In yesterday’s Markets and Money, I discussed currency pegs and how they caused problems when the pegged rate was out of kilter with economic reality.
China just gave us another example of the effects of a flawed currency peg, or managed exchange rate. Yesterday, the central bank announced that it would place restrictions on margin lending in an effort to stop stock market speculation.
China’s stock market promptly fell 7.7%, its biggest decline since June 2008.
But the authorities are fighting a losing battle. Let me explain why…
China has pegged its currency, the yuan, to the US dollar since 1994. It removed the peg in 2005 to allow for a one-off revaluation but has more or less always tried to manage the exchange rate to favour exports. It’s not a hard peg like the Swiss maintained against the euro, but it’s still a managed exchange rate.
That’s why China has such a huge trade surplus and why it has accumulated foreign exchange reserves of nearly US$4 trillion…the largest such hoard in modern history.
What many people don’t understand is that to maintain the pegged value of the currency, the central bank must effectively ‘print’ yuan to swap for dollars.
As a simple example, think of a Chinese exporter selling goods to the US. They exchange their dollar sale receipts for yuan to pay for wages, etc. The central bank buys the dollars and creates new yuan at the pegged exchange rate to give to the exporter.
When this happens on a massive scale, the central bank ends up printing a huge amount of yuan to maintain the pegged exchange rate. If they didn’t, the yuan would rise against the US dollar (thanks to excess US dollars flowing into the economy) and China’s exporters would lose competitiveness.
As a result of this policy, there is a huge amount of liquidity flowing around the Chinese economy. Given the centrally planned nature of the economy, the central bank can do a number of things to curb the inflationary nature of maintaining the currency peg.
They can ‘sterilise’ the newly created yuan by issuing notes and bonds of varying maturities. They can increase banks’ reserve requirements to ensure lending and credit growth doesn’t get out of hand. China did both of these things and more to contain the inflationary effects of managing the exchange rate.
But the crisis of 2008 caused the authorities to panic. They ordered the banks to lend aggressively to stave off a deep downturn…but credit growth soon got out of hand. The credit inflation genie was out of the bottle, and they couldn’t easily put it back in.
What made it harder was that nearly everyone in a position of power in the Chinese Communist Party was doing quite well out of the credit bubble, so there wasn’t much of an attempt to rein it in.
But the credit bubble became so extreme that the new leadership under Xi Jingping (elected in November 2012) began to try to curb it. This included a purge of many of the officials involved in the corruption and greed brought about by the credit boom.
The main effect of the credit boom was a substantial rise in land and property prices. But that bubble began to deflate last year, and now the punters are looking for the next asset boom to play.
Given the stock market’s roughly 70% decline from the peak in 2007, it looked like a good place to have a punt…but now the government’s trying to put out that fire as well.
Such are the problems you get trying to manage an exchange rate. In a dynamic economy, nothing can remain fixed. To maintain some sort of balance, everything must have the ability to move and adjust against everything else.
All prices are relative, not absolute. Trying to make them so will only cause distortions in other parts of an economy. This is a stark lesson of history that is obviously lost on politicians. They try the same thing time and time again. And we suffer the consequences.
So will the speculators now start building a position to bet on the end of the loose yuan/dollar peg? You bet they will, but the question is which way? Does the yuan revalue or devalue? Does it go up or down against the dollar?
In recent years, the consensus bet has been on a revaluation. That is, speculators sell US dollars for yuan in the expectation that the yuan will eventually revalue higher against the dollar. Add a healthy dose of leverage and you can make big gains (or big losses) on small moves in a currency.
Last year, the People’s bank of China tried to hurt the speculators by forcing the yuan down against the dollar. It was a costly intervention for some.
But maybe the damage done by China’s credit bubble — the malinvestment and the huge amount of bad debts created — means that the yuan will actually fall, not rise against the US dollar, if left to market forces.
If confidence in the Chinese economic miracle starts to wane, then the currency will decline whether China runs a healthy trade surplus or not. Look at Russia — their trade surpluses haven’t stopped the ruble from taking a beating recently. It’s all about confidence.
China is an emerging nation trying to deal with an unparalleled credit boom. More than likely, it’s in for years of low economic growth — much lower than everyone has been accustomed to or still expects to see.
When this becomes apparent, it’s likely the currency speculators will change their bets. You’ll see capital flight from China and a falling yuan vis-a-vis the dollar.
The current US dollar bull market will make it that much harder for China to maintain the exchange rate. Its goods will become less competitive against Europe, Japan and South Korea.
I don’t really expect any of this stuff to play out anytime soon. But it’s worth keeping in the back of your mind.
The revaluation of the Swiss franc last week is a wakeup call to the speculators out there looking for other managed exchange rates to exploit. Eventually, they’ll target China too.
How will that affect Australia if it comes to pass? Well, for a start, a weaker yuan would make commodity imports more expensive. And if the central bank is forced to raise interest rates even a little to help the currency, it would hurt asset markets and the demand for property. That would be a blow to the iron ore market.
In short, don’t expect a sustained recovery in Aussie bulk commodities like iron ore or coal anytime soon. The days of the Chinese miracle are over. 2015 will be another year of China trying to manage the fallout from their epic credit boom.
Let’s hope they can pull it off.
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