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Please Plan Now For A Yuan Devaluation

Business, China, Company Strategy, Economics
By John Richardson on 19-Feb-2015


By John Richardson

IF YOU haven’t already planned for the possibility of a substantial drop in the value of China’s Yuan then you have no more time to lose.

I suggest every chemicals company that finds itself in this situation should get down to work immediately. The hard questions about why nobody in your company picked up the warning signs – which were flashing amber as early as May 2013 – should be asked later on.

For me these warning signs started flashing red in the second half of 2014 when it became clear that China’s growth was slowing. I warned that the government had long set three main priorities – jobs, jobs and jobs – and that employment was under threat as a result of economic rebalancing. I felt that a Yuan devaluation might be one means of protecting jobs.

Then in November, James Gruber, a Melbourne Australia-based financial journalist and fund manager, with whom I work closely, published this important research note on how the unwinding of China’s “carry trade” * could by itself force a Yuan devaluation (*see my footnote for a definition of this carry trade).

At that time he had the foresight to warn that capital outflows, on a slowing Chinese economy and a stronger US dollar, could be the mechanism behind the winding of these carry trades.

And this is how he saw the future playing out:

Initially, we suspect that China would try to defend the currency by liquidating foreign exchange reserves. That would risk a deflationary spiral, however. It would shrink money supply, reduce credit growth, leading to falling asset prices and further capital flight.

Remember that this strategy was pursued initially by the Asian tigers in 1997. It was abandoned as it proved too painful. Devaluation was eventually favoured and the Tiger currencies declined close to 60% on average.

If capital flight were to occur, we believe China would eventually follow the less-painful route of devaluation too.

Official figures, which were released in January, showed that in Q4 of last year capital flight had risen to $91 billion compared with $56.7 billion in Q3.

And then came last week’s release of data on China’s imports, exports, consumer price inflation, producer price deflation and employment for January.

Wind forward to this week when:

  • “My personal view is that the domestic and foreign situation looks more and more like the Asian Financial Crisis,” said Guan Tao, director of international settlements at China’s State Administration of Foreign Exchange. The 1997-1998 Asian Financial Crisis was triggered by capital flight from Thailand, Indonesia and South Korea. This led to currency devaluations and a region-wide banking crisis.
  • “We can sense the atmosphere of the Asian Financial Crisis is getting closer and closer to us,” added Guan, who identified capital flight on a weakening property market as the biggest risk for China.
  • Bank of America (BOA) warned that Yuan depreciation is one of the few tools left for China to ensure it gets a good share of global demand and meets its growth and jobs targets.
  • The ripple effects in China, and globally, of this happening would be substantial, added the BOA. (See my post from February 2014]. These ripple effects would include a further fall in commodity prices, the unwinding of the carry trade, more downward pressure on Chinese property prices and a resulting rise in bad debt, said the bank.
  • Whilst banks and property companies with heavy foreign debts would suffer from a devaluation, China’s exporters would benefit, said the BOA [These would include Chinese chemicals companies, which, thanks to the 2008-2013 stimulus package, have lots of spare production to dispose of].
  • “There is more cash betting against the yuan than there has been for 10 months, according to recent survey data from Reuters on investors’ positions in the dollar against Asian currencies. Many investors say the currency is still too strong given China’s declining growth rate, falling inflation—which is at a five-year low—and dismal economic data,” wrote the Wall Street Journal. 

The worrying thing for me is that China, whilst it might well have the right long term vision, looks as if it could well lose control of the immediate crisis.


*Definition of the carry trade: Traders have been borrowing in developed-market currencies with very low interest rates, predominantly in US dollars, and buying Yuan-denominated assets with much higher yields. This has enable to make money through “interest-rate arbitrage” – higher deposit rates in China compared with overseas. They have also made money from steady Yuan appreciation. Here is how this worked: You borrowed in US dollars and converted to Yuan. By the time you had to repay your US dollar loan, the Yuan was stronger and so you made a currency gain.