Start The Countdown to Yuan Devaluation, USDCNY Back to Old Peg Value of 8.28

ZH: Grant's Almost Daily: China Impulse Control
Could another Chinese currency devaluation be in the cards? Recall that the August 2015 yuan deval was followed by a severe bout of global risk aversion, culminating in a 9% intraday decline in the S&P 500 on Aug. 24, 2015. On that day, a trading halt in eight S&P 500 stocks cascaded into an ETF pile-up featuring major dislocations to net asset value and stoppages of 42% of all equity ETF’s. Will this time be different? The bulls hope so.
History repeats, only this time much bigger.

The 2011 slowdown in Chinese growth and reserve decline peaked at 2.8 percent yoy in May 2012 accompanied by mild yuan depreciation, mostly centered in offshore CNH.

In the ensuing growth wave, reserve growth peaked at 15.4 percent yoy in December 2013, adding $800 billion into the peak of $4 trillion in June 2014 (the U.S. Dollar Index began to rally in July).

In the ensuing contraction, reserve decline peaked at 15.8 percent yoy, taking off a $1 trillion and bottoming out at $3 trillion in January 2017. The yuan devalued 11 percent from peak to trough, including the 3 percent "shock" devaluation in the month of August 2015.

This wave of reserve accumulation peaked in January 2018 at 5.4 percent growth, adding $140 billion. We may see a few more months of accumulation or not, but it won't be meaningful. This entire accumulation will be wiped out in a single month during the coming contractionary wave.

China has added credit controls, but there's also much more renminbi floating around with a claim on reserves. Even though there are fewer holes, adding water to the bucket increases pressure on the existing holes. Outflows will be substantial if China doesn't allow for a larger decline in the yuan, especially if it reverses on credit and prints/lends to keep nominal GDP growth elevated.
China's reserve backing of M2 money supply is already below that of the Asian Tigers heading into the 1997 Asian Crisis.

Here's a scenario to show how quickly China's reserve position versus money supply can deteriorate. Assume credit growth of March 2018 continues at 7.7 percent annualized growth (this is a slow rate that assumes no pick-up in credit. The economy will slow further at this rate of M2 growth). Assume reserves peaked and will drop to around $2.6 trillion by April 2019, a decline of around $50 billion a month. In order for reserve coverage to be the same 11.4 percent of reserves as in March 2018, the yuan would have to devalue to around USDCNY 8.28, the peg level from the mid-1990s through the mid-2000s.

Events may not play out that quickly, credit growth could accelerate and reserves could decline more than expected, although $50 billion seems like a conservative estimate to me. Yet that puts China in a precarious position if there's a run on the yuan.

In order to preserve it's reserve position, it would have to do a much larger devaluation such as 10 percent, and then use reserves to defend from there. Last time the 2 percent "shock" ended up as an 11 percent total depreciation, higher form the yuan's peak value. Outflows peaked after the devaluation as well, not before.

The key for a big depreciation is disinflationary/deflationary global monetary conditions that causes the U.S. Dollar Index to rise. If the U.S. dollar depreciates, the yuan can piggyback it and avoid a crisis. Global inflation will boost global growth, USDCNY would fall and Chinese reserves might stabilize or even rise. I don't think this scenario is likely. Instead, it looks like growth and inflation are peaking. China is on a glide path to a major depreciation in the yuan. Any additional pressures from trade conflict or a recession in the U.S. or financial market panic/bear market and things could get ugly in a hurry.


  1. "The key for a big depreciation is disinflationary/deflationary global monetary conditions that causes the U.S. Dollar Index to rise."

    Why do you see that as likely? The Fed is on a very gradual rate increase path, probably behind the curve. Trump is preemptively jawboning to keep rates low. The Chair is new and unlikely to divert from the current path.

  2. PPI and especially CPI are the tail of the inflationary dog. I don't think the Fed is behind the curve, they're ahead of the curve. There's very little sign yet (could change) of a sustained acceleration in global or U.S. growth. I see the opposite, China's credit slowdown will lead to a "surprise" slowdown in emerging markets.