2017-01-24

China Will Devalue the Yuan

My view isn't that China should devalue the yuan, but that a depreciating yuan is inevitable because China doesn't want a depression. If China is willing to accept a contraction in GDP growth, rising unemployment and widespread bankruptcies, then of course the best option is to have a recession and deflation. Punish those who took on too much debt, too much risk and bad decisions (jail/execute them if they are your political rivals?), rather than socializing losses across the economy. Let companies go bankrupt and clean up the mess, clean the balance sheets and restart the business cycle.

Instead, China refuses to allow any clean up and piles more inflation on top of more inflation. The devaluation of the yuan already took place and is still ongoing, from 2008 to 2017. There was a brief interlude when they thought to slow credit growth a smidgen and it led to fear of a real estate collapse. What followed was a stock market bubble and then another real estate bubble.

Chinese outflows are driven by the overvaluation of the Chinese yuan and Chinese assets. As long as the yuan and Chinese assets (namely housing) are overvalued, there will be outflows. The target value for Chinese reserves is zero if the yuan-denominated assets remain overvalued.

China can let asset prices collapse, causing a collapse in debt and money supply, balancing out the economy. Or China can let inflation rip inside of China, north of 10 percent per annum for a few years, such that wages catch up with home prices (an example of two prices out of whack because of credit inflation). Or China can find a way to reform and grow the private economy, something it has failed to do for nearly 20 years.

Or China can push the US to reform the global monetary system. My view is based on the global economy and U.S. dollar cycle. China is not an island unto itself. It is struggling with U.S. dollar deflation today. Layering on socionomic analysis, the chart of the U.S. dollar says there will be more dollar appreciation (deflation?) and President Trump's economic agenda could create it overseas via trade, tax and energy policy. If DXY gets to 120, EURUSD will be 85 cents and USDCNY will be 8 without any yuan-specific depreciation.

Reuters: Chinese banks told to issue dollar-denominated debt-sources
China's central bank is said to have encouraged banks to issue more offshore US dollar bonds at a time of steep declines in the country's foreign reserves, raising supply prospects for the sector.

The People's Bank of China (PBoC) encouraged banks at a meeting late last month to issue more US dollar bonds, according to two market sources. The guidance was verbal and no specific measures were mentioned, they said.

"PBoC's stance was quite supportive (on the issuance of US dollar bonds)," said one of the sources. "In heeding the call, banks will probably issue more US dollar bonds at a faster pace this year."
China needs more U.S. dollar credit to meet dollar demand, but the U.S. isn't providing it. The eurodollar market is in contraction as Jeffrey Snider of Alhambra has explained. Trump's economic agenda will further shrink the flow of dollars to China.

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