Originially posted at Agilityforex.com
After a brutal sell-off in February of this year, the Chinese Yuan has slowly gained back about half of the ground it lost in the People’s Bank of China engineered bloodbath, where the currency had its largest short-term decline in years. The free-fall came in conjunction with the Chinese government widening the trading band by two percent as they follow the path to making the Yuan a free floating reserve currency. At the time, markets were worried that the Chinese were weakening the Renminbi in order to stimulate growth. Although still in high single digits, the Chinese economy has weakened significantly from its glory days of ten percent plus expansions annually. However, in hindsight, it seems that these fears were groundless. Looking backwards, the spike in USD against CNY earlier in the year was most likely an attempt to reduce one sided short-dollar carry trade bets.
There have been costs to Chinese corporations associated with the Central Bank’s intervention. Many of the companies were borrowing offshore in dollars and paying in Yuan, taking the view that the Renminbi would forever strengthen. The move in the currency obviously went against this view. This caused significant losses to Chinese corporate balance sheets. Perhaps the slow appreciation since the peak of the decline in March is an attempt to help repair these paper losses. In any case, the point has been made-don’t make one-way bets with the Chinese currency or you might get burned.
The real question is where does the Yuan go long term? How should you position your portfolio relative to China? Can you make money still with a Yuan pair trade? To answer these questions, investors need to have an understanding of the history of the currency and an appreciation of the government’s goals regarding the Renminbi. It is in China’s best interest to eventually have a free floating Yuan to promote use as a global trading and reserve currency. This outcome will only foster economic stability in the Middle Kingdom. The Chinese Communist Party leadership has been remarkably patient and determined in moving their economy towards a capitalist system that will rival America’s economy. They realize that reserve currency status will give them the margin of error and currency hegemony that the United States currently enjoys with the USD. The Chinese envy this status. So seen in this light, widening the trading band of the currency is an attempt to push the status of the currency forward and to wring corruption out of the system. This goal is admirable.
However, the Chinese government also realizes its export oriented economic model cannot last forever. The Chinese population are becoming wealthier and expectations for the good life are rising. Other Asian nations are becoming more competitive as far as labour costs are concerned. China cannot be the low cost producer forever. In this light, the Party is pushing the shift to a domestic consumption oriented model. A stronger currency supports this effort. China is also very dependent on imports of raw materials. A strong Yuan helps this situation as well. The government realizes that no nation, in the long-run, has ever devalued its way to stable prosperity.
So what are investors to do? Is the Yuan at these levels a buying opportunity? Or is the currency becoming too volatile. In my opinion, the Yuan will continue to appreciate over time, although there will be much more short-term volatility. Investors should take a partial position at these levels against the dollar and keep some powder dry to add size on the dips. That being said, I don’t believe the Yuan is still a short term trade. The central bank intervention has seen to that. I think this is a longer term bet that could take time to materialize. In that vein, if you have capital to put to work over the medium term, consider taking a bite of Yuan.
L. Todd Wood is a former emerging market debt trader with 18 years of Wall Street and international experience. He is also an author of historical fiction thriller novels. His first of several books, Currency, deals with the consequences of overwhelming sovereign debt. He is a contributor to many media outlets and is a foreign correspondent for Newsmax TV. LToddWood.com