Well… what a time to be getting back! I was hoping for a quiet period to catch up on things, but instead we get the first major CNY shift in a decade. There are already so many words published on it, but much of it seems not dissimilar to rambling. Amidst all the noise, I wanted to share a few thoughts.
The fact of the matter is, no one knows exactly how this CNY move will affect things. To begin with, much will depend on how fast, how far, and how long the depreciation goes. How the Chinese policy makers and Chinese banks manage the move is also a major factor. Then there are the multiple indirect effects from things like the impact on other EM currencies, commodity prices, etc.
Having said that, here are a few things that I think we can say with a reasonable amount of confidence:
The PBoC communications department is very inexperienced. Go ahead and read the series of press releases from 8/11:
- The PBC Announcement on Improving Quotation of the Central Parity of RMB against US Dollar
- The PBC Spokesman Answered Press Questions on Improving Quotation of the RMB Central Parity
- The PBC Spokesman Answered More Press Questions on the RMB Exchange Rate
Now, maybe the Chinese press releases are much better (I highly doubt it) but without a doubt the English press releases were confusing at best and misleading at worst. What does ‘significant fluctuation’ mean? How about ‘basically stable at an adaptive and equilibrium level?’ It remains unclear, still, what the primary objectives of the recent moves are. In conjunction with the policy flailing following the stock market collapse, I think it’s reasonable to say that Chinese policy makers have much to learn about managing markets. This implies that the volatilities of currencies linked to China are likely to be higher.
The direct economic impacts from the currency move so far on DM economies are limited. China remains a fairly closed economy, with high barriers to entry for foreign corporations. The estimates of the impact on US inflation that I’ve seen is in the area of 10bps or so. Pass through is also mitigated by the fact that many foreign corporations have moved their production to cheaper locals like Vietnam in recent years.
The indirect effects are likely to be much more numerous, and likely stronger. How will the other EM currencies and economies adjust? How will Chinese commodity demand adjust?
China will need to continue to rebalance its economy – away from investment, and toward consumption. Michael Pettis has written reams of posts on this, so I won’t repeat them here.
The policy moves thus far are far from sufficient from addressing the major drivers of capital outflows. Ultimately, expected real investment returns in CNY assets are too low relative to opportunities abroad. This includes returns from export businesses – otherwise companies more exporting companies would be set up. There are a couple ways to rectify this – either real interest rates can move somewhat higher, or the currency can move quite a bit weaker. The former option runs the risk of cascading defaults, so it seems like the Chinese authorities are trying the second option.
In addition, there is one thing I would venture to conjecture:
I think there is a good chance the RMB ultimately depreciates 20% or more in real terms. Now, it’s hard to put a tight confidence band around how far a currency ‘needs’ to move in the best conditions, but it is particularly hard for China because of the lack of reliable economic statistics. This itself suggests a higher probability of an overshoot. But we do have a bit of precedence to guide us. The last time the RMB REER has depreciated significantly was from 2002-2005, with the BIS measure of CNY REER going depreciating almost exactly 20%. The appreciation move leading up to that was ~55% from 1994 (when the data started) to the highs in Jan 1998. By comparison, the move from the 2005 lows to March 2015 highs was 60%. In addition, China has often been compared to Japan in the 70’s. This chart from the San Fran Fed highlights:
This is relevant because we can use the 1970’s Japanese experience to draw some parallels. Interestingly, the Yen appreciated a similar 50% from Jan 1976 to Oct 1978, (admittedly a much faster pace) but then ultimately depreciated 27%, hitting a low in Oct 1981. The slower pace of the RMB appreciation suggests a more moderate correction.
With respect to other assets:
In the absence of strong fundamental trends, the majority of S&P price action this year seems to be driven by changes in the ‘uncertainty risk premium.’ IMO, the uncertainty around what the PBoC is trying to accomplish and/or do was a major driver of recent gyrations, even as most agree that the direct economic effects are not large. The PBoC seems to be learning as it goes though (there is a pre-announced press conference late tonight US time) so hopefully we get some stability.
Global yields are starting to look too low again. My 3% fair value estimate for the US long end remains, so current levels look decent enough to start establishing opportunistic shorts.
The 1y1y forward oil strip is showing tentative signs of stabilization. Levels are now basically unchanged since 8/3, the longest stretch since late June.