The yuan depreciation thesis rests on a simple fact: China is creating credit far faster than it is growing reserves. Unless the country's economy strengthens such that the capital account can open and the yuan becomes a reserve asset, eventually high inflation or currency depreciation will hit. The alternative being the government allows a deflationary recession that cleans out the bad debt. Very few governments ever choose the latter solution and there's no sign China will choose it either.
The dollar bear thesis rests on the assumption that the U.S.A. and more specifically the U.S. dollar, will "take one for the world." The dollar will lead global currency depreciation, salvaging the U.S. dollar system for another decade and kicking off another global credit boom. Some combination of India, Latin America and Africa will drive global growth.
The dollar "bull" thesis (bull in quotes because we're discussing relative to currency, not relative to real assets) rests on the assumption the USA refuses, cannot or fails to lead the world in currency depreciation because the rest of the world creates credit at a faster pace. The U.S. manages its currency for domestic goals and starts the process of abandoning its role as reserve currency. Arguably this began under Bush and Obama with the weaponization of dollar. Trump has extended the policy, with new goals of boosting U.S. manufacturing and employment. The "bull" thesis also wins out if one or more central bankers fail. It wins out if a deflationary wave goes too deep or too long, overwheliming central bank intervention.
The bull case is far from a slam dunk. Marketes can ignore reality for long periods of time if underlying trends are supportive. The yuan could rally for a decade or more if it becomes a reserve asset or global capital invests more in China. It could run for years if there are multi-year inflows into China, even if the currency's fundamentals deteriorate. Right now, there's some evidence of a shift in global capital flows as commodities rally, but fundamental risks in China remain.
The U.S. Presidential election will determine if trade war continues or rolls back. If it continues, China's trade surplus will eventually come under pressure. Credit growth outstrips reserves. Reserves are flat, almost eerily flat. Jeffrey Snider wonders if China isn't doing what Brazil tried earlier last decade: The Contingent Hole In China’s Brazil Dollar Strategy.
In the context of the PBOC’s 2019-20 straight line for its forex asset base, why would anyone rule out “contingent liabilities” masking an otherwise relatively straightforward eurodollar squeeze? We understand both why the Chinese would want to hide such a thing, as well as the general idea about how that would work. Not the specifics; we’ll never be privy to those, but we’d expect a contingent inflow only in the one sense that in others looks like the same old outflow.
China's reserves will fall below 10 percent of M2 in October at this rate. That number is meaningless until it isn't. The real amount of "excess" reserves is smaller than 10 percent because China needs a portion of reserves for liquidity. Conservatively, call it $1 trillion. That cuts reserve coverage to about 7 percent of M2. What does that mean in practical terms? In extremis, if 1 out of 14 yuan wants to go overseas, it would drain all of excess reserves. This doesn't include all the credit in the economy not contained in M2. Every yuan in circulation has a claim on reserves. Rising reserves are also a problem for China because it will be interpreated as cheating on trade. Even if things go well for China and the yuan appreciates, they will have to open the capital account or increase imports because there will likely be trade pressure. In sum, China's political-economy remains under pressure.
Capital controls can work, but Chinese currency need not flee overseas for a loss in value. If Chinese want out of fiat and cannot find a foreign outlet, they can buy housing. If housing is restricted, equities. Leadership would love an equity bubble because that would attract foreign capital. Gold and other real assets are an option, but that may put pressure on reserves again.
I have been looking for yuan depreciation for some time. I expected the other side of this event would be U.S. dollar strength. Given the rise in the euro and yen, the alternative scenario of developed vs emerging economy currency blocs is a greater possibility. The euro and yen could appreciate against everything, including the U.S. dollar, even as the U.S. dollar enjoys impressive gains against most currenices in the world. The DXY did break an important multi-year moving average in July though, and the prior two breaks accompanied bear markets. The window is open for a rapid decline in the greenback. If this happens, potential yuan depreciation moves out several years. The DXY remained "oversold" for roughly two years in prior bear markets and suffered mutiple quarters of consecutive depreciation. A final low would come later with bear markets lasting about 5 to 6 years.
On the other hand, the bounce in the dollar in September occurred right where the charts said it should. If the dollar surprised by breaking higher and that accompanied a global recession caused by the fallout from economic damage in 2020, a yuan crisis could be a 2021 story. And if we didn't need more wildcards, Tucker Carlson of Fox News will be interviewing a Chinese scientist who claims the coronavirus escaped from a Chinese lab. President Trump watches Carlson's show. If there's a credible bombshell, he will be talking about it on Wednesday.
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