Monday, March 30, 2015

Why China won't devalue and start a currency war

I got a lot of responses from recent post on a possible RMB devaluation (see Searching for China's (financial) WMDs). Most of it was push-back from likely readers of Zero Hedge*.

Almost daily, we are seeing headlines about weakness in the Chinese economy. As an example, the latest HSBC Flash PMI contracted to 49.2, which was an 11-month low and indicated contraction. Readings like these created pressure for more stimulus and raised expectations of currency devaluation, especially if you read ZH.

Why China won`t devalue in the near future
Nothing could be further from the truth. There are two major reasons why Beijing will not devalue the yuan in the immediate future:
  • The PBoC isn't prepared for a major devaluation; and more importantly
  • China would lose face.
My previous post used a military analogy to watch for signs of a RMB devaluation and I will try to continue that framework in this case (see Searching for China's (financial) WMDs). If you were going to war, what you would do is mobilize your troops. Rush combat aircraft to the front. Cancel all leave and call up the reserves.

We are not seeing any signs of that in China. Instead, the PBoC is following a slow and methodical script of internationalizing the yuan. One of the steps of full convertibility, which isn`t scheduled to occur until the end of 2015 (via China Daily, emphasis added)::
The governor of the People's Bank of China released a time schedule on Sunday to make the country's currency more user-friendly as a step toward making international investments easier.

The reform aims to meet the International Monetary Fund's requirements before its evaluation on whether the yuan could be a part of Special Drawing Rights.

This means the yuan would join the US dollar, euro, pounds sterling and Japanese yen as part of the supplementary foreign exchange reserve maintained by the IMF.

"By the end of 2015, the last year of the 12th Five-Year Plan (2011-15), China plans to make the renminbi capital account convertible," said PBOC Governor Zhou Xiaochuan when he met chief executive officers from the world's top business groups at the China Development Forum in Beijing on Sunday.

Zhou said: "It is time to change the current policy that restrains Chinese individual residents from buying equity and financial products in overseas markets. Also the Qualified Foreign Institutional Investors plan is not flexible enough to satisfy foreign residents' investment needs on the mainland.

"A set of pilot policies and regulations will be released this year, to basically achieve the requirements for a currency that can be used more easily."
In other words, full convertibility is a prerequisite to the internationalization of the yuan. If China were to devalue now, it would create untenable pressure on the CNY trading band.

Playing the AIIB long game
As well, consider this WSJ article about how China is playing the long game with the formation of the Asia Infrastructure Investment Bank, or AIIB:
The progress China has made so far marks a rare victory for Beijing on the world stage, officials from both inside and outside China said, and the careful planning by Beijing is making the new bank a more serious challenge to U.S. dominance of the international economic system in place since the end of World War II.

“China is playing the long game effectively,” said Cornell University economist Eswar Prasad, a former senior China official at the IMF. “They are in absolutely no rush. They know other countries will come to them.”

Beyond giving up a veto, Beijing is also trying to address concerns from the U.S. and elsewhere about the institution’s transparency and governance.

Jin Liqun, a Chinese official picked by Beijing to set up the bank, has been lining up retired World Bank staffers in Washington to help them work out governance issues and to build up the new bank’s credibility with Western countries. One of his first recruits is Natalie Lichtenstein, a former World Bank lawyer. Ms. Lichtenstein declined to comment on her role at the new China-led bank.

Mr. Jin, interim chief of the new bank, said over the weekend that more than 35 countries will join as the bank’s founding members by the end of this month. South Korea and Australia, U.S. allies in the Asia-Pacific region, are expected to come on board by then, according to Chinese officials involved in the effort.
The AIIB is a high prestige project for China and it is part of Beijing`s long game to extend its political influence in Asia. The WSJ reported that President Xi Jinping outlined the goals of the AIIB on the weekend [emphasis added]:
In a speech to a regional forum Saturday, Mr. Xi presented China as a partner willing to “jointly build a regional order that is more favorable to Asia and the world.” He highlighted a new China-led infrastructure bank and other initiatives designed to leverage hundreds of billions of dollars to finance railways, ports and other development projects, and foster regional economic integration.

Throughout the 30-minute speech, Mr. Xi stressed that China’s vision, while centered on Asia, was open to participation by all countries. He was careful not to place China at the center of this emerging order, as some regional politicians and security experts have warned could happen.

But Mr. Xi said given China’s size, it will naturally play a larger role. “Being a big country means shouldering greater responsibilities for the region, as opposed to seeking greater monopoly over regional and world affairs,” Mr. Xi told the Boao Forum for Asia, an annual China-sponsored conference named for the southern seaside town where it is held.
Undoubtedly, the AIIB will finance itself by issue yuan denominated bonds, once the yuan is internationalized.
China’s planned infrastructure bank will have $100 billion in capital. Properly borrowed against, that pool could provide $1.3 trillion in financing—still short of the trillions in estimated infrastructure demand, according to Fred Hu, a founding partner of Primavera Capital Group.
If China were to effect a major devaluation now with, say, a shock-and-awe QE program, Beijing would lose face in a major way. Viewed from that context, better to suffer some short-term pain for long-term gain. That's why a major devaluation of the RMB is highly unlikely in the immediate future.

* Where would we be without ZH? It's the financial equivalent of the supermarket tabloid detailing the deathbed confession of the soldier who guarded the aliens who landed at Area 51.


Tim Simmonds said...

Love your take on ZH!Many thanks for sharing your thoughts.

Anonymous said...

Thanks for your comments. Makes sense to me.

ZH is OK for introducing issues you might not otherwise know about. Then you can check them out with someone who knows something. The easiest way to judge who really reads ZH is by the frat boy comment section.