China’s Currency Catch-22
Paola Subacchi
LONDON – Officials at the People’s Bank of China (PBOC) have long insisted that “China won’t weaponize the renminbi.” And yet, implicit in their promise not to manipulate the currency for strategic ends is their ability to do so if they so desired.
China’s monetary policy has come to the fore now that US President Donald Trump has imposed import tariffs on a range of Chinese goods. Many are wondering if China will respond to Trump’s trade war by threatening a currency war. If it does, the world should call its bluff.
To be sure, with more than $3 trillion in foreign reserves and an established – albeit not entirely successful – system to manage its exchange rate, China has enough financial and monetary leverage to bring the US economy to its knees. But having the weapons it needs does not mean that China can afford to use them.
In June, the renminbi had its worst month on record, dropping 3.7% against the dollar. Analysts are divided about the cause. Some view it as the result of a slowdown in economic growth, coupled with market concerns about the introduction of US tariffs and dollar appreciation on the back of rising US interest rates. Others suspect that Chinese monetary authorities intervened to weaken the renminbi, in order to offset the impact of US policies.
The Chinese government has a long history of intervening to ensure that the renminbi’s exchange rate aligns with its economic goals. But, since 2016, when the renminbi was included in the basket of currencies that determines the value of the International Monetary Fund’s Special Drawing Rights (SDR), the exchange rate has been determined mainly by market forces.
Still, despite PBOC Governor Yi Gang’s insistence that China’s exchange rate reflects demand and supply (with a basket of currencies as a reference), monetary authorities have the power to intervene when necessary. And though such interventions have been less frequent than in the past, they have continued to muddle market signals.
In the context of today’s trade war, however, an “engineered” competitive devaluation of the renminbi, even if technically possible, would not be in China’s best interest. Unlike in the past – and despite the Trump administration’s view of China as an unreformed currency manipulator – a weak renminbi has more costs than benefits for China.
For starters, by increasing import prices and bolstering export sectors, a weaker renminbi would undermine the Chinese government’s goal of shifting away from export-led growth and toward a model based on higher domestic consumption. Moreover, a weaker renminbi could invite renewed US complaints about currency manipulation.
Finally, and more crucially, a weak renminbi at the same time that dollar-denominated assets become more attractive could cause China to suffer capital flight. In this scenario, Chinese monetary authorities might be forced to reverse course and prop up the renminbi. By then, such an intervention would have to be large, implying a significant decrease in the country’s official reserves, as happened in 2015 and 2016.
Complicating matters further, China’s monetary authorities are already struggling to maintain financial stability under conditions of slowing economic growth, a total debt-to-GDP ratio of around 250%, and monetary-policy normalization on the part of the US Federal Reserve.
China thus finds itself between a rock and a hard place. To discourage new lending and reduce the risk of capital outflows, the PBOC should tighten monetary policy. But counteracting the negative impact on growth resulting from rising US interest rates and tariffs calls for more monetary accommodation.
So far, China’s answer to this conundrum has been to relax capital requirements in order to create more liquidity into the banking system. But if Chinese savers expect the renminbi to depreciate further, this measure could be offset by capital outflows – even with the capital controls the government currently has in place.
Looking ahead, Yi may have to resort to more than verbal assurances to support the exchange rate. That could mean that China and the Fed will end up selling – or at least not rolling over – US Treasury bonds at the same time. In the event, US interest rates could go through the roof, implying serious risks for global financial stability. So, while a weak renminbi is worse for China than it is for the US, a PBOC intervention to strengthen the currency could undermine the Fed’s policy normalization, and financial stability generally.
China’s lack of a fully liquid and convertible currency means that there will always be a fundamental divergence of exchange-rate regimes across the international monetary system. And this divergence will continue to produce distortions that intensify the global effects of new US monetary-policy trajectories.
The solution to this problem is straightforward: eliminate the distortions. China should float the renminbi so that its exchange rate becomes truly market-determined, even as it continues to manage capital flows. A “managed” approach of this kind would help China strengthen its financial system and develop the renminbi as a major international currency.
Unfortunately, China seems as beholden to its current exchange-rate regime as the Trump administration is to its trade policy. The US and China’s irreconcilable approaches are not good for anyone. We all should be concerned about what may come next.
Paola Subacchi is a senior fellow at Chatham House and visiting professor at the University of Bologna. She is the author, most recently, of The People's Money: How China Is Building a Global Currency .
Over the past 4+ months, we’ve been working away trying to keep our readers aware of the risks and concerns that were originating out of some foreign markets and how that might relate to the US markets. We remember a point in time back in June or July 2017 when we, suddenly, started receiving emails and calls from moderately large Indian, Indonesian and other foreign development companies asking to schedule time for an “introduction call”. It is not unusual for us to receive cold calls from development firms looking for new projects, but at one point we were getting 2 to 3 calls a week.
