viernes, 28 de agosto de 2015

viernes, agosto 28, 2015

Asia's Best Minds

Why China’s Currency Could Fall 20%

Strategist Russell Napier says further weakness is needed to reflate the world’s second largest economy.

By Russell Napier           
 
In case you missed it, China just devalued by 1.9% to reflate the economy. It’s not enough; that scale of move has never been enough to achieve reflation. So we are moving to a much lower Chinese exchange rate, a much more flexible exchange rate and probably much less buying of Treasuries by the PBOC. The one fixed point in the firmament of global macro trades is now gone.

The illusion of Chinese control is finally ending and with it the ‘certainty’ that China grows strongly while maintaining its link to the USD. It is time to grasp both the short-term implications for prices and, much more importantly, the longer-term implications for the structure of the global monetary system.

This is the most material change in Chinese exchange-rate policy since 1994. The Chinese Communist Party route to power may have been founded on the myth of the Long March, but their rise to economic power has very much been based on following a different highway in the form of an undervalued exchange rate. The exchange rate is no longer undervalued and thus the exchange rate link has been abandoned and investors are very much off-road again. The twists and turns of asset prices over the coming days, weeks and months will indeed appear as ‘crazy patterns’.


When the one important fixed variable in any equation is replaced with an unknown variable, solving that equation becomes much more difficult; uncertainty rises and so does volatility. The established patterns, of predictability, certainty and state control break down into disorder and chaos. For this analyst the removal of that fixed variable will mean global deflationary forces are exacerbated until the RMB gets to a level commensurate with a major Chinese reflation.
The biting point for such a reflation will be at much lower levels of the exchange rate.

Until that time comes, as China cuts the selling price of exports and as EM countries face new perils, the failure of the world’s central bankers to reflate their economies will be the dominant force in markets. It will indeed feel that the sky ‘is folding under you’.

In particular, a sudden cessation of capital flows to EM, many already reeling from falling commodity prices and declining exchange rates, could push some highly leveraged countries into default. For those familiar with such episodes previously, or even more recent events in 2008-2009, the investment lessons are clear: get long cash in general and get long USD in particular.

SO HOW FAR COULD THE RMB DECLINE AGAINST THE USD? This analyst has consistently forecast that it will have to be in excess of 20%. This is not a forecast based on any calculation of the level of the exchange rate necessary to make China highly competitive in the trade in global goods. It is a ‘guestimate’ based upon just how much Chinese money and credit have to grow to sustain Chinese economic growth at a level acceptable to the Chinese Communist Party.

In the past such growth has had to be nearer 30% than 20% at economic peaks and ramping money and credit growth to this level today, given the existing external deficit, would probably produce a decline in the exchange rate of more than 20%. If your exchange rate is tending to fall when the growth in broad money has been close to 10%, then a major increase in the growth of the supply of RMB must have very material impacts for your exchange rate. This is a lot more than 1.9%.

The first move in the exchange rate merely prepares the way for the ramp-up in money and credit growth that will result in much larger declines in the exchange rate. Such a small, controlled move in the exchange rate invites further capital outflow as private-sector capital seeks to protect itself from further declines. Thus it is likely to push China into even larger external deficits, driven by a larger capital-account deficit, and make reflation even more difficult at the new lower exchange rate.

The 1.9% move cannot thus, in itself, be the end of the exchange rate adjustment as it is likely to produce a larger external deficit and higher interest rates. The fact that both domestic and offshore RMB interest rates rose on the devaluation indicates that a much larger move in the exchange rate is needed to enable the reflation of China. So why engineer such a small devaluation, given its role in provoking further capital outflow and pushing interest rates higher?

Politically, the exchange-rate move can be explained as the result of market forces, following many months of declining foreign exchange reserves, while at the same time clearly being seen as insufficient to permit the necessary scale of reflation. Politically it acts as an overture, setting the scene for the Communist Party to explain to the world that much further declines in the exchange rate will be necessary if China is to avoid the perils of a debt deflation and become once again an engine of global growth.

The small devaluation is thus politically astute, even if it backfires economically by initially pushing interest rates higher. A major devaluation of the RMB has devastating impacts, particularly for EM, in a world struggling to defeat deflation and thus it needs significant political cover. The seeming economic failure of the initial devaluation sets the stage for its political success.

There are a range of deflationary impacts from the devaluation of the RMB. The most direct one is that it will permit Chinese exporters to cut the USD selling-price of their products. These price cuts will add materially to global deflation at lower levels of the RMB. The boost to competitiveness comes at the expense of those who compete with China. This will result in declines in their exchange rates, or where exchange-rate targets are in place, tighter monetary policy. Those with the flexibility to depreciate their exchange rates can also cut their USD selling-prices and add to global deflationary pressures.


- This is an extract of a longer report which has been edited for length.

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