Thoughts on the RMB
- I am a frequent critic of Beijing policy ineptitude but it simply cannot be underestimated the magnitude of what they are trying to accomplish with regards to the RMB. If you look back on the history of transitions of not insignificant countries transitions from fixed to floating or near floating currency regimes, the shift is rarely smooth.
- If we make a simple assumption that the RMB is going to behave more like an EM currency against the USD, or even vaguely similar to the EUR/JPY, it is probable that over the past 12-18 months, the RMB would have lost 20-40% of its value. Consequently, even if you take the low end of that range, that would imply that the RMB needs to decline 15%+ to reach a more appropriate value. There are other ways to look at this but they all imply the RMB is overvalued by a not insignificant amount.
- One of the numerous worrying aspects here is the apparent lack of understanding Beijing demonstrates with regards to markets. For instance, Beijing is a fan of markets on the Mainland when they go up, but not when they don’t do what the Party wants. Price setting is one of the Beijing’s most treasured privileges in every market. However, the international currency market will not obey Beijing dictats.
- You can see this battle being fought in the regular PBOC announcements and in the markets. PBOC announcements are filled with announcements how strong the economy is, the strong fundamentals of the RMB, and no reason for depreciation or outflows. While they understandably have an interest in not triggering panic, these releases give them an image that they have no idea what is going on in their own economy they are so detatched from reality. Then in the offshore market, there is this repeated intervention game going on where the CNH moves sharply away from the CNY and it stays diverged for a few days continues to diverge then the PBOC comes in and typically in the span of a few minutes moves the CNH back to near parity with the CNY. Most worryingly for the PBOC, these currency guerillas keep coming back for more. They keep coming back because they know fundamentally the RMB is overvalued by at least 15%.
- The biggest risk is pretty simple: the PBOC is trying to gently steer the RMB lower. This is going to be difficult for a variety of reasons. First, the market knows the RMB is going in one direction and they like those odds. Even if a hedge fund just shorts the CNY/CNH overnight with a not insignificant leverage and sells at trading open, recently, they would be making solid money. Second, external factors which played into Chinese policy objectives are going against them. Probably the last thing China or the RMB needs is a Fed rate hike but that is likely what’s coming. Third, the domestic economic environment is such that capital wants to leave. It is no coincidence that the giant ball of money rolls between asset classes in China, one seemingly crazier than the previous fad. Chinese investors, retail and institutional, know that quality investment options in China are limited and are very interested in moving money elsewhere.
- I don’t see the slow slide in the CNY having much of an impact on FX depletion. The decline will likely come in counterfactually slightly better but the difference is enough to have a significant impact. In fact, there is a strong possibility that the lower CNY rate while lowering the direct need for FX intervention is actually going to worsen it indirectly. If investors believe that the RMB is going lower, they will move more money out of China. To counteract this pressure, the PBOC is required to intervene even more just to keep it from plunging even more. There is some evidence of this phenomenon of this, even though I’m not ready to pronounce it as definite.
- The PBOC and RMB are benefiting in one clear way from its link to the USD. The current account surplus has ballooned, primarily due to falling import prices and steady global demand. This has helped ease the need for intervention to hold the RMB steady, even if this was not their design. Consequently, capital outflows are unintentionally being softened due to a favorable environment. Should there be any reversal, due to a variety of factors in this favorable current account surplus situation, the RMB could face enormous and rapid pressure.
- I differ philosophically from many of the IB’s and traders in RMB predictions. With everyone releasing 2016 predictions, every prognostication eventually tells the same story with slight degrees of difference. The RMB will be 5% or 8% lower in 2016, a very linear process. I see the RMB, and many