Last Sunday (31 January) Zero Hedge ran an article drawing attention to the big
names in the hedge fund community who are betting heavily that the yuan will
suffer a major devaluation any time between the next few months and perhaps
the next three years.
The impression given is that this view is universal, almost to the
exclusion of any other.
A market cynic would point out that when everyone is short, there is no
one left to sell, so it is a good time to buy. This may indeed be true, and
gives the Chinese authorities the opportunity to squeeze the bears mercilessly
should they so choose. However, as Zero Hedge points out, some bear positions
are in the form of put options rather than naked shorts, so hedge fund losses
in this case would be limited to option money if the trade goes wrong.
Instead, whoever sold the options to them will ultimately absorb the losses
to the extent they have not hedged their corresponding positions in turn.
The advantage of buying long-dated OTC put options is that you can wait
for a financial strategy to come right. The motivation for buying them is
therefore less to do with market timing, and more to do with economic
expectations.
At its simplest, the common view appears to be that China is suffering
from the debt problems that follow an excessive expansion of bank credit, the
unwinding of which is expected to lead to crippling deflation. This view is
variously informed by the findings of Irving Fisher in his analysis of the
1930s depression, and perhaps the Austrian school's description of
credit-driven business cycles thrown in. To these can be added the experience
of modern credit bubbles, particularly the aftermath of the sub-prime crisis
of 2007/08, which remains fresh in hedge-fund managers' minds. It amounts to
a rag-bag of impulsive thought, and consequently it is assumed a large
devaluation will be required to reduce the prices of China's exports, so that
China's labour force will remain competitive and employed.
There are many empirical examples that disprove the idea that devaluation
is the route to export success, so it is something of a mystery why it should
be seen as a certain outcome for the yuan. The root of the idea that
devaluation for China is an economic cure-all is the supposed improvement it
gives to the balance of trade. And here the mystery deepens, because the fall
in prices for imported commodities has actually increased China's trade
surplus, so much so that the trade surplus for all of 2014, which was $382bn
equivalent, was exceeded by just the last seven months of 2015, while at the
same time the economy was supposed to be collapsing. The total trade surplus
for 2015 at $613bn was a record by a very large margin. A devaluation is
definitely not required on trade grounds.
Instead, China's trade surplus is a secure platform from which to pursue
market-based reforms. And here the objective is more about permitting the
population to build personal wealth, increasing the numbers of the middle
class instead of destroying it. This is an alien concept to western
macroeconomists, leaving them uncomfortable with their anti-market,
pro-interventionist ambitions. They have a monetarist and Keynesian notion
that devaluation counters the price deflation they think China faces,
encourages moderate inflation, and stimulates animal spirits. This depends on
the broad question as to whether or not a retreat into monetary manipulation
actually solves anything, and more importantly, whether or not the Chinese
authorities also believe in these theories.
The Chinese authorities appear to show little interest in fashionable
macroeconomic suppositions. Instead, the leadership's motivation runs counter
to western political thinking. China is made up of over forty different
ethnic groups, which without a strong central government, would probably be
at each other's throats. Western-style democracy would simply lead to civil
war and a disintegration of the state, as evidenced elsewhere in Iraq,
Afghanistan, Egypt, Libya and now Syria. It is for this reason that the state
communist party ruthlessly suppresses all political discord.
The Chinese leaders know that political oppression can only work if it is
not in the masses' economic interest to oppose their government. For this
reason, they use the market to enhance individual wealth, and are acutely
aware that a failure to better the people's condition risks fomenting
dissent. Economic factors align the leadership's interest with those of the
people, not democratic representation.
This is what drives economic policy. The leadership is mercantilist in its
approach, rather like the East India Company when it ruled India. Individuals
working with John Company, as it was known, had the opportunity to accumulate
great fortunes, and if they survived the diseases and fevers, these nabobs
returned home to Britain and became landed gentry. The elite in China is
motivated in a similar fashion and are conditioned on loyalty to the state
and its commercial objectives.
