The Debate Over Renminbi Policy
John Mauldin
Longtime readers know how much I respect and rely on the Gavekal group for thought-provoking research. They have a truly unique organization, one in which even junior analysts can question conventional wisdom and ask uncomfortable questions. Moreover, they aren’t afraid to let the world (or at least their clients) see their disagreements.
Today I have a recent piece in which Louis Gave jumps into the team’s debate over renminbi policy. In true Gavekal style, he openly questions what others in the firm think about China’s currency. I won’t steal any of his thunder but just encourage you to read this piece carefully. It covers a great deal of very important ground.
Louis will have much more to say about China when he speaks at my Strategic Investment Conference in Dallas this coming May 24-27. We’ll also have Gavekal’s other two principals, Charles Gave and Anatole Kaletsky. They rarely all appear in the same place at the same time, so having the three of them together will be a special treat. I’m really looking forward to the good-natured arguments that will no doubt erupt among them. I always learn from their debates.
Speaking of SIC, our early registration period ends this Sunday, Jan. 31, and with it the chance to save $500 off the walkup rate. We’ll soon start promoting the conference more widely, so if you want to get in, you should act quickly. I wish I could tell you about some of the additional speakers we are very close to getting, but until the paperwork is finished you can’t talk about it. You are really going to want to be at this conference. It will be the event of the year. You can find more information and register at the SIC 2016 website.
I am still at the ETF.com conference in Hollywood, Florida (which is close to Fort Lauderdale). We are staying one more day to have dinner with friends and were thinking that a little beach-time reading would be good. But so much for sunny Florida – this morning saw tornadoes and rain and lots of wind. I could’ve gone back to Texas for that. In theory, I will get to have dinner with my good friend Suze Orman – if her plane doesn’t get stuck on the island where she is because of winds there. I really hope she can hop on over here, because she is just tons of fun to be with.
One of the good things about being at a very large conference like this is that many of the speakers and attendees are friends, so there is a lot of catching up, sharing of notes, and learning opportunities. I fully intend to be in bed by the time you get this issue of OTB, as an early night after the last three really does seem to be the better part of wisdom. You have a great week.
Your finally attacking his inbox analyst,
John Mauldin, Editor
Outside the Box
The Debate Over Renminbi Policy
Louis Gave
One of the core tenets of Gavekal’s philosophy is
that we embrace open debate. Rather than concealing the diversity of our
analysis beneath a single suffocating “house view”, we strongly believe that
conducting our —often animated—discussions about the big topics of the day out
in the open adds value for our readers. And few of our recent debates have been
as lively as the one over Beijing’s renminbi policy. Joyce’s view is that the
Chinese currency is set to weaken this year as Beijing bumps up against the
impossible trinity and accepts depreciation as a price worth paying for
interest rate cuts to support growth (see Going Down With The Renminbi). In contrast, Chen Long and
Arthur argue that with key financial reforms now in place, the Chinese
government is backing away from its policy of renminbi internationalization
(see Retreating From An International Renminbi). In true Gavekal
style, I would like to take issue with both views.
There are two separate topics here:
1. Whether the renminbi is
likely to rise or fall over the coming years. Right now, this is one of the
questions which has got global markets in a panic.
2. Whether the renminbi will
make the grade as a truly international currency.
Of course, you could say that the two are related:
for the renminbi to go up, it needs to become an international currency; and to
a large extent, there is no doubt that increasing internationalization would
lend the currency a nice tailwind, as more and more people, companies, central
banks etc. start to save in renminbi. This argument is one of the reasons
I have been bullish on the renminbi for the last decade. In my view, as we move
from no one in the world saving in renminbi, to perhaps 2%, then 5%, then one
day even 10% of the world’s savings (ex-China) being allocated to renminbi assets,
the underlying demand for the currency would mean an increasing number of
marginal buyers. And more buyers usually mean a higher Price.
A Japanese
precedent?
But that is not the only path to currency
strength. As Arthur has pointed out, during the 1990s and 2000s, the yen was
broadly strong, and Japanese government bonds were the best performing bonds in
the world, in spite of a fall in global yen usage, weak domestic growth, short
term interest rates that had been cut nearly to zero, and repeated bouts of
quantitative easing from the Bank of Japan. This yen strength was the result of
domestic deflation, large increases in domestic savings, deleveraging by the
corporate sector, and of course a large current account surplus.
In other words, conditions that were not that
different from those we see in China today. This brings us back to the first
question above: Is the renminbi likely to rise, or fall, over the coming years?
