By John Richardson
CONVENTIONAL wisdom, as everyone should have discovered over the last 16 months, has a horrible habit of being completely wrong.
Today, therefore, if anybody tells you this, “China might widen the band within which the Yuan trades against the US, but, other than that, it won’t allow a sharp depreciation of its currency against the dollar, or any other currency for that matter,” PLEASE, PLEASE build an alternative scenario.
One reason I have long argued that the Yuan might be allowed to significantly fall in value is protecting jobs.
The unemployment data from January might exert more pressure on Beijing to do something quite drastic to the value of the Yuan, which HSBC estimates has recently risen in value by as much as 35% against a competing basket of currencies.
But I think there is another not widely understood reason why China might well have no choice but to significantly depreciate the Yuan: The unwinding of its “carry trade”.
James Gruber, a Melbourne Australia-based financial journalist and former fund manager, outlined the case for the unwinding in a November 2014 Research note, which you can download by clicking here.
Here is a summary of the note and updated analysis of what is happening today.
First of all, let’s look at this issue in three phases.The first two phases give you some essential history, with the third phase detailing what is happening today.
Phase One was a roaring success for China:
- In 1994, the value of the Yuan was deliberately depreciated by no less than 50%.
- This helped China become the “workshop of the world” as a result of a huge boost in its export competitiveness.
- China’s large trade surplus – where more foreign currency, mostly US dollars, was flowing into the country than flowing out – put upward pressure on the value of the Yuan.
- China’s central bank, the People’s Bank of China (PBOC), was under orders to relieve this pressure in order to protect jobs in export industries.
- So it became the “buyer of last resort” of US dollars on the interbank market, and thus built-up huge foreign currency reserves estimated today at around $3.9 trillion.
- This kept the value of the Yuan down, and had another benefit: It kept US interest rates low, and so encouraged US consumers to buy even more Chinese goods.
- The PBOC had to find a way of paying for these US dollars purchases, and it did this by printing lots of Yuan.
- The Chinese banks then took this printed Yuan, which it obtained by selling US dollars to the PBOC, and lent it out, mainly to state-owned enterprises. The result was inflation at home as investment in China surged, and disinflation abroad.
- But who cared? Nobody really gave this any serious long term thought as the global economic was booming and there was lots of money to be made.
Phase Two began, following the 2008 Global Financial Crisis:
- Foreign direct investment slowed and trade surpluses dwindled, leaving China highly dependent on this “carry trade”.
- This is how the carry trade worked: 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.
- It is worth noting that this did not, by any means, just involve foreign speculators.
- The Bank of International Settlements says US dollar loans to Chinese firms have increased from $270 billion in 2009 to $1.2 trillion today.
- Polyethylene, iron ore and copper were used as “collateral” for these trades, which adds yet another layer of complexity.
- Estimates of the total size of the carry trade range between US$500 billion and US$2 trillion. I suspect that closer to $2 trillion is the likely figure because of all the use of commodities as collateral. This would be the world’s largest-ever “carry trade”.
Phase Three is today’s “faultlines” in the carry trade:
- The winding down of the US quantitative easing programme, and the prospect of a US interest-rate rise in 2015, has led to capital outflows from China –a partial reversal of this carry trade.
- Two other factors are contributing to this capital flight. Firstly, both foreign and local investors are moving money offshore because of the weakening economy. And secondly, local investors, fearful over anti-corruption, are getting money out of the country whilst they still can.
- The scale of this capital flight is already very alarming. For example, in Q4 last year China’s capital and financial account deficit reached its highest level for more than years – $91.2bn, according to a preliminary estimate by China’s State Administration of Foreign Exchange.
How might China respond?
Over to James, who again wrote in November:
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.
This “carry trade” argument is another great example how, to put it very bluntly, central banks have “stuffed up” the global economy:
- One of the many problems created by the US Fed’s QE programme is is flows of “hot money” – first in and then now out of China and other emerging economies.
- China “bet the farm” after 2008 on a stimulus package that has seen its debts quadruple from $7 trillion in 2007 to $28 trillion in the middle of last year, according to McKinsey.
- Because of these huge debts, China became heavily reliant on the carry trade to keep its economy on the rails.
- This could have left it with no real choice but to “export deflation” to the rest of the world through a Yuan devaluation.
What does this mean for chemicals?
Take a look at the chart at the top of this blog post, which details the rise of China’s polyvinyl capacity versus local consumption since 2005.
Most of China’s PVC is made vial coal – i.e. the carbide process.
And so you can assume that in a lower oil-price world, the carbide advantage over ethylene-based PVC guarantees operating rates in China far below capacity over the next few years.
But throw significant currency depreciation into the mix and everything might change..
They too might see their typical cost-per-tonne economics changed by a weaker Yuan, resulting in a big rise in both their production and exports.