This forms the basis of the cycle of five-year economic plans, which can
be regarded as the equivalent of business plans, something unknown in western
politics. The thirteenth version commences with the year of the monkey on
Monday, the full details of which are due to be released in March. We already
know that it will tell us how production will be directed to improve the
earnings and the standard of living of the lowest paid workers. Greater
controls will be imposed on pollution and the use of water resources. The
internet will be accorded greater economic resources within the
"Internet Plus" project. Social insurance will be increased and extended
towards better healthcare and pensions. And lastly, financial reforms will
continue to liberalise markets.
What will not be mentioned in these plans, which are for domestic
consumption, is geopolitics, the financial war between China and America. It
is this aspect of China's future about which the hedge fund managers seem
woefully ignorant. And it is a bad mistake to ignore the importance of
geopolitics to both China and America, because it has the potential to have a
far larger effect on the CNY/USD exchange rate than anything else. If there
is any doubt in the reader's mind that there is a financial war being waged,
it is worth reading in its entirety a speech given last April by
Major-General Qiao Liang, the Peoples Liberation Army strategist. There
is a translation here. Of the many quotes available the best one to show
why financial power is seen by the Chinese to supplant military power is the
following:
"A few strokes on a computer keyboard can move billions or even
trillions [of dollars] of capital from one location to another. An aircraft
carrier can keep up with the speed of logistics, but it can't keep up with
the flow of capital. It is thus unable to control global capital."
It is appropriate at this juncture to make a simple observation: you do
not win a financial war by undermining your own currency. Instead, you should
undermine the enemy's currency.
This is precisely what China is doing to the dollar. Last year China
elevated her currency's standing on the world stage by forcing the IMF,
against America's will, to include it in the SDR basket. This year she plans
to establish gold and oil contracts priced in yuan, two key commodity markets
which Chinese demand now dominates. China has also established the Asian
Infrastructure Investment Bank to act as the financing arm for an Asia-wide
industrial revolution, to be spearheaded by China. She has successfully
replaced, for the purpose of this trans-Asia project, the various
multinational organisations set up in the wake of the Bretton Woods
agreement.
So 2015 was the year when China did the groundwork to replace the dollar
throughout Asia, the Middle East and North Africa, as well as sub-Saharan
Africa, which she also dominates commercially. 2016 will be the year when the
dollar finds its hegemonic status is increasingly confined to the Americas,
Western Europe, Japan, diminishing parts of South-East Asia and western
financial markets.
This brings us to another consideration ignored by the US-centric hedge
fund community: the dollar itself is likely to take a big hit in 2016.
Besides the damage inflicted by the internationalisation of the Chinese
currency and the loss of hegemonic status that it imparts to the dollar, deflationary
forces are increasing in America's domestic economy, because it is
suffocating under a debt burden now too great to bear. The analysis hedge
funds are applying to China would be more appropriately applied closer to
home, and in this case the Fed will probably seek ways to devalue the dollar
to counter a gathering slump. And unlike China, which has a record trade
surplus, the US has an increasing trade deficit.
American monetary policy is failing, and the Fed is on the back foot.
China meanwhile has a plan, and that is to redeploy labour currently making
cheap price-sensitive goods for America and elsewhere. The low-end of the
labour force will be retrained and re-employed into both higher-value
production and in the development of infrastructure on an Asia-wide basis.
Asian development will be spearheaded by the yuan as the common currency for
cross-border settlements.
In summary, a significant devaluation for the yuan is neither necessary
nor desired by the Chinese authorities. The announcement that China will
start targeting the yuan against a basket of currencies and not the dollar is
consistent with the strategy of undermining the dollar's value. With dollar
reserves accumulating at a record rate because of the trade surplus, China
should have no problem maintaining a yuan rate of her choosing. If anything
she will seek to dispose of dollars on the basis they are over-valued
relative to the commodities she needs for the future. China will sell her
dollars not to protect the yuan, but to dispose of an overvalued currency.
The views and opinions expressed in the article are those of the
author and do not necessarily reflect those of GoldMoney, unless expressly
stated. Please note that neither GoldMoney nor any of its representatives
provide financial, legal, tax, investment or other advice. Such advice should
be sought form an independent regulated person or body who is suitably
qualified to do so. Any information provided in this article is provided
solely as general market commentary and does not constitute advice. GoldMoney
will not accept liability for any loss or damage, which may arise directly or
indirectly from your use of or reliance on such information.
