Is The Yuan Crash Inevitable?

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Includes: CNY, CYB, FXCH
by: Victor.

Summary

Manufacturing is moving out of China, but innovative technology is not moving in.

Much "growth" of China in the last few years is production of no genuine value.

However, stability is to be expected until October when President Xi is "re-elected".

This article is about the outlook of China's economy. Firstly, it will point out why China can no longer enjoy spectacular growth that they used to have. Then, it will discuss how the Chinese government has made it worse by funding "white elephant" projects with debt in the past few years. Finally, despite such difficulties, it will explain why stability is expected for the next few months.

China is the most prominent growth story in the past two decades. In the early 1990s, the annual GDP of China was just roughly half a trillion dollars. Just after twenty six years, however, it is already the third largest economy in the world, just behind the US and the Eurozone. According to the International Monetary Fund, China's nominal GDP was about 11 trillion US Dollars, compared to the US's 19 trillion and the EU's 16 trillion.

China GDP Chart

Such amazing growth was made possible by the enormous labor force back in those days when China just started. As a country tries to develop the economy, its people usually give up the extraction of natural resources (like farming) to work in manufacturing industries where labor is intensive. With low salaries and a hardworking culture, China has managed to become the World's Factory, and one could hardly find anything which was not "made in China" ten years ago.

Unfortunately, as the general level of income increases, foreign businesses started to pull out of China and move to cheaper ASEAN countries like Malaysia and Vietnam. As a result, the thing that China has been relying on for its explosive growth was suddenly gone. To make matters worse, while this shift was happening, the 2008 financial crash occurred. It became seriously doubtful if China would be able to maintain its position in the global economy.

China is a strange place in which there is financial prosperity without democracy. The people's faith in the government is largely correlated with its economic success. If people start losing jobs and businesses begin closing down, there will be social instability, to say the least. Therefore, the government decided that they had to do whatever it took to maintain its growth target.

Regrettably, China still lacked the knowledge and technology to develop a high level economy. For example, developed economies like the US and the UK do not rely on cheap workers for economic growth, but rather on technological innovations which are often found in the Silicon Valley in California, or the Silicon Fen around Cambridge. To keep the expansion going, the Chinese government only had one solution at their disposal: to create jobs for the sake of creating it.

One notorious way that China used to create phony growth is building those so-called "ghost cities", which refer to congregations of empty buildings that nobody occupies after they were completed. Worse yet, many of these projects were funded with debts, so they ended up borrowing huge amounts of money to create something that is of no use to anyone. For the past ten years, the Chinese government debt had been steadily increasing while growth had slowed down from over 10% to less than 7%.

China Government Debt Chart

Of course, the clever investors could smell the problems in China, and capital started to flow out of the country. Since 2015, money has been flowing out of the country, and it caused the government a lot of their foreign currency reserve to slow down the devaluation of the Yuan (as shown below). The reason that they did this was to prevent the people from losing faith in their money and transferring it abroad, which would accelerate the bleeding.

China Total Reserves Chart

It is worth noting that it was only a year or two before when Bitcoin enjoyed a huge surge in value and traded over $1,000 a coin for the first time. It went up so much because many Chinese investors had already realised that the crypto-currency was the most convenient way to work around the government and transfer their money freely, but then their dream ended as the Chinese government shut down major Bitcoin operations in the country.

Anyway, while the Chinese are losing their battle on the economic front, they are also up for a big event in the political arena. For those who have no idea, the most powerful political person in China is not the President, but the General Secretary of the Chinese Communist Party, who is elected in the General Assembly every five years. President Xi Jingping, who is also the current General Secretary, is determined to serve the next five years after the 19th Assembly in October this year. He does not want any uncertainty in the country until the election is over.

In order to ensure stability, the government has taken two measures to keep the capital outflow in check. Firstly, they are restricting their capital account except for transfers approved by the government. Secondly, they increase interest rates in unison with the Federal Reserve. So far, it had worked so magnificently that they are considering partially lifting the control.

However, these are only short-term measures which cannot go on forever. Currency controls and high interest rates do not stimulate any real economic growth that the government really wants. Sadly, if they go back to the old way, then their currency reserve will start bleeding again. Therefore, there is only one long-term solution for them: to devalue the Yuan at some point in the future.

Many great investors like Kyle Bass have seen China's problem ages ago, but they underestimated the political side of the game (and went in too early), so they ended up losing. Nevertheless, I believe that their long-term view is correct. Based on the above-mentioned reason, I think it is a very wise idea to consider shorting the Yuan at the end of the year, which could be done through exchange-traded funds like CYB, CNY and FXCH.

In summary, the Chinese government has borrowed too much to pursue paper growth without actually improving the economy. They are now having difficulty in stopping capital outflows without draining their currency reserve away. Even though they are applying currency control in the short term, eventually, they will have to bite the bullet and let the Yuan to debase.

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.