Over or Under: The Current and Future Value of the RMB

This article by George Magnus gives an outstanding overview of the Chinese economy and predicts a devaluation in the RMB. Today I would like to tell you why he is wrong in predicting a devaluation. The RMB is, in fact, undervalued.

The over valued consensus

The over valued consensus is quite easy to explain. Chinese growth is dependent on creating large amounts of debt. Those with capital, rich people, are increasingly worried about how that debt will be paid. Due to their concerns, capital is fleeing China. This creates a positive feedback loop for capital outflows. Because so much money is leaving China, there is more supply of RMB than demand.

Why the over valued consensus is wrong

Capital flight is part of the cycle China has created. Rapid increases in debt cause capital flight. People are scared of the economic system that got them rich, however the economic fundamentals of that system are unchanged. That economic system is built upon transferring wealth from savers and consumers to investments and producers.

It was not that long ago that the graph below was enough evidence to convince the world that the RMB was undervalued.

china-current-account-to-gdp-1

This is China’s large current account surplus. It is this graph that convinces me the RMB is undervalued.

The Chinese growth model dictates an undervalued currency. The same growth model dictates more savings than investment. These cannot change. The current capital flight is also a necessary part of the growth model (see my previous post about cycles), however it can be controlled. The current account surplus isn’t going anyway, however the capital account deficit can be controlled or manipulated. Controlling the capital account is a political decision; it is a political decision well within possibility.

Timing

So, there is a current account surplus and a capital account deficit. Why do I think the current account is more serious in regard to the value of the RMB aside from political ability to control the capital account?

fixed-asset-investment

I believe that investment will no longer be able to sustain economic growth. This graph is similar to the Battle of the Bulge. The Chinese government is throwing their weight into propping of investment, but ‘miracle’ growth from high investments and financial repression is over. Only government backed investment is keeping growth rates stable. I believe that this is a greater immediate disaster than China’s capital account deficit.

Predictions

George Magnus gave a prediction of the RMB devaluing to 7:1 by the end of the year. My prediction is a little different. I believe that Chinese investment levels will drop by the end of the year, and Chinese savings rates will not change. Thusly, China’s current account surplus will rise.

I believe that this time next year, China will run an increasingly large trade surplus with the world. I believe this trade surplus will grab international attention and be received poorly. The current account surplus will put upward pressure on the RMB.

Step one of my prediction is a rise in China’s current account surplus. Look for it to rise over 3%. Step two involves international backlash. The main party would be the United States. Look for the United States to start mentioning key phrases such as “currency manipulator” during and after the election.

I’m not alone

A Chinese devaluation is increasingly popular to read about. The battle between the capital and  current accounts is interesting to watch. Money is steadily leaving China, however outflows are slowing in volume. I’m not alone in predicting a stronger RMB. Consider this graph that I took moments before publishing this blog post (taken from Christopher Balding’s blog).

swap-price

If swap prices are now predicting a stronger RMB, it is worth considering the points I have brought up. A weak RMB was always fundamental to the Chinese growth model.  Capital outflows will have a hard time reversing what has been in place for so many years.

So, what is a cycle anyway?

I recently read this excellent article from the FT. In regard to our dialogue today, this is the important part:

“The free movement of capital will lead to an optimal allocation of resources and the   integration of open, competitive and efficient European financial markets and             services. It will also help maintain “responsible” macro-economic policy and can foster growth through finance and knowledge transfers (direct investment).”

European Commission

“There is now a growing recognition that the short term nature and inherent volatility of global capital flows are problematic.”

– Christine Lagarde

Surely, only one of these statements must be correct… right?

What is a cycle?

Credit moves in cycles. Let’s start with some simple examples.

Between 1500 and 1800, France abrogated it’s debt eight times. During this time French monarchs had a habit of executing major domestic creditors. Creditors lent money to the French crown, and when favorable conditions changed debt was forgiven. In the beginning money is lent. In the end debt is forgiven and a head is lost.

This is not an extreme example. The US occupation of Haiti beginning in 1915 was rationalized as necessary to collect debt.

Why do we have these cycles?

Why did domestic creditors issue money to the French crown if they risked losing their head? The same reason that people would trust Mozambique to repay a $850 million tuna bond. In finance or economics we refer to this as ‘searching for yields,’ and leftists often refer to this as ‘greed.’

This is nothing new. Between 1822-1825, Latin American states raised more than 20 million pounds. London, in a search for higher yields, caught silver fever.

This increase in credit leads to increases in debt. If history is any indication, the increase in debt often proves to be unstable, and countries are forced to restructure their debt. From 1826- 1828 Buenos Aires, Chile, Greater Columbia, and Peru defaulted on their external debt. London’s silver fever was for naught.

If you would like to know more about the history of debt and credit cycles I highly recommend This Time is Different, which I am paraphrasing in today’s post.

Friction in the world’s cycle

The opening quotes from the European Commission and Christine Lagarde are not mutually exclusive. Instead, they provide the dominant ideology at their point in the credit cycle. So Ms. Lagarde’s comments highlight  the prevailing mood of the world: there is great political fragility in our current version of globalization.

This political fragility comes in many forms: reassertion of national identities as a response to global immigration, rejection of centrist political parties, and general distrust of federal and international institutions. In the same way that the European Union refuses to acknowledge its immigration woes, fighting a cycle causing enough distrust to cause Britain to leave the EU, China is refusing to admit its unsustainable reliance on increasing rapid credit growth and debt. China is fighting the credit cycle.

The same cycle that is showing political fragility in the rise of Donald Trump is causing large capital outflows in China. High debt levels can adversely affect growth any time there is uncertainty about how debt servicing costs will be paid. Intelligent actors will do what is necessary to protect themselves and their assets from bearing the costs of debt. This is happening now.

Money is leaving China, and what it wants is safety and security. Pre-communist China defaulted in 1921 and 1939 on its external debt. It then relied on domestic debt to fund its political needs; domestic debt grew exponentially. Although China was able to fight the cycle in order to fight the Japanese, someone is going to pay that money. Someone, just like the French creditors pre 1800, is going to lose money and maybe a head.

The most well connected and wealthy in China are not stupid. They want to move their capital before the cycle leaves their wealth exposed. Any company not prepared to accept this new environment won’t survive the changing cycle.