The point behind what we are sharing is that sometimes the signs are right in front of you if you are paying attention to the messages. In this case, a number of things had recently transpired – the biggest of which was the recent US Presidential elections as well as a renewed US equities market and increased volatility in certain currency markets. We also believe the currency controls in India (near November 2016), as well as the Chinese cash restrictions imposed shortly before this, were also factors that played into the current outcome. Our opinion is that these dynamic factors in the global economy, as well as the fact that many government reporting/news agencies are slow to catch onto a dramatic shift in market sentiment, resulting in a latent and somewhat aggressive price rotation in the global markets.
Which brings us to January/February 2018 – when the US and Global markets tanked, unexpectedly, by nearly -13.5%. While many analysts throughout the globe were concerned this rotation could be the start of a much deeper and potentially catastrophic global market collapse, our proprietary predictive price modeling systems and analysis systems kept telling us the US markets climb out of this rut and attempt to rally to new highs. In some ways, we took a lot of flack from others calling for this type of market rally when everyone else was calling for a breakdown in price. Still, look at where the US markets are now in comparison to all of those short-sellers that were convinced the markets were going to tank?
Right now, there is a very interesting dynamic at play that may not last forever – and most of the industry analysts are starting to catch onto what we’ve been talking about for months. That fact is that capital is very fluid and will migrate to the healthiest and most suitable investment environment possible when the environment where this capital currently resides is unfavorable or deteriorating. As we learned in the movie “Wall Street” – “Greed, for lack of a better word, is good” (Gordon Gekko: 1987 “Wall Street”). In our interpretation, Greed is the essence of the survival of capital in different market environments. Greed and Fear are two very similar emotions and they both, at times, are very good to have in measured levels. Both of these emotions drive capital into and out of markets as a natural occurrence of the global markets.
This dynamic, the capital migration that has been taking place for approximately 12+ months, may come to an end at some point in the near future and we have to be prepared for it. If we think about this scenario, what would cause this capital migration to subside or end and change dynamics? We can think of two scenarios that would be likely to play out to result in this transition :
Take a Look at Our Previous Forecast on March 28th
This chart clearly shows where prices were expected to move, which was sharply lower through spring and this summer. See complete 5 part series on global indexes
Now, let’s start off by checking this Weekly chart of our China/Asia custom index and where it is today. One can clearly see the pennant/flag formation (the Green lines) that originated in early 2018. This pennant formation recently broke out to the downside and has already fallen nearly half way to our downside target which is incredible.
The current downside move aligns with a 38.2% retracement from the highs and we believe this move could be just starting. In other words, we believe a full 50%, or more, a pullback from these highs could be in the works if the data originating from China/Asia recently is correct. The entire region of China and SE Asia is open to interpretation and legal issues with little certainty about anything.
This next Weekly BRICs chart shows a similar pattern. A sideways pennant formation originating in early 2018 that broke out to the downside. A clear breach of price support and a more than -38.2% price drop so far. Our Blue price support line, originating from 2016/2017 lows, shows us that critical support is currently about -11% lower than the current price. You can see from our drawn arrows that we believe this level will create price support and price will rotate well into the end of 2018 before breakout out of this new pennant formation and moving dramatically lower. Right now, time will tell how this plays out 5+ months into the future, but at this time, unless the global market dynamics change dramatically, this is what we believe is the most likely future outcome.
Lastly, this is the Weekly European Custom Index that shows, yet again, a somewhat similar pattern without the recent price breakdown. Originating in early 2018, a deep price rotation has created a very clear price rotational cycle. This rotation is forming a very clear pennant formation, again, and we believe the final outcome, at this point, will be a breakdown of price in the European markets as the Brexit and other regional economic and political issues continue to play out. As a word of warning, our last Red arrow (drawn on this chart) does not point to a target price level – it is just indicating that we believe a breakdown in price is the likely outcome.
If we were to add a simple Elliot Wave count to this in an attempt to isolate potential future moves, our estimate (with limited data) would be that we are in the midst of a Wave D correction. In other words, this is a corrective price trend “in an uptrend”. The move lower, as we are predicting, may not drop below the 50% retracement levels shown on this chart before finding support and attempting to start a new upside price move.
Pay attention to the global market news and the news of certainty or uncertainty originating from the global economies. Capital is “Greed and Fear and work every day”. Capital will always attempt to exit hostile or dangerous economic environments and find a more suitable environment for growth and stability. As the continued global market turmoil continues to unfold, understand that Trillions of dollars will be sourcing the safest and best returns on the planet. As these dynamics play out, there are tremendous opportunities for traders and investors to follow the cash and ride the waves. There may, certainly, be some wild rotations and waves as this capital moves around, but the longer term trends that should establish as this capital moves around should be substantial. Get ready for some excellent trading opportunities over the next 12 to 24 months.
The point behind what we are sharing is that sometimes the signs are right in front of you if you are paying attention to the messages. In this case, a number of things had recently transpired – the biggest of which was the recent US Presidential elections as well as a renewed US equities market and increased volatility in certain currency markets. We also believe the currency controls in India (near November 2016), as well as the Chinese cash restrictions imposed shortly before this, were also factors that played into the current outcome. Our opinion is that these dynamic factors in the global economy, as well as the fact that many government reporting/news agencies are slow to catch onto a dramatic shift in market sentiment, resulting in a latent and somewhat aggressive price rotation in the global markets.
