Tuesday, December 27, 2016

Anything But Yuan

With Chinese FX reserves getting to levels where they have to slow down their support for the yuan, they have opted to put in stringent capital controls to stem the flood of outflows.  There are obvious repercussions to this in the financial markets.  The most obvious is a reduction in Chinese capital flowing to foreign markets.

The Chinese have been almost solely focused on buying up real estate, as it is their preferred store of value.  In particular, they helped to boost the luxury real estate markets in big cities like New York, Los Angeles, London, Vancouver, Toronto, etc.  They added more fuel to the fire to high end real estate, which was already getting a boost from increasing financial asset prices over the past 5 years.  I would argue that compared to stocks, there is a bigger wealth effect from increasing home prices because they are viewed as more permanent, and is usually a bigger part of a middle to upper middle class person's net worth.  Luxury housing supply is increasing at time when demand will be decreasing.  A bad situation for that sector.

The financial media is right to be worried about China.  It is in a very difficult situation where their crazy money printing and debt build up over the past 8 years has created an excess of cheap yuan looking for a home.  And it doesn't want to stay in China, with real estate already overinflated and equities overvalued considering all the nonperforming loans on the banks' books.  The wealthy Chinese realize that the yuan is way overvalued and should be trading more like 10-12 yuan/dollar than 7/dollar.  That is why Chinese corporations are finding clever ways to invoice to keep more dollars and not have to exchange back to yuan.  Or using their yuan to buy up dollar based assets, like real estate, or do foreign company acquisitions.  Anything but yuan.

This weakening yuan is a headache for the PBOC because it can't cut rates and pump as much credit into the system as it needs to in order to pump up the economy.  If they do, the pressure on the currency increases and more FX reserves need to be used to keep the yuan stable against the dollar.  It is becoming increasingly clear that the best of two bad options to get out of this dilemma is to keep pumping credit into the system, devalue the yuan, and make the big debt pile more palatable via inflation.  Of course, that will make imports into China much more expensive, and reduce confidence in the yuan, but it will help to increase Chinese exports, a way to rebuild their FX reserves.  This also reduces the pressure to keep building more worthless buildings, roads, and bridges to nowhere, to keep up their GDP numbers.  The overcapacity everywhere is a whole another nightmare hanging over China's head.

With China increasing exports through a weaker currency, that will give a deflationary push on manufactured goods, and also crowd out some of their competitors, a net negative for global growth ex China.  All in all, this China situation is a time bomb waiting to explode, and it can do some real damage now that equity prices are so high.  Something to look for in 2017.

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