By Zarathustra, the founder of Hong Kong blog Also sprach Analyst. He was educated at the London School of Economics and the Chinese University of Hong Kong and was once a Hong Kong-based equity research analyst focusing on Hong Kong real estate (which he did not really like), with a secondary coverage on China real estate sector (which he actually hated). Cross posted from MacroBusiness
Let’s face it, China is manipulating its currency. You can call it whatever you want, but China is manipulating its currency.
As part of its trade policy, China has been trying to prevent they Yuan from appreciating quickly. They have also taken the lesson from 1985 Plaza Accord in which the US and others forced Japan to float Yen, and are quite determined not to repeat that. Of course, that did not help with the US’s trade deficit, and Japan is still running trade surpluses two and a half decades later.
Even though the consensus seems to have ruled out a hard landing in China, and that the consensus seems to believe the yuan is a one way bet upward, it is always good to ask the question of whether something opposite can happen when the consensus is leaning to one extreme.
The fact about monetary policy is that you cannot have all of the following three things at the same time:
1. Fixed exchange rate
2. Absence of capital controls
3. Independent monetary policy
China is attempting to do all three, but cannot reallyaccomplish all three things in full. It has a sort of fixed exchange rate with a moving target. It has some capital controls (for instance, capital is easier to be getting into the country than out). And its monetary policy seems to be independent, but in reality isn’t.
Because of the allegedly undervalued yuan, China has been running a persistent trade surplus. And because of its capital control which favours in-flow and limits out-flow, it also has surpluses in the capital account. As a result, we seem to always have too much money sloshing around in China, and the growth of its money supply makes the effect of quantitative easing in the United States looks insignificant (that also means that China has to intervene in the market by buying foreign currencies and assets, and hence the large foreign exchange reserve). That’s particularly true when the $US weakens. As I have shown previously, even though Chinese Yuan has been creeping higher against the $US dollar, it has not appreciated against many other currencies.
There are two questions here. The first is what if the $US strengthens? This remains a contentious issue here among investors, with many still convinced that $US will become toilet paper. But if $US strengthens against all other major currencies, and if the Chinese wants to keep that peg with $US dollar, it means that they have to allow the yuan to appreciate against all other currencies. Chinese exporters will not like it, and not only that. Strengthening of the $US will bias the monetary policy of China towards the tightening side.
The second question is that in the face of a potential hard landing, how will the People’s Bank of China respond though monetary policy? As mentioned above, the monetary policy of China is not 100% controllable in the hands of the PBOC because the currency peg would impose some limits as to how much easing or tightening PBOC can actually do (although we cannot be sure exactly where the limitations are). If the Chinese economy entered into a hard landing and a massive monetary stimulus is required, my conjecture is that there might be a possibility (not high for the moment) that China could hit the limit of monetary easing if things get too bad and the peg with $US is maintained. In that scenario (the probability does not look very high at the moment), China would have to make the currency fully convertible in order to perform completely independent monetary policy. And if they float their currency during the bad times, the outcome would probably be exactly opposite what the West has been hoping for. It will not go up, but go down. In fact, China would want to see depreciation of its currency in the even of hard landing. Which may help explain why the yuan forwards market is currently pricing depreciation not appreciation.
I have to stress that the probability of this happening is remote, and it’s a contentious argument. But the key point is that when China finally does float its currency, the outcome might surprise everyone. For investors who are betting on the long-term appreciation story of the yuan, it would be best if you are aware of the risk. And for politicians in the United States, forcing China to float its currency does not guarantee the outcome you want.