Is a lower Yuan really a case of currency manipulation or is there more going on here?
By Tony Termini
The Chinese Yuan began 2016 at 6.4837 to the US Dollar. Today the currency exchange rate stands at 6.8995. That represents a tad more than a 6% decline in a little more than a year’s time (the higher the exchange rate, the fewer US Dollars one Yuan can buy). And, according to US President-elect Donald Trump, this is the result of blatant currency manipulation. But is it? The facts point to something else. And, that something else should concern investors more than if the Chinese government were actually a meddling currency manipulator.
(Chart Courtesy of X-Rates.com)
Our research suggests that China is in the early stages of what could ultimately become a full-blown currency crisis. If this is the case, then the Yuan could trade as low as its 2005 level of 8.2665.
A currency crisis begins as investors lose confidence in an economy and begin to pull money out of it. This capital flight hastens a decline in the value of the local currency. We would argue that this loss of confidence and subsequent currency flight began with the selloff of the Shanghai Composite Index in June 2015.
(Chart Courtesy of Stockcharts.com)
As the chart above illustrates, the market has not recovered from that decline and currently trades at a little more than half its valuation at the 2015 high.
As a side note, but also as a timely reminder that bolsters our case that investor confidence has not yet returned in earnest to Chinese equities is the fact that in Monday trading the Shanghai Composite Index suffered its biggest one-day loss in more than a month, falling more than 2% before recovering only after government-backed investment funds intervened.
We believe that the origins of China’s current economic woes were the artificial and unsustainable growth rates the economy experienced in the last decade when in some years GDP rose by more than 14% (Source: The International Monetary Fund, World Economic and Financial Surveys, November 2008).
Since then, year-over-year GDP growth has slowed consistently and current estimates put 2017 economic expansion at between 2.7% and 3.4% (Sources: The International Monetary Fund, World Economic Outlook Report, October 2016, The World Bank Global Economic Prospects Report, January 2017).
Slowing economic growth absolutely engenders capital flight and we don’t see a reversal of this trend. In our opinion, this is what is causing the Yuan to be as weak as it is. If growth continues to slacken, which we believe it will, then unemployment rates in the country are likely to rise. And, we would not be surprised if the country’s current official reports cite numbers that are slightly lower than reality. In the final analysis, if the growth rate of the Chinese economy slips further, it would be more evidence to us that indeed the country is suffering from the early stages of a run on its currency. To put teeth into that argument one only need look at China’s foreign reserves. In November, reserves hit a six year low (Source: Reuters, December 7, 2016).
That trend continued through the end of 2016. According to the Chinese State Administration of Foreign Exchange, official reserve assets declined by more than $220 billion in 2016. In addition to the decline in US dollars held in reserve, the country’s reserves of Special Drawing Rights decreased by an amount equal to an additional $100 billion. So, why should investors care if there is a run on the Chinese Yuan?
Investors should be concerned because a currency crisis in China would have major repercussions around the world. To put this into perspective it is well to juxtapose China’s current situation with events surrounding the Asian Currency and Financial Crisis of 1997/1998. In July of 1997 the Thai Bhat collapsed because a lack of foreign reserves forced the Thai government to float the currency rather than support its peg to the US dollar. This happened after a prolonged period of remarkably high economic growth rates. Those growth rates were unsustainable and eventually the strain on the economy and the country’s currency came to a head. Yet, instead of it being a local matter, Thailand’s currency crisis spread throughout the region, which in general had also experienced remarkably high, and yet unsustainable economic growth rates (Source: Federal Reserve Bank of New York, “What Caused The Asian Currency and Financial Crisis?”, January 1998).
What followed the collapse of other currencies in the region was a worldwide selloff in financial assets. While the selloff was not an uncontrolled panic, in the United States stock prices lost some 7% of their value in what has come to be remembered as the “mini-crash of 1997” (Source: US Securities and Exchange Commission, Trading Analysis of October 27 and 28, 1997, September 1998).
So, we believe that there is risk that China’s current currency problems could pose a larger threat to equity investors. And, it is for this reason that we maintain the perspective that a prudent investor should allocate a portion of his or her portfolio to gold.