yuan real trade weighted index against China's 61 most important trading partners hovers near its highs with respect to its trading range of the last five years, despite the slow depreciation in the first half of 2016.

China Trade Balance & TWI

Source: ieconomics.com, BIS.

The Chinese have a great challenge to tackle ahead. The global community should be really concerned too, since any misstep by China could set in motion the biggest fear of investors and markets across the globe; a one of a kind global deflationary shock of epic proportions. Investors should wish that the Chinese will manage to hold the line, but at the same time should brace themselves for every possible eventuality. The world seems to have reached closer to a yuan accident than ever!

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.

Additional disclosure: The views expressed in this article are solely those of the author, provided solely for informative purposes and in no case constitute investment advice.

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