China: Lots Of Red Flags

| About: iShares China (FXI)


Try as you might, you won't be able to dissuade China bears from their convictions.

The country is full of red flags (both figuratively and literally).

Make no mistake, China's currency will continue to weaken.

I've probably spent more time than I need to outlining why so many people believe the Chinese RMB (NYSEARCA:CYB) will continue to depreciate basically in a straight line until such a time as Beijing decides to just float the damn thing and let it find a market clearing price.

China is full of red flags (both figuratively and literally). There's the WMP problem, the NPL issue, and now the looming threat of a bond market meltdown. These issues are set against a backdrop of capital flight and FX reserve liquidation - the inevitable byproducts of the central bank's ongoing effort to control the pace of the yuan's depreciation.

For many, a short RMB bias is a no-brainer and given the factors mentioned above, it's not difficult to see why. There are also technical/mechanical dynamics at play that I don't think most investors have taken the time to understand. For example, this isn't just about the yuan versus the dollar. If the dollar moves higher against the currencies in China's trade-weighted basket, the PBoC has to weaken the yuan fix if Beijing wants to keep the currency stable against the TWI. It's just math. It's not a debate.

But thanks to the fact that the vast majority of market watchers don't seem to care very much about what's going on, the Politburo has succeeded in convincing more than a few investors that reports of the currency's demise (read: inevitable devaluation) are greatly exaggerated.

For instance, adopting the trade-weighted index as a reference was a parlor trick. And yet I still see the yuan's relative stability versus the TWI cited as evidence that the RMB is in fact on solid footing. Never mind the fact that analysts the world over (whose job it is to quickly interpret these types of things) immediately recognized that the adoption of the basket signaled China's intention to push the currency still lower against the dollar.

Then there's the very real possibility that Chinese corporates will look to pay down foreign currency debt in an effort to get out ahead of further RMB weakness.

And on, and on. Here's Goldman's rationale for the short thesis (my highlights):

  • The CNY fixing, CNY spot, and CNH spot depreciated 6.8%, 6.9%, and 6.2% vs. the USD in 2016, extending the bilateral depreciation to 14%, 15%, and 16% since their respective peaks in 2014.
  • On Dec 29, the SAFE announced that the composition of the CNY CFETS index will be modified effective January 1, 2017. USD/G3 currency weights will be reduced, while more EM currencies will be included. Our economists see this as a signal of continued policy focus on managing the CNY on a trade-weighted basis and increasing its flexibility vs. the USD.
  • Notwithstanding the latest volatility in the CNH market on spiking CNH HIBOR, we think the narrowing interest rate/yield gaps between the US and China, and the strong demand for Chinese corporates/individuals to diversify their currency exposures should lead to further depreciation pressures for the Rmb fundamentally. Our economists expect USDCNY to reach 7.3 by end-17, implying 5.2% Rmb depreciation vs. the USD, but they see the Rmb to be broadly stable against a basket of global currencies (CFETS).

All of the above notwithstanding, some market participants point to brief moments of respite like last week's yuan rally as evidence that in the end, the PBoC's hand is simply too heavy to bet against.

In reality, the heavier the central bank's hand, the more desperation can be inferred.

As I discussed early on Sunday morning, China's new capital control measures seem to be at least in part a last ditch effort to curtail capital flight facilitated by underground banks. But as is the case with all of Beijing's other attempts to keep Chinese citizens from moving their money out of the country, the effort seems likely to fall woefully short.

From "Mr. Chen," to the UnionPay end around, to buying up property in Vancouver, people will find a way.

On Sunday, Barclays was out with a brief note underscoring all of the above. The bank cautions investors not to place too much emphasis on recent yuan strength which was largely a product of forced capitulation. Here's some color:

At the turn of the year, China's efforts to slow the yuan's fall and capital outflows have sent a mini shockwave to Asia FX markets, bringing to memory the HIBOR and CNH short squeeze of January 2016. Although China's economic data (eg, manufacturing PMIs) have continued to improve, investor concerns of a one-off devaluation/free float of the CNY is high against the background of tightening capital controls. Authorities have tightened scrutiny on individual USD50k outflows that have been reset at the beginning of the year. Separately, policymakers are reported to be pushing state-owned enterprises to sell foreign currencies. The PBoC has also updated its CFETS CNY NEER, with a shift toward a basket more reflective of China's trading partners that would also reduce the USD's weight, thereby creating more room for CNY weakness vs. USD without exerting pressures on the CNY. More significantly, tighter offshore liquidity has forced capitulation of many long USDCNH positions (given the rise in funding costs), resulting in a sharp move lower in the currency pair just as it was close to breaching the psychologically important 7 level (Figure 10). The abrupt turn in the USDCNH has led to mini-wave of contagion effects on global markets, driving an unwind of recent long USDAsia and pay US rates/short UST positions.

Now note what the bank says about the prospects for other Asian currencies (my highlights):

We believe that the recent strengthening of the CNY and other Asia currencies should be transient [Heisenberg: recall last when the USD/KRW fell 1.3%, the most since September 22]. As the Politics of Rage gathers steam in developed economies, Asia's growth and trade outperformance is likely to come under scrutiny. The immediate focus is on President-elect Trump's campaign declarations of trade tariffs and currency manipulation by China, which have wider implications for Emerging Asia. Under this outlook, we think the KRW, SGD, TWD and PHP are the most vulnerable Asian currencies.

Sound familiar? It should (to regular readers anyway). I said the exact same thing on Saturday with regard to at least two of the currencies mentioned above. To wit:

Current account surpluses will narrow with rising oil prices and the implementation of protectionist trade policies in the developed world.

Citing Deutsche Bank, I pointed out that so far at least, Asia FX isn't pricing in a number of structural headwinds - or if they are pricing them in, the cross currency bases aren't reflecting it:

(Chart: Deutsche Bank)

There you have it. A fresh recap of why virtually the entire world anticipates RMB weakness up to and until the PBoC moves to a free float.

The moral of the story is that you should probably respond to Beijing's chest beating about the RMB the same way you respond to their bluster about anything else (e.g. the inherent stability of their economy, etc.): with a chuckle.

Oh, and stay vigilant. More red flags are popping up all the time.

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.

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