What is China doing with the Yuan?
1. Front loading yuan weakness
2. Yuan depreciation is a policy tool. With SDR decision in the rearview mirror, China is stepping up their currency reform. Its the first year of their 5 year plan to rebalance the economy
3. Yuan intervention overnight is a familiar tactic used by the PBoC. Back in August, they weakened the Yuan 2% and then intervened by ordering state banks to buy yuan in an effort to drive out speculators.
Why are they doing this?
1. Currency is Overvalued
2. Weaker Currency is Consistent with Monetary Easing
3. Its Competitive Devaluation
4. Necessary part of their plan to provide underlying support for their economy as they shift from export to consumption
1. These actions will flame the currency war in the region
2. Kills the Fed’s chance of tightening in March
3. More outflows
4. More yuan weakness with intervention to slow the decline
5. Yuan weakness is one of the greatest risks for the financial markets in the near term because a weaker yuan means less purchasing power for Chinese individuals and businesses = weaker profitability for US businesses selling to China
6.75 is our target for USD/CNY
I was on the Business News Network earlier today discussing whether China’s Yuan move is a big deal. Click on the image to access the video:
News that China surpassed Japan as the world’s second largest economy is one of the biggest stories in the financial markets. For more than 4 decades, the only country with a larger economic output than Japan was the U.S. However over the past 20 years, the Japanese economy stagnated, giving China the opportunity to usurp Japan and snag a title that it has held since 1968. Just 5 years ago, China’s gross domestic product was around $2.3 trillion, about half Japan’s but rapid growth has pushed economic output to $5.88 trillion in 2010. While the Chinese economy grew, the Japanese economy contracted by 1.1 percent, bringing Japan’s economy to $5.47 trillion last year.
Although the absolute size of their economies are comparable in U.S. dollar terms, Japan and China could not be any more different. China has 10 times more people than Japan but the GDP per capita is also 10 times less. Some may look at this as room for growth but the rest of us may feel that the income inequality reflects the inherent weakness of the China economy. More than 150 million people, which is 10 percent of the population live on less than $1.25 a day. While growth in Japan is likely to pick up in 2011, it will have a very difficult time reclaiming its title from China.
Will China Usurp the U.S.?
The next big question investors are asking is whether China will usurp the U.S. to become the world’s largest economy. Currently the U.S. economy is 3 times the size of China’s which means that the Chinese economy would need to triple in order to match U.S. levels. This is an incredible feat that will be difficult to achieve but not inconceivable. In fact, many economists believe that China could eclipse the U.S. sometime between 2020 and 2030. Chinese incomes are rising and it is the government’s goal to reduce income inequality significantly over the next decade.
Implications on the Chinese Yuan
For the financial markets, this means that over the next 20 years, there will be a significant change in the dynamics of the foreign exchange market. Not only will the Chinese Yuan be revalued and set at higher and higher levels, but I expect much more flexibility in the Chinese currency. In fact, by 2030, I would be surprised if the Chinese Yuan did not become a free floating, fully convertible currency that is as actively used as the euro and possibly even the U.S. dollar. This will of course undermine the importance of the Japanese Yen and other currencies.
With each Chinese rate hike, there has been a smaller and smaller impact on the currency market. The first rate hike back in October elicited the biggest reaction because it was the first rate hike in nearly 3 years. At the time, all of the pro-cyclical currencies plunged against the U.S. dollar with the euro falling 1.5 percent and the Australian dollar declining by more than 2 percent. When China raised rates again on Dec 27th, the euro ended the day slightly higher against the U.S. dollar while the Australian dollar remained unchanged. The price action today is very similar to December which suggests that investors are skeptical about China’s ability to tame their roaring economy. Slower Chinese growth is undoubtedly negative for global growth but we have been down this road before and even though there have been signs of slower growth in the Chinese economy, it has not had a significant impact on demand. The Reserve Bank of Australia for example has recently attributed their rosier outlook to a strong Chinese economy.
Unsurprisingly, rising inflationary pressures is the primary motivation behind China’s rate hike. We have been looking for another rate hike from China since they tightened in December and with prices rising due to geopolitical risks, the Lunar New Year and a recent drought in the grain producing Northeast part of the country, China did not want to take any risks, opting to preempt a further increase in inflationary pressures by raising interest rates. Given the health of the Chinese economy and the prospect of stronger global growth, we have not seen the last of China’s policy actions. We expect more interest rates hikes and more reserve requirement ratio hikes in 2011. Although these actions will drive the Chinese Yuan higher, if global growth is supported by other countries around the world, it will soften the blow of Chinese tightening.
Everyone is talking about the possibility of China raising interest rates. What if they did? How could it impact currencies?
In October, the PBoC surprised everyone by raising interest rates for the first time since 2007. At that time, we said the central bank rarely makes one off changes and we believe that the central bank will raise interest rates again before the end of the year. On the day that the PBoC raised rates (which was October 19), all of the major currencies including the Japanese Yen fell sharply against the U.S. dollar. This suggests that if the Chinese central bank were to raise rates again, it could exacerbate the flight to safety into U.S. dollars.
However interestingly enough, the move in USD/JPY was mild compared to the move in other currencies. Safe haven flows into U.S. dollars overshadowed demand for Yen – Japan leans more heavily on China than the U.S.
Therefore if China were to raise rates again, the U.S. dollar should be the biggest beneficiary.