RMB Regime Change

The change to China’s currency regime has potentially large consequences for global financial assets. It should prompt new thoughts. The reason why it surprised many was on account of the authorities’ insistence that they did not see the currency as a tool to promote growth,  the relative stability and strength of the currency in the past 20 years and, due to the tight way in which it is managed, the lack of volatility over recent years. The general consensus was that relative currency stability would further China’s desires for the RMB to be accepted as a transactional base currency with regards to their longer range plans for capital account opening and inclusion in the IMF’s currency basket of Special Drawing Rights.

Whereas the relationship between monetary policy and currency in, for example, the Eurozone or Japan is readily accepted, in the case of China, it comes with a heavy freight of political considerations, both within Asia and, in particular, the US. Opinion could be said to be asymmetric as it is only weakness that vexes, not RMB strength. In the past two decades, nations, both sides of the Pacific, have come to fear China’s export strength and have had to deal with the hollowing out of their own domestic industries.

The economic context of the three day weakening of the daily fix between the 11th and 13th of August was clear enough. A persistently weak run of economic data, capped off by the July export numbers (-8% yoy) in light of a persistent relative strengthening of RMB, evidenced in the below chart of real effective exchange rates.

REER relative to 10year average

Source: Bank for International Settlements

Professional investment managers had, perhaps surprisingly, not much active exposure in the RMB which is freely traded in non-deliverable offshore contracts. Investing in Chinese equity and bonds remains more a regional, specialist activity managed from Shanghai, Hong Kong or Singapore. The offshore rates differ from official onshore rates which fluctuate within a 2% band of the daily fix. The onshore rate regime sits somewhere between a fixed currency and a floating currency; an area normally referred to as a dirty float, though, perhaps in this case would be better referred to as a dirty fix.

In suggesting that the daily fix would reference the offshore rate, the officials at the Peoples Bank of China (PBoC) promulgated a powerful logic that then pushed the fix down three consecutive days before the resultant back-draft of surprise prompted them to halt the process on day three. This has not done anything for Beijing’s reputation for financial management which was undeservedly robust.

From their perspective, all subsequent decisions carry gargantuan risks and the ranks of bureaucrats are no longer peppered with international experience: none have had any education outside of China or Russia. On the one hand, further steps to weaken the currency will stimulate increased capital flight, but, if not of sufficient size, will not provide assistance to the export sector. If the new flexibility in the fixing is abandoned, China’s aim for capital account opening and international recognition of its currency is in jeopardy. There is a risk of incoherence in policy setting and adoption.

A meaningful depreciation of the RMB will set off a deflationary pulse around the world. Reduced purchasing power from China may remove an element of global corporate profit growth. This in turn crimps returns from the only remaining prospective asset class: equities.

By being short the Chinese currency, part of the negative impact of this possibility is offset.

For our own part, we hold a short RMB position in our core portfolios, including TM Cerno Select. We increased this position on August 11th. Prior to that date, it was our view that the weakness in the Chinese economy would be persistent enough that there was a moderate medium term possibility of a large currency adjustment. What has taken place is a small (-2.9% as at August 14), near-term adjustment to its currency which presages further near to medium term adjustments. To gauge a sense of magnitude, the currency would have to weaken by 23% to return to its relative 10 year average on a Real Effective Exchange Rate* basis.

*The weighted average of a country’s currency relative to a basket of other major currencies, adjusted for the effects of inflation. The weights are determined by comparing the relative trade balances, in terms of one country’s currency, with each other country within the index.

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By |2015-08-14T11:41:48+00:00August 14th, 2015|Asset Class Returns, Cerno Capital Posts, Other Posts|

About the Author:

James is a co-founder of Cerno Capital and lead manages a number of the firm’s collective and private portfolios. After qualifying as a chartered accountant in London (Coopers & Lybrand, 1989) he relocated to Asia. Between 1991 and 2004 he worked as an equity analyst, head of research, and latterly as an equity strategist at WI Carr, Paribas, HSBC and UBS, based variously in Hong Kong, Singapore and Jakarta. James graduated from the University of St Andrews, Scotland with an MA in Philosophy & Logic in 1986. James is a Member of the Chartered Institute for Securities & Investment.