Is Chinese Yuan Really A One-Way Upward Bet?7 October, 2011, 13:51. Posted by Zarathustra
Tags: Chinese Yuan, Economy, Renminbi
Let’s face it, China is manipulating its currency. You can call it whatever you want, but China is manipulating its currency (for that matter, I would also argue that Hong Kong dollar is manipulated).
As part of its trade policy, China has been trying to prevent Chinese Yuan from appreciating quickly. They have also taken the lesson from 1985 Plaza Accord in which the US and others have forced Japan to float Japanese Yen, and are quite determined not to repeat that. Of course, That did not help with the US’s trade deficit, and Japan is still running trade surplus for the next two and a half decades.
Even though the consensus seems to have ruled out a hard landing in China, and that the consensus seems to believe Chinese Yuan is a one way bet upward, it is always good to ask the question of whether something opposite can happen when the consensus is leaning to one extreme.
The fact about monetary policy is that you cannot have all of the following three things at the same time:
fixed exchange rate
absence of capital controls
independent monetary policy
China is attempting to do all three, but China cannot really accomplished all three things in full. It has a sort of fixed exchange rate with a moving target. It has some capital controls (for instance, capital is easier to be getting into the country than out). And its monetary policy seems to be independent. Or is it?
Not entirely. Because of its allegedly undervalued Chinese Yuan, China has been running a persistent trade surplus. And because of its capital control which favours in-flow and limits out-flow, its also having surpluses in capital account. As a result of that, we seem to always have too much money around in China, and the growth of its money supply makes the effect of quantitative easing in the United States looks insignificant (that also means that China has to intervene in the market by buying foreign currencies and assets, and hence the large foreign exchange reserve). That’s particularly true when the US dollar weakens. As I have shown previously that even though Chinese Yuan has been creeping higher for a while against the US dollar, it has not appreciated against quite a number of other currencies.
There are two questions here. The first is that: what if the US dollar strengthens? This, of course, remains to be one of the most contentious issue here among investors, with many still convinced that US dollar will become toilet paper. But if US dollar strengthens against all other major currencies, and if the Chinese wants to keep that peg with US dollar stable, it means that they have to allow Chinese Yuan to appreciate against all other currencies. Chinese exporters will not like it, and not only that. Strengthening of US dollar will bias the monetary policy of China towards the tightening side.
The second question is that in the face of a potential hard landing, how People’s Bank of China could respond by monetary policy. As mentioned above, the monetary policy of China are not 100% controllable in the hands of the PBOC because the currency peg would impose some limits as to how much easing or tightening PBOC can actually do (although we cannot be sure exactly where the limitations are). Now what if the Chinese economy entered into a hard landing and a massive monetary stimulus is required? My conjecture is that there might be a possibility (not high for the moment) that China could hit the limit of monetary easing if things get too bad and the peg with US dollar is maintained. In that scenario (which I have to stress that the probability does not look very high at the moment), China would have to make the currency fully convertible in order to perform completely independent monetary policy. And if they float their currency during the bad times, the outcome would probably be exactly opposite what the West has been hoping for. It will not go up, but go down. In fact, I have been suspecting that the Chinese would want to see depreciation of its currency in a hard landing, and the forward market is now pricing in depreciation, not appreciation.
I have to stress that the probability of this happening does not look high at the moment, and this would be a highly contentious point to make. The key point is that one day when China finally floats its currency, the outcome might surprise everyone if the market expectation is leaning too much on the one side.
For investors who are betting on the long-term appreciation story of Chinese Yuan, it would be best if you are aware of the risk that this is not necessarily a one-way bet. And for politicians in the United States, just let you know that forcing China to not manipulating its currency does not guarantee the outcome (i.e. Chinese Yuan appreciation) you want to see.