Not so long ago, a big Chinese currency devaluation seemed both inevitable and imminent. The story went like this: China had borrowed tens of trillions of dollars in response to the Great Recession and squandered much of it on uncompetitive factories and ghost cities. The companies and governments that own these worthless assets were about to about to go broke en masse.
China would, as a result, have no choice but to cut the yuan's value by as much as 40% to make domestic debts manageable and export industries competitive. Hedge funds, led by Hayman Capital's Kyle Bass, were gearing up to bet billions on this event.
From a Bass report to his investors (via the Value Walk website):
Over the past decade, we have worked diligently to identify anomalies in financial systems, governments, and companies around the world. We have been vigorously studying China over the last year, with the view that the rapid credit expansion in the Chinese banking system will result in significant credit losses that will require the recapitalization of Chinese banks and materially pressure the Chinese currency. This outcome will have many near-term and long-term effects on countries and markets around the world. In other words, what happens in China will not stay in China.
The unwavering faith that the Chinese will somehow be able to successfully avoid anything more severe than a moderate economic slowdown by continuing to rely on the perpetual expansion of credit reminds us of the belief in 2006 that US home prices would never decline. Similar to the US banking system in its approach to the Global Financial Crisis ("GFC"), China's banking system has increasingly pursued excessive leverage, regulatory arbitrage, and irresponsible risk taking. Recently, we have had numerous discussions with various Wall Street firms, consultants, and other respected China experts, and they almost all share the view that China will pull through without a reset of its economic conditions. What we have come to realize through these discussions is that many have come to their conclusion without fully appreciating the size of the Chinese banking system and the composition of assets at individual banks. More importantly, banking system losses - which could exceed 400% of the US banking losses incurred during the subprime crisis - are starting to accelerate.
Our research suggests that China does not have the financial arsenal to continue on without restructuring many of its banks and undergoing a large devaluation of its currency. It is normal for economies and markets to experience cycles, and a near-term downturn that works to correct the current economic imbalance does not qualitatively change China's longer-term growth outlook and transition to a service economy. However, credit in China has reached its near-term limit, and the Chinese banking system will experience a loss cycle that will have profound implications for the rest of the world. What we are witnessing is the resetting of the largest macro imbalance the world has ever seen. [emphasis added]
So how did we get here? Since 2004, China's real effective exchange rate has appreciated 60%. The majority of this appreciation occurred in the last few years as the ECB and BOJ both actively targeted weaker exchange rates to stimulate Europe's and Japan's large export sectors, respectively. While the markets seem solely focused on China's exchange rate versus the US dollar, this fixation misses the point that many other manufacturing economies and currencies, including those belonging to Japan, Europe, Russia, and several Southeast Asian countries, have gained significant price advantages at China's expense. If China is to achieve the required clawback of its real effective exchange rate, the renminbi will need to devalue against a trade-weighted basket of currencies and not just the dollar. In effect, the required devaluation against the dollar will need to be multiplied to achieve the necessary result.
As the renminbi appreciated over the last decade, China undertook a massive infrastructure spending program in order to maintain politically-determined GDP growth targets in the face of these headwinds. This policy action created a system of distorted incentives (not to mention a dramatic misallocation of capital) whereby local officials were promoted to higher office by exceeding those targets without regard to the return on investment of the projects they supported. In 2005, exports and investment constituted 34% and 42% of China's GDP, respectively. By 2014, exports had fallen to 23% and investment had grown to 46%. This growth in investment was funded by rapid credit expansion in China's banking system, which grew from $3 trillion in 2006 to $34 trillion in 2015.
Today China is at a point where its banking system can no longer support such massive growth, and the strong renminbi has effectively undermined the competitiveness of China's export economy. A dramatic devaluation of the renminbi is warranted to regain export competitiveness; however, the Chinese authorities have errantly fought against this so far, spending around $1 trillion to defend their currency. The continued capital outflows and emerging need to deal with losses in the banking sector will eventually force China to change tack and allow (or enable) a devaluation that resets growth as many countries have done over the past eight years.
China: Divergence in Bank Asset Growth and GDP
There's much, much more in Bass' letter, all of it pointing to an epic crisis in which the exposure of China's fake growth numbers, historically-unprecedented levels of malinvestment and evaporating foreign exchange reserves combine to force a devaluation.
But apparently not yet:
(Wall Street Journal) - The yuan hit its strongest level against the dollar since early December on Friday, after the Chinese central bank boosted the fixed rate to keep up with the euro's big gains overnight, analysts said.
Analysts said the move likely came as a result of a sharp rally in the euro Thursday, after European Central Bank President Mario Draghi appeared to suggest that the central bank wouldn't cut interest rates further into negative territory. Mr. Draghi's comments came after the central bank delivered another rate cut and ramped up its bond-buying program.
China wants to keep its currency in line with those of top trading partners Japan and Europe, said Daniel Tenengauzer, a managing director at RBC Capital Markets. "With the euro going up after the ECB yesterday, it makes sense that the bank would raise the fix," he said.
Last year, the People's Bank of China said it would change the way it manages the yuan's value, with the exchange rate now being measured against a basket of currencies of its trading partners rather than the dollar alone. The move was seen as a demonstration of China's determination to make the yuan a global currency, with a value determined more in line with other major currencies.
So is the China devaluation thesis false or just early?
History teaches that huge imbalances seldom just evaporate. Most of the time they're rectified through sudden, wrenching change -- market crashes, recessions/depressions and, yes, devaluations.
In China's case, the combined effects of an overvalued currency and a global slowdown have caused its exports to plunge, while supporting the yuan has forced it to burn through nearly half a trillion dollars of foreign exchange reserves in the past year. Since it can't fix the global economy, devaluation seems to be the only remaining tool in the box.
But history also teaches that imbalances can persist for a shockingly long time before causing a crisis. So add the overvalued yuan to the list of Money Bubble sub-sections that should have blown up long ago -- and will certainly blow up one of these days -- but for now, somehow, are still going.