Macro: The Bottom Line (3/3/2014)

 

The Chinese yuan: an engineered currency depreciation?

 

In this week's edition of Macro: The Bottom Line, we focus on the curious slide in the Chinese yuan (RMB) over the past couple of weeks. Since the start of February, RMB has weakened over 1.6% versus USD (from 6.05/USD to 6.14/USD on Feb 28). This sounds like a mere drizzle compared what's been happening to other emerging market currencies lately. But for a tightly managed currency like the yuan, it's caused quite a stir. In fact, what makes it all the more bizarre is that this may well be an officially engineered depreciation.

 

The RMB depreciated sharply vs. USD in February 

What do we mean? To start off, we'll give a quick refresher of China's currency regime. Prior to July 2005, China maintained a hard peg for the RMB versus USD (at a rate of 8.2/USD). The primary goal was to keep the currency artificially weak, to protect the country's export-driven economy. Since July 2005, however, China relaxed its FX regime from a hard peg to a "managed float," in which the currency was allowed to "float," though only within pre-specified limits. These limits took the form of a daily trading band, beyond which the PBOC, China's central bank, would intervene to prevent any further moves. Currently, the trading band stands at +/-1% around a daily "reference rate" set by the PBOC, China's central bank.

 

Despite tight management of the exchange rate, the new FX regime has allowed fundamentals to be (slowly but surely) priced in. With the exception of an interlude following the 2008-2009 financial crisis, the PBOC has allowed the RMB to crawl higher, reflecting the strong flow of export dollars and foreign direct investment (FDI) into China. With this kind of a track record, it's easy to see why a prevailing view began to engrain itself into investors' mindsets: that the RMB had only one way to go - up!

Since China loosened its hard peg in 2005, the RMB has mostly gone in one direction: stronger

Until this February, that is. You see, China is now a much different country than it was in 2005. It is no longer the world's sixth largest economy; it is the world's second largest. With the growing economic clout comes ever-growing trade and financial linkages with the rest of the world, and the liberalization of China's capital markets (including its currency) cannot be put off forever. In line with this thinking, the PBOC is now preparing to widen the RMB's daily trading band beyond the current 1%, taking another step toward a fully free-floating regime. But there's a problem: if everyone is convinced that the RMB can only go up, what's to prevent the currency from shooting through the roof under a less restrictive currency regime, thereby crippling the country's still-crucial export base?

That's where last month's interventions came in. The PBOC was well aware of how entrenched the RMB bulls were. They came to the realization that the only way to flush them out of their positions, was to administer them a good dose of volatility. The markets had to be convinced that being long RMB was no free lunch, that it was possible to lose money on the trade.

To the extent that this got markets jittery, the PBOC certainly did its job.

 

But what does this mean for the RMB over the longer term? Is the decade-long bull market in the yuan coming to an end? We at Red Bull think not. Rather, the near-term tumble in RMB may provide a good entry point to get exposure to the yuan.

The PBOC can stir the FX markets all it likes. But it cannot fully vanquish the forces of supply and demand. First, China continues to run very large current account surpluses, unlike most other major economies, emerging or developed. Think of this as the difference between how much income China is receiving from the rest of the world, versus how much income China is sending abroad. With the balance in surplus, China is essentially raking in much more income from selling its goods/services to abroad than it's paying to purchase goods/services from abroad.

China's current account surpluses, while off from their 2007 peaks, still bring in $200bn of foreign currency a year 

 

Second, China remains a top destination for foreign investors, with foreign capital - including the all important foreign direct investment - continuing to flow into the country in force. For all the turbulence in the emerging markets, China's huge consumer market, relative stability, and well-stocked financial war chest (including $3.5 trillion of foreign reserves) are too juicy to ignore. In 2013 alone, net capital and financial inflows into the country totaled nearly $250bn.

All in all, that's a lot of foreign currency entering the country. Or in other words, a lot of ongoing demand for RMB.

 

We'll be writing more on the topic going forward, and stay tuned for some recommendations on how you can take advantage of this rare dip in the RMB.

 

 An update on Ukraine: We cannot close this week's Macro: The Bottom Line without a word on Ukraine. You might recall that in last week's post, we largely downplayed the implications of the crisis in the Eastern European country. Well, events have taken an unexpected turn, with Russian troops marching into the country's Crimean peninsula, under the pretext of defending Ukraine's Russian-speaking population. As you might expect, rhetoric from Moscow, Kiev, Brussels, and Washington have taken on a much more confrontational tone. Outright war has suddenly become a plausibility (though one we still consider very remote).

So far, the specter of a conflict on Europe's doorstep has sent oil prices above $100/barrel, and the "safe" currencies - the dollar, the yen, and the Swiss franc - have started to firm versus their counterparts. Beyond this, we do not anticipate a full-blown market crisis, both for the reasons we outlined last week (Ukraine's limited economic significance and Russia's reduced "oil leverage"), and due to the unattractive risk-reward tradeoff for the West to actually get involved militarily. But the developments in Ukraine remain a wild card, and we'll continue to monitor the situation.