Hope 'Floats': All Lies Must Die

| About: WisdomTree Chinese (CYB)
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Summary

Perpetuating a lie is an exceptionally difficult thing to do.

China is figuring that out the hard way with its untenable FX policy.

In the end, the currency will have to float.

The thing about perpetuating a lie is that it's hard. Really hard.

So hard, in fact, that it almost always turns out to be an exercise in futility.

I know this from personal experience. And so do the good folks at the PBoC. Let me give you an apt comparison.

Once, during a (relatively brief) period of my life, I had a live-in girlfriend. She wasn't a fan of alcohol. Regular readers will recognize why that presented a real problem. I would often find myself attempting to explain away the distinct smell of scotch or bourbon that hung over my dark blue suit jackets at night like fog over a dark blue lake in the morning. "How many drinks did you have?" "Two." Of course, I really meant 12.

Similarly, China has been attempting to explain away the one-way depreciation of the RMB (NYSEARCA:CYB) we've all witnessed since the "one-off" devaluation in August 2015. "How much will it depreciate?" "2%." Only the PBoC really meant 12%.

The longer you try to perpetuate a lie, the more the evidence invariably mounts that you are, in fact, lying. You can downplay the evidence as "slander", etc., but no one will believe you. Such is the case with the Politburo and the RMB.

An alarming decline in China's FX reserves clearly indicates the central bank has been frantically intervening in the spot market, and more recently, dramatic moves in Hong Kong money markets suggest the PBoC engineered a short squeeze designed to drive up the offshore yuan.

The FX reserve story has been told so many times that I needn't recount it. But I will show you a chart which shows how large of a role intervention activities have played when it comes to quantifying reserve burn:

(Chart: SocGen)

As to the engineered short squeeze in the offshore market, I documented the entire episode virtually in real time last week (see here and here, for instance). Perhaps the best way to illustrate what happened is to show you - for about the tenth time - the absurd move in the CNH O/N depo rate:

(Chart: Bloomberg)

So what exactly was Beijing trying to do there besides squeeze the shorts? Well, they were likely attempting to drive up the offshore spot in an effort to bolster confidence on the mainland. Consider the following from FT (my highlights):

Thursday marked the eighth day that the offshore renminbi traded at stronger levels than in onshore market; a ninth day on Friday would mark the longest winning run since the 2015 devaluation.

Last week the offshore renminbi recorded its biggest two-day gain against the dollar since that market began in 2010, surpassing the onshore level in the process. The move confounded expectations that the Chinese currency would continue its weakening trend of last year, when the offshore rate lost 5.8 per cent and the onshore declined 6.5 per cent.

Traders and analysts have speculated the early-year drama has been spurred by intervention in the foreign exchange market - something the People's Bank of China never confirms or denies - and that any action was designed to engineer the stronger offshore rate.

"That's what China has done much better this year - manage the offshore rate," said the regional head of currency trading at one bank. "Big renminbi developments never happen because of offshore speculators; it's all about people onshore having confidence in the signals they see in the offshore market."

Here's a visual:

All of this is just a prolonged (and increasingly painful) attempt to avoid letting the currency float.

Indeed, efforts to obscure the need to let the RMB find a market clearing rate have become so elaborate that Beijing is now fiddling with the fixing mechanism to allow more elasticity in the USDCNY fix when the broad dollar is weaker than on days when the broad dollar is stronger.

(Chart: Goldman)

That effectively means the recent strength you've seen in the trade-weighted basket isn't entirely real.

(Chart: Citi)

And so, the debate is heating up: to float or not to float, that is the question. Below, find a few arguments for a floating RMB and a few arguments against.

"For" via Bloomberg:

The long-term benefits for China outweigh the costs. A quick transition to a market-determined exchange rate would allow the country to preserve its foreign-currency reserves, re-assert control over domestic monetary policy and combat criticism from U.S. President-elect Donald Trump that Communist Party apparatchiks are manipulating the currency.

"At the end of the day, what you have to accept is the value of the currency as it is right now isn't appropriate," said Luke Spajic, the head of emerging Asia portfolio management at Pimco, which oversees about $1.55 trillion and is calling for a mid- to high-single digit yuan depreciation over the next year. "Things need to change."

"For" via FT:

Crossing the river by feeling the stones' - China's default policy approach - combined with a great deal of 'kicking the can down the road' now seems increasingly untenable vis-a-vis the exchange rate.

Along with the financial costs of managing the exchange rates there are increasing political costs. The new Trump administration is likely to embrace the narrative of China as a currency manipulator that was a prominent feature of the US-China relations in the pre-financial crisis years. It does not make sense for China to risk starting the relationship with the new US administration on a potentially hostile note for the sake of defending a below par policy.

So, the best course of action would be to stop market interventions and let the renminbi float.

"Against" via Allianz:

China will free float yuan eventually, but only when it's appreciating. Free floating now will lead to immediate outflows.

"Against" via Mizuho:

If they're going to liberalize the exchange rate, there's only one way to go: the renminbi would depreciate. The market would panic as we witnessed in 2015.

Yes, the market would "panic," outflows would increase, and there's a very real chance that a self-feeding dynamic would take hold whereby those outflows would beget more outflows.

But at the end of the day, all lies must die. Unless you intend to take them to the grave.

With reserves sitting at just over $3 trillion, China can still hold out for a little while longer, but given the ineffectiveness of Beijing's capital controls, even that's debatable.

(Charts: SocGen)

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.