Right now, I think it is fair to say that the
consensus view is heavily tilted to the bearish side (when was the last time
you met a renminbi bull?). To me this bearish bias underlines a simple
reality: Everywhere around the world, we are in the middle of a massive US
dollar buying panic. I see signs of this panic everywhere I look, from
renewed speculation against the Hong Kong dollar peg (a dud trade if ever
there was one), to the recent front page article in Canada’s National Post
newspaper advising people to go out and do their grocery shopping now as prices
are sure to soar because of the Loonie’s collapse, to the number of people
falling over themselves to explain why China—the world’s largest exporter and
the country now running the largest trade surplus in history (not just in
China’s history, but in the whole of recorded world history) needs a much
weaker currency.
Long in the tooth
Meanwhile, what is interesting about this US
dollar buying panic is that most major non-US dollar counters (except for
sterling) have actually been holding up reasonably well lately. In the midst of
this buying panic, the euro has not made new lows, the yen has rallied strongly
(granted, the yen always rallies when things are bad in markets) and gold has
been hovering between US$1,050 and US$1,110/oz for a while. In short, it feels
as if the US dollar’s “strength” may be getting a touch long in the tooth?
Frankly this should not be too surprising. If
there is one trade that looks obvious for 2016 it is that the US Federal
Reserve will not raise rates the four times it has promised. You can pick your
own reason why the Fed will hold back. With the ISM manufacturing PMI below 50,
corporate spreads making post-crisis highs, US industrial production in
negative territory, headline inflation far below target, US profit margins
shrinking, and equities falling, there are more than enough to choose from.
Weak footing
So, given all of the above, why has the renminbi
started the year on such a weak footing? Obviously, when a market weakens, it
means there must be more sellers than buyers. On the “buyers” side, I tend
to think that most potential renminbi buyers are shying away because of the US
dollar buying panic mentioned above. But what is probably more interesting is
the “sellers” side. From a cursory look at the financial media, you would think
that we are at the beginning of a massive exodus of Chinese capital out of
China. In short, the bearish argument for the renminbi is simple: the renminbi
will go down, and go down a lot, because the Chinese people themselves are
losing faith in their own currency.
One can make this argument about any currency. If
the British were no longer to trust the pound, then the pound wouldn’t be worth
very much. If the Swedes were to decide that they are no longer willing to hold
krona, then the value of the krona would crash.
But somehow this argument gains far more media
traction when it comes to China. The reason, I think, is that (whether we
realize it or not) most of us in the Western world tend to regard the
Chinese government as illegitimate, since it was not chosen through elections.
And given that the government is “illegitimate”, surely any smart person will
seek to ship his or her savings abroad, because an “illegitimate” government
cannot have a credible currency.
On-the-ground
evidence
My problem with this line of thinking is that
there is little evidence on the ground that this is what is actually taking
place. Sure, Chinese people have been taking money out of China. But that is
nothing new. Ask anyone in Vancouver, Sydney, Auckland, Hong Kong, or Bordeaux.
Chinese money has been coming in for years.
Macau was built as one huge conduit
to get money out of, and sometimes into, China.
The big question today is whether many more
Chinese people are taking their money out, and whether they are doing it on a
scale large enough to overwhelm China’s US$600bn trade surplus. The recent
contraction in China’s reserves suggests that this is what is happening, and of
course this is what the media are latching onto. But I am troubled by the fact
that at the anecdotal level, there are few signs of these massive capital
outflows. For example, one easy way for Chinese people to send money abroad is
through the Shanghai-Hong Kong Stock Connect scheme (which channels funds
indirectly into the Hong Kong dollar); but this has barely been utilized.
Meanwhile, real estate transaction volumes in the markets typically favored by
Chinese buyers—Vancouver, Hong Kong, Macau, Sydney, Auckland—have fallen
recently (although prices have proved more sticky). So if the Chinese are
shipping their money out of China, where is that money going? In what
asset markets can we see volumes and prices rising?
Exporters now
hedging
This brings me to my next point. Maybe the drop in
the renminbi is not primarily linked to the Chinese public panicking over the
value of their currency and deciding, en masse, to buy US dollars. Perhaps it
has more to do with large numbers of Chinese exporters adjusting their currency
exposures and hedging their positions as they have been caught up by the
general global US dollar buying panic. To me this seems a much more plausible
explanation. And it is one for which there is anecdotal evidence. A number of
Hong Kong-based friends in the import-export business have recently told me
that they are now hedging their foreign exchange exposure for the first time.
If this is what is happening on a general scale—and admittedly it is a big
“if”—we should probably not read too much into recent market moves, as they
will have been the result of short term panic-buying by corporates, rather than
the start of wholesale capital flight out of China.
None of this detracts from the views put forward
by Arthur and Chen Long. As they point out, the situation has changed, and it
is clear that from now on the PBOC will:
1. Manage the renminbi more
against a trade-weighted basket of currencies (much like Singapore) than
against the US dollar, and
2. Tolerate a greater degree
of exchange rate volatility than in the past.