Which brings us to January/February 2018 – when the US and Global markets tanked, unexpectedly, by nearly -13.5%. While many analysts throughout the globe were concerned this rotation could be the start of a much deeper and potentially catastrophic global market collapse, our proprietary predictive price modeling systems and analysis systems kept telling us the US markets climb out of this rut and attempt to rally to new highs. In some ways, we took a lot of flack from others calling for this type of market rally when everyone else was calling for a breakdown in price. Still, look at where the US markets are now in comparison to all of those short-sellers that were convinced the markets were going to tank?
Right now, there is a very interesting dynamic at play that may not last forever – and most of the industry analysts are starting to catch onto what we’ve been talking about for months. That fact is that capital is very fluid and will migrate to the healthiest and most suitable investment environment possible when the environment where this capital currently resides is unfavorable or deteriorating. As we learned in the movie “Wall Street” – “Greed, for lack of a better word, is good” (Gordon Gekko: 1987 “Wall Street”). In our interpretation, Greed is the essence of the survival of capital in different market environments. Greed and Fear are two very similar emotions and they both, at times, are very good to have in measured levels. Both of these emotions drive capital into and out of markets as a natural occurrence of the global markets.
This dynamic, the capital migration that has been taking place for approximately 12+ months, may come to an end at some point in the near future and we have to be prepared for it. If we think about this scenario, what would cause this capital migration to subside or end and change dynamics? We can think of two scenarios that would be likely to play out to result in this transition :
- Emerging markets stabilize, forming near-term bottoms and establishing some optimism regarding opportunities for upside price advances. This, in our opinion, may be enough of a catalyst for capital to move back into these markets in an attempt to capture returns with diminished risk factors – resulting in GREED outweighing FEAR.
- Something decreases the US and major global market standing in terms of currency strengths and global market dominance. In this case, we believe some massive credit or debt risk factor would have to occur that greatly decreases the capabilities of the mature global markets (US, UK, Canada, Japan & Europe). Should something like this happen, where the biggest and most stable markets on the planet are diminished, then capital may aggressively move away from these markets and into any other market that may appear to benefit from these diminished expectations.
Take a Look at Our Previous Forecast on March 28th
This chart clearly shows where prices were expected to move, which was sharply lower through spring and this summer. See complete 5 part series on global indexes
Now, let’s start off by checking this Weekly chart of our China/Asia custom index and where it is today. One can clearly see the pennant/flag formation (the Green lines) that originated in early 2018. This pennant formation recently broke out to the downside and has already fallen nearly half way to our downside target which is incredible.
The current downside move aligns with a 38.2% retracement from the highs and we believe this move could be just starting. In other words, we believe a full 50%, or more, a pullback from these highs could be in the works if the data originating from China/Asia recently is correct. The entire region of China and SE Asia is open to interpretation and legal issues with little certainty about anything.
This next Weekly BRICs chart shows a similar pattern. A sideways pennant formation originating in early 2018 that broke out to the downside. A clear breach of price support and a more than -38.2% price drop so far. Our Blue price support line, originating from 2016/2017 lows, shows us that critical support is currently about -11% lower than the current price. You can see from our drawn arrows that we believe this level will create price support and price will rotate well into the end of 2018 before breakout out of this new pennant formation and moving dramatically lower. Right now, time will tell how this plays out 5+ months into the future, but at this time, unless the global market dynamics change dramatically, this is what we believe is the most likely future outcome.
Lastly, this is the Weekly European Custom Index that shows, yet again, a somewhat similar pattern without the recent price breakdown. Originating in early 2018, a deep price rotation has created a very clear price rotational cycle. This rotation is forming a very clear pennant formation, again, and we believe the final outcome, at this point, will be a breakdown of price in the European markets as the Brexit and other regional economic and political issues continue to play out. As a word of warning, our last Red arrow (drawn on this chart) does not point to a target price level – it is just indicating that we believe a breakdown in price is the likely outcome.
If we were to add a simple Elliot Wave count to this in an attempt to isolate potential future moves, our estimate (with limited data) would be that we are in the midst of a Wave D correction. In other words, this is a corrective price trend “in an uptrend”. The move lower, as we are predicting, may not drop below the 50% retracement levels shown on this chart before finding support and attempting to start a new upside price move.
Pay attention to the global market news and the news of certainty or uncertainty originating from the global economies. Capital is “Greed and Fear and work every day”. Capital will always attempt to exit hostile or dangerous economic environments and find a more suitable environment for growth and stability. As the continued global market turmoil continues to unfold, understand that Trillions of dollars will be sourcing the safest and best returns on the planet. As these dynamics play out, there are tremendous opportunities for traders and investors to follow the cash and ride the waves. There may, certainly, be some wild rotations and waves as this capital moves around, but the longer term trends that should establish as this capital moves around should be substantial. Get ready for some excellent trading opportunities over the next 12 to 24 months.
