A Contrarian View Of China: Tying It All Together

Recently China has once again attained prominent status among the investment community, where while the majority still adheres to the old, permabullish view that Chinese risks are contained, increasingly more fund managers are convinced that the Beijing-based central-planned economy is due for a major pullback. One such one investor, as we pointed out previously, is Jim Chanos, whose exemplary track record means his opinion should never be ignored. Somehow we doubt Chanos is much insulted by Jim Rogers' derogatory remarks of his understanding of the China situation. He who laughs last...

Any discussion of Chinese prospects has major implications on the country FX rate, especially vis-a-vis its peg with the dollar. Here experts again disagree, with one analyst who has set forth a controversial idea is SocGen's Albert Edwards, whose position, against the grain of prevailing opinion, is that China will devalue the yuan in the face of the same headwinds that are forcing the US to do all it can to do the same. Edwards' colleague, Dylan Grice provides another compelling perspective, arguing that the Chinese bubble has no option but to burst in the near term, and any investment overtures should be delayed until at least such time.

And where FX is concerned, one must obviously evaluate the implication on that country's FX reserves, especially if, as in the case of China, said reserves are massive, and amount to over $2.4 trillion. Today, we presented some speculative observations on what may be occurring behind the scenes of the Chinese economy, where a peculiar disconnect has occurred in the last 6 months as Chinese US Treasury holdings have not kept up with the country's aggressive growth in FX reserves. Is China simply diversifying its US debt holdings, or is there something more sinister going on?

Below we present another view, this time of Corriente Advisors, whose report "A Contrarian View of China" comes as close to tying it all together as is possible under the current information (or lack thereof) regime.

The paper's conclusion provides some unique observations:

  • Over the past decade, China has accumulated a massive sum of total FX assets - approximately $2.7 trillion, by our calculations
  • Conventional wisdom suggests that China's accumulation of FX assets is an indication of strength and high savings, and that the RMB will only move higher vs. the USD
  • Our work suggest otherwise. Based on our analysis, we conclude that
    • Because of the peg and the common perception that the RMB is undervalued, the RMB has been in a bubble for several years
    • China's accumulation of FX reserves is the result of extensive monetary expansion
    • A significant and underappreciated source for China's FX reserves has been speculative capital inflows
    • Massive monetary expansion and speculative foreign capital inflows have fueled asset bubbles within China that inevitably will burst
    • The next significant move for the RMB vs the USD is most likely LOWER.

And here are the Corriente-proposed catalysts that could cause the Chinese government to devalue the RMB vs the USD (whether the US will allow such a move, is a totally different topic altogether).

  • Stronger US Dollar: As a net exporter of goods, China has benefited from a weak dollar. If the USD (and, as a result of the peg, the RMB) were to strengthen vs. other major currencies, then Chinese exports would become less competitive, adversely affecting the Chinese economy and hampering job growth. If the USD strengthens vs. other major currencies, we believe it is highly likely that China will devalue the RMB vs. the USD to remain competitive. Further, we believe this to be a highly probable scenario, as global USD-denominated debt deflation reduces the amount of USD outstanding and pressures the USD to strengthen vs. other major currencies
  • Protectionism/Trade War: Rather than China implementing import tariffs of its own, which would heighten trade tensions, protectionist policies by the U.S. could be met with a currency devaluation.
  • Bursting of the Chinese Asset Bubbles: Declining asset prices would cause foreign capital flight out of China, shifting demand to buy USD and sell RMB, especially by speculator who funded their asset purchases with USD-denominated debt. In addition, the resulting wealth destruction and unemployment in the construction sector would likely compel the government to devalue (or allow a depreciation of) the RMB to boost its export sector.
  • Removal of the Peg: Removing the pef and allowing the USD/RMB exchange rate to freely adjust to market forces would eliminate China's primary rool for monetary accommodationm thereby creating a drag on the Chinese economy and asset markets. Paradoxically, unless the PBoX were to compesnate enough through other means of money creation, the ensuing fall in asset prices would result in foreign capital flight and downward pressure on the RMB.

Full Corriente presentation is certainly a must read for anyone interested by China.

Corriente China


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