But these are not surprises. They are natural,
healthy developments that the PBOC has been telegraphing for years. As I have
argued repeatedly over the past year, the days when a simple buy-and-hold
strategy could earn you 250bp more in dim sum bonds than in US treasuries,
with 2% less volatility, are now clearly over. There was a window of opportunity
for quick-footed investors to make easy money with less risk, but
it is now closing. From now on, returns in the Chinese bond market will be
more volatile. But this volatility will also offer opportunities for sharp
investors.
Buy the dip?
This brings me to the next important question. For
the past five years, one of the simplest ways to make decent money in Chinese
bonds was through a “buy the dip” strategy. Each time the renminbi and dim sum
bonds dipped—and they tended to dip together—investors could buy in, confident
that the Chinese government would step in to support the market. And why would
the government step in? Because of its desire to promote the renminbi as a
credible international currency, that could be used for trade financing (to
prevent a repeat of the 2009 trade freeze), and one that could be used to
denominate central bank reserves around the region and across emerging markets.
If as Chen Long and Arthur argue, we are now seeing a change in this
policy to establish the renminbi as an international currency, investors will
have to ask themselves whether renminbi bonds are still a good buy-the-dip
asset, even as the volatility increases and the dips get bigger.
Now to be sure, there is a lot to dislike about
what the Chinese government has been doing lately. Indeed, two years ago, at
the Communist Party’s third plenum, foreign investors were given a glimpse of a
China that would embrace supply side reforms, deregulate industry, and embrace
restructuring. It was easy to get excited. Since then, Beijing’s track record
on reform has proved increasingly disappointing. As Arthur has pointed out
recently, it feels as if things are going the wrong way fast on the policy
front (see China:
Still Off Course). The abduction over the holidays of Hong Kong
book-publisher Lee Bo, allegedly by mainland security agents, was a deeply
shocking development. As Talleyrand said of the Prince de Conde’s murder by
Napoleon, “It was worse than a crime; it was a mistake”. One has to wonder what
President Xi Jinping was thinking (assuming that the deci sion to kidnap a Hong
Kong bookseller was taken at the highest level). How could his stance not have
been: “I am the president of China. I am above such trivialities”? Worse, like
Henry II, did Xi effectively exclaim: “Will no-one rid me of this turbulent
priest?” Either way, such developments bear out Arthur’s case that all is not
well in Chinese policymaking circles.
Still, going back to what China’s renminbi policy
will be going forward, and whether the buy-the-dip strategy still makes sense,
I note that one of the points Arthur makes is that the Chinese leadership is
simply too reluctant to let market forces determine either the value of the
renminbi or the level of interest rates, for the renminbi to become widely
accepted as a credible international currency or bond market.
Paradox
But there is a paradox here. It is precisely this
reluctance to let the market dictate the value of the renminbi or the level of
Chinese interest rates that has made the renminbi such an interesting
alternative to the US dollar, euro and yen for trade financiers and central
bank reserve managers. It was this very reluctance that ensured the success of
the buy-the-dip strategy.
Put simply, the only reason foreign central banks
were prepared to shift capital into the renminbi, or companies consider
financing trade in renminbi, was because there was an implied Chinese
government guarantee that the volatility of the renminbi against the US dollar
would be confined within “acceptable” limits—an implied guarantee which effectively
underpinned the high returns of the buy-the-dip strategy.
Currency basket
The Chinese government’s new “promise” is that
this volatility will now no longer be measured against the US dollar, but
against a basket of currencies. There are several ways to see this promise:
1. The first, as Joyce has
argued, and as the consensus appears to believe, is that this is a promise that
the Chinese government will be unable to keep. In this view, the Chinese
government has simply made too many promises for it to keep them all, so some
will have to be sacrificed. One of the victims will be its promise for the
exchange rate.
2. The second—and the one I
am inclined towards—is that this promise is not surprising. It is consistent
with the broad pattern that has been unfolding over recent years, and which
continues to point towards the renminbi establishing itself, slowly but surely,
as an international currency, with all the normal attributes you would expect
of a major currency, including greater volatility than the renminbi has shown
in the past. Naturally this process is happening in a very Chinese manner: one
small step at a time, and very slowly.
Policy options
To understand why, imagine you are sitting in
Beijing and planning how to internationalize the renminbi so that over time,
more and more of your imports can be denominated in your own currency, rather
than in somebody else’s (somebody you might not be able to trust 100% in a
crisis, and somebody you definitely see as a rival for regional geopolitical
hegemony). To achieve your objectives, what would you do today?
1. Your first option is to
deregulate interest rates, deregulate the exchange rate, relax capital controls and
let prices settle wherever they may. To some extent, I detect in Arthur a sense
of frustration that this course of action is not being embraced more openly.
Leaving aside the fact that, in terms of Chinese policymaking, such a drastic course
of action would be unprecedented, I would question whether, given the current
nervous state of markets, such a course of action would be productive. On the
contrary, it could easily trigger panic. And if it did end up triggering a
panic, would the ultimate goal of moving away from US dollar dependency have
been furthered, or undermined? Please don’t get me wrong: I am all for market
prices rather than government prices. But this approach reminds me of the story
of the American tourist who got lost in the Irish countryside. Spotting a
farmer, he asked the way to Dublin, only to be told: “Ah! Dublin is it? Well if
you want to go to Dublin, you don’t want to start from here…”.
2. Your second option is to
conclude that you are screwed. Growth is collapsing and you have a debt crisis
on your hands. In this scenario your best option is to forget about your
international plans and focus on domestic problems. Hunker down, probably
devalue the renminbi, and probably forget about your dreams of an international
currency. Ć¢To some extent, this is what Joyce has been
arguing, and I also get a hint of this line of thinking from Chen Long and
Arthur’s most recent report. But if Beijing were really going down this path,
then why would policymakers have bothered intervening in the foreign exchange
market to the extent that they have over the last six months? If Beijing has
cooled towards its internationalization strategy, why would it have bothered
with funding the Asia Infrastructure Investment Bank and the Silk Road Fund etc?
Why would policymakers bother pretending that the renminbi is moving from being
managed against the US dollar, to be ing managed against a basket? An awful lot
of money would have been poured down the drain for no good reason.
3. The third option would be
to continue gradually internationalizing the renminbi by slowly increasing its
exchange rate volatility, turning the currency into something more than just a
US dollar proxy. Of course, the process won’t be linear, but over time the
renminbi will increasingly come to resemble a “normal” currency—one other
countries feel comfortable borrowing in (note South Korea’s recent issue of
panda bonds), and which companies feel comfortable holding as working capital.
Personally, I believe Beijing is still following this path, even if recent
policy moves have proved disappointing.
As a result, investors have a choice to make. They
can conclude that:
a) Beijing is losing
or will lose control of its exchange rate in the face of massive capital
outflows. To me, this belief is another example of the current US dollar
buying panic. While I was very bullish on the US dollar five years ago, it
seems to me that in the near future we will get confirmation that the Fed will
not be tightening, a policy path which may well shine new light on the growing
US twin deficits.
b) Either the Chinese
government no longer regards renminbi internationalization as its policy
priority, or it is not prepared to pay the price of having a truly
international currency. I am not sure I buy into the argument that we have
reached the stage at which the Chinese government will have to accept greater
market volatility as the price for further internationalization. We may well
reach this point one day, but for the time being, as the renminbi continues to
build market share, it seems to me that the main concern of investors is
whether the buy-the-dip strategy continues to makes sense.
c) The Chinese
government still wants to internationalize its currency, if only because Xi is
a more nationalist president than his predecessors, and keen to establish China
as the unchallenged Asian power as part of his “China Dream”. If this is the
case, the buy-the-dip strategy will continue to makes sense over the coming
years, even if the dips get bigger, and the volatility greater.
Obviously, believers of the third option (and I
count myself among them) will note that the recent sell-off is the biggest dip
on record, and that it therefore presents an interesting buying opportunity for
the renminbi and renminbi bonds.
Under-owned assets
To be fair, this view is driven largely by the belief that renminbi assets remain one of the most under-owned asset classes in the world today and that this “under-ownership” will gradually diminish over the coming years as an ever-growing number of marginal buyers enter the market.
This is the big difference with Japan. In January
1990, Japanese equities were 48% of the MSCI World, and there were seven
Japanese financials among the top ten companies in the index. Back
then, every equity and every bond manager was long Japanese assets whether he
or she liked it or not. This positioning opened the door to two decades in
which foreigners sold Japan (and even then, shorting the yen and the JGB
market was a poor trade).
Having said that, there is nothing pre-ordained
about foreigners buying more Chinese assets. For this to happen, Chinese
policymakers need to ensure that the environment is attractive for foreigners
to deploy capital. Greater currency volatility would be a deterrent to foreign
capital inflows. So would backtracking on supply side reforms, keeping zombie
companies alive and kidnapping book publishers. Nevertheless, long term
renminbi internationalization remains a powerful tide, and one that I,
personally, don’t want to try swimming against. The probability remains in
place that over the coming years we will continue to see greater use of the
renminbi in international trade, regional project finance, world central bank
reserves, and global bond issuance.
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