Not Yuan Weakness, Dollar Strength

I expected a breakdown in the yuan not only because of inherent imbalances between credit inflation and accumulated reserves, but also due to U.S. dollar strength. Weakness in the yuan is due to the latter at the moment.

First on the imbalances. There was enough inflation baked into the Chinese monetary system for a double-digit depreciation several years ago. The situation only grows worse with the Chinese economy growing at 6 percent and credit growth at double-digits. The theoretical target price (as opposed to market price) for USDCNY is ever rising until these trends change.

China is pouring credit into a saturated market,. Like pouring water into an already filled bowl, the overflow goes somewhere, in this case into housing and outflows. As the U.S. dollar rises in relative value against other fiat currencies, the yuan rises with it. The valuation gap between Chinese assets and foreign assets widens as the currency appreciates versus much of the world, and this is on top of the high domestic inflation of prior years which has yet to be accounted for in the currency market.

The outflows to date are still mostly the result of fundamentals. Chinese investors are buying overseas assets because they're cheap and they will keep buying as long as they remain cheap. Depreciation expectations have yet to play a major role in outflows. The PBoC would like to keep it that way, but the wildcard is the U.S. dollar.

China has effectively said currency appreciation is over. The yuan flatlined versus the euro following the adoption of the currency basket at the end of 2015, and the two move in near lock-step since, albeit with less volatility for the yuan.

The U.S. dollar is fully in control here. An appreciation of less than 1 percent will push USDCNY past 6.83, erasing all yuan appreciation since the re-peg ended in 2010. Depreciation expectations have not played a large role in the market to date, but once 6.83 is taken out, technical traders will look for a breakdown. Even without any shift in expectations, if the U.S. Dollar Index moves past 100 and on to new highs, USDCNY will climb past 7. A move towards 105, 110 or even 120, and the yuan could be down 5, 10 or 20 percent without any need for depreciation expectations.

Note that if Trump wins the presidency, China will not be able to count on the U.S. export market and will have little incentive to hold down USDCNY appreciation.

Related: ‘Something’ In ‘Dollars’; August

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