Shorting the Chinese currency is the most popular trade among hedge funds in 2016. As one trader in New York puts it: “Everybody is betting on a devaluation of the yuan.”
Mark Hart of Corriente Capital, for example, thinks the Chinese currency will go down 50 percent against the dollar in 2016.
Despite some relatively substantial swings, the currency is more or less unchanged for the year, though, as China has used $100 billion of its currency reserves (it had as many as $4 trillion at its height in August 2014) to defend the yuan as even more capital flowed out of the country.
So investors like Mark Hart and Hayman Capital’s Kyle Bass think this reserve drain caused by capital outflows cannot continue forever and, at some point, China will just have to let its currency go. But is this really true?
Banking Crisis
At the heart of the argument in the short yuan community is China’s bad debt problem, which nobody really disputes.
“China’s banking system is approximately $30 trillion in size and the bad assets are approximately 24 percent or so. That’s $7 trillion–$8 trillion of bad assets,” says Evan Lorenz of Grant’s Interest Rate Observer, citing research from J Capital Research.
So international investors are selling not just the bad assets and moving the money abroad to safety. The same is true for Chinese citizens, according to research by Goldman Sachs and the Institute of International Finance, at least as much as they can without being hindered by capital controls.
Chinese corporates are also paying back foreign debt or are investing in overseas assets, again putting pressure on the currency.
“You saw China can do a $44 billion bid for Swiss seeds and chemicals group Syngenta AG, you saw China’s Zoomlion bid $3.3 billion for Texan crane maker Terex Corp., and you have Chinese companies bidding around $3 trillion for General Electric’s home appliances business,” says Lorenz.
Defending the Currency
The only entity standing between this wall of cash leaving China ($637 billion in 2015 according to the IIF) and a much lower Chinese yuan is the People’s Bank of China with its already much depleted stash of foreign exchange reserves of $3.2 trillion as of Jan. 31, 2016.
This seems like a lot, but the hedge fund managers are speculating that China can’t use all of the $3.2 trillion to defend the currency because some of it is needed to finance imports and other international obligations. Kyle Bass, for example, estimates that $2.7 trillion is tied up.
Lorenz also says a lot of the money is held in illiquid investments, like loans to Venezuela, and cannot be used to defend the currency like U.S. Treasurys, which China can sell at any time. As of December 2015, China had $1.25 trillion in Treasury holdings, according to the U.S. Treasury.
“Its stock of liquid assets with which it can defend its currency are probably a lot smaller than that $3.2 trillion. I’ve heard estimates of anywhere from $800 billion to $1.2 trillion of its reserves might actually be illiquid,” says Lorenz. The exact composition of China’s currency reserves is a state secret.
Enough Money
Peking University professor Michael Pettis, however, thinks China’s stash is large enough, at least for the moment.
“The appropriate amount of reserves China needs to guarantee necessary imports and the payment of obligations on the capital account is probably [$1.4 trillion],” he wrote in a note to clients of GlobalSourcePartners.
Pettis argues that the People’s Bank of China (PBOC) can actually draw on foreign currency within the banking system to defend the currency or use it for trade because the biggest banks in China are state-owned.
He also notes that China has some reserves stashed away in a very unlikely place: commodities. China stockpiled a lot of base metals and energy commodities as soon as their prices started to decline a few years ago. State-run companies thought it was a buying opportunity. Because Chinese growth has slowed and many of the commodities haven’t been used, they could now be liquidated relatively easily for dollars.
“So China may actually have the equivalent of more foreign exchange reserves than reported, perhaps around $3.5 trillion,” wrote Pettis.
He also thinks China needs less working capital to finance imports because their prices have declined and it does not need to worry as much about export shocks like other countries. It exports more manufacturing goods rather than commodities, unlike Brazil and Australia for example. The Brazilian Real is down 28 percent against the dollar over one year.
But even Pettis says China can’t afford to keep bleeding reserves at the current pace, or it will result in a loss of confidence, regardless of fundamentals.
“If China continues to lose between $40 billion and $100 billion a month in reserves for many more months, the depletion in reserves itself becomes self-fulfilling as credibility is undermined,” he wrote.
No Devaluation
One compelling argument to solve China’s reserve drain is just to devalue 20 to 50 percent, be done with it, and keep the reserves. But this is unlikely to happen, says Lorenz.
“Chinese corporates have taken out large U.S. dollar and other denominated debt in the last couple years in a bet that the renminbi was going to appreciate. So you would first of all bankrupt the companies that had borrowed internationally,” he says, as they could not repay dollar-debt with earnings in renminbi which have dropped sharply in value.
He also notes that such a large move in an election year would only add fuel to the flames of the likes of Republican presidential candidate Donald Trump, who accuses China of being a currency manipulator.
Last but not least, it could also undermine China’s bid to become part of the International Monetary Fund’s (IMF) reserve currency in the Special Drawing Rights (SDR) basket. China was approved to join the SDR last November but will not actually be part of it until October this year.
“The IMF could withdraw the inclusion, which would be a major loss of face for China. China also has staked a lot of its credibility to maintain its peg and it doesn’t seem like officials want to lose face now after they lost so much credibility in terms of their management of the stock market last year,” says Lorenz.
Historical Context
There is another, more remote reason why the Chinese regime would not want to devalue, says Willem Middelkoop, author of “The Big Reset.”
“The Chinese experienced hyperinflation in the 1940s, as recently as 70 years ago there was hyperinflation,” he says. Historically, big external currency devaluations were part and parcel of domestic devaluations in the form of inflation.
Middelkoop believes the hyperinflation helped the Chinese Communist Party come to power in the late 1940s, and the lessons of history still ring true with the current regime leadership.
“They understand they should avoid a collapse of a paper currency system at all times. That’s one of the only ways they can lose power. That’s why they are so scared about big moves in financial markets. They understand very well they have to control financial markets and currency markets … It’s all about staying in power,” writes Middelkoop.
