Chinese Revaluation: Be Careful What You Wish For

Includes: FXI, PGJ
by: Sean Maher

International pressure on China to revalue its currency (the Renminbi or RMB) by at least 10-15% remains intense; an incoming US administration led by either candidate is likely to adopt a much tougher diplomatic stance. The RMB has appreciated 20% against the dollar since 2005, but then it would be hard not to given the sorry state of the greenback, although the rise has accelerated in recent months.

For a variety of domestic reasons, I believe a one-off revaluation is now very much on the agenda in Beijing, and may be the key macroeconomic event later this year or early next. Chinese authorities are struggling to control both rising inflation (a generalised emerging market issue) and a wave of speculative liquidity flooding through their current account to circumvent official capital controls.

In April, a record $74 billion entered China from overseas. China’s trade surplus and foreign direct investment accounted for only a third of this sum, leaving over $50 billion unaccounted for. This is almost certainly purely speculative capital, or 'hot money' in the words of the authorities, which is betting on the continued rise of the RMB. The central bank has to sterilise these massive capital inflows through a complex process whereby it first buys the foreign exchange and then, to prevent the money supply from growing too fast, it mops up the excess RMB notes by issuing local currency bonds upon which it pays interest.

Goldman Sachs estimates that this is causing the central bank to lose about $15 billion a month as the RMB steadily appreciates. Meanwhile, the stock market collapsed 14% last week, and has now more than halved from the peak last October. In Shenzhen, China’s richest city, average house prices are down 6 percent on their level a year ago and apartment vacancy rates are at record highs. Make no mistake, China is slowing, and fast.

I have commented before on the unsustainable nature of Chinese growth (see: China 'Miracle' faces Meltdown), which is now causing huge economic stresses as investment productivity falls to levels last seen in the Mao era. Those stresses are focused on a dysfunctional financial system that is now being swamped by tens of billions of short term capital inflows, effectively forcing the government's hand on revaluation.

So how do currency speculators gain exposure to a potential revaluation in a supposedly closed system? Apart from endemic fake invoicing of exports, it is becoming clear that copper and other industrial commodity imports are being used for currency speculation; evidence for this commodity financing play can be seen in data from the Chinese Commerce Department which showed Chinese foreign exchange reserves in the first quarter amounted to $1.68 trillion, a 40% rise.

Even allowing for the net trade surplus and foreign direct investment, $85 billion of this cannot be explained. I suspect that these speculative capital inflows massively inflate apparent Chinese demand for many commodities (this is reflected in rapidly rising private stocks) and the bull case for global resources. So what are the implications of a sudden 10-15% revaluation?

  1. Bullish for commodities in the very short term on the knee jerk basis that they can afford to hoover up even more. Crucially, China's terms of trade are now deteriorating rapidly as the world's largest net commodity importer, making a revaluation even more valuable to stem imported inflation; this year China will become a net food importer for the first time ever, and can be expected to have as enormous an impact on the grain markets as it has had on energy. Longer term, apart from food, the inevitable squeeze on Chinese growth would also negatively impact commodity demand and prices, as would the release of hoarded stocks.
  2. Bearish for Treasury bond yields (as if anyone needs another reason to sell bonds). Firstly, China would no longer be the buyer of last resort as reserve accumulation slows, and this liquidity factor alone could add 75-150bps to long term bond yields. Secondly, prices for imported manufactured goods would rise across the board and it would become untenable even for those clever magicians at the BLS to suppress surging US inflation, an effect that would accelerate the nascent bear market in government bonds. Sell bonds (and Wal-Mart (NYSE:WMT)/Costco (NASDAQ:COST)).
  3. Bullish for developing Asia, as most low added value and labour intensive Chinese manufacturing moves offshore to Vietnam, Indonesia etc. This has already begun in fact. Chinese overseas investment via the state banks and private companies would also surge with their boosted purchasing power.
  4. Bearish for Chinese GDP growth and companies/countries reliant on Chinese capital goods demand like Japan, as revaluation will help to limit chronic overinvestment in capital projects and consumption becomes a larger share of the economy. Bullish for foreign exporters of branded consumer goods to China. Domestically, stock market winners would be companies that import raw materials in dollars but sell largely in RMB including airlines such as China Eastern and China Southern (planes and fuel) and auto makers like SAIC Corp. (steel, rubber etc).
  5. Bearish for political stability; although the Communist Party can handle the fallout from reduced growth (unemployment currently is sub 4% and wage inflation over 20% in the South) and take the hit on the reduced value of its foreign bond holdings, the real risk I believe is what happens that speculative tide once revaluation finally occurs. Do currency speculators stay invested, awaiting the next upward move? Or do they bail out en masse, triggering a capital flight crisis similar to that suffered elsewhere in Asia in 1998? The latter development would shake the Party's authority to the core. It all depends on the magnitude of the move which has to be big enough to calm speculation and satisfy trading partners but not so big as to drive a rush to the exits.

Far from being a panacea for the US trade deficit (which has been improving rapidly in any case, and few US businesses compete directly with the Chinese any more), an imminent Chinese revaluation would stoke the inflationary pressures that already threaten to derail central bank efforts to reliquefy credit markets in the aftermath of the sub prime mess. Remember that, the next time you hear a politician spouting protectionist China bashing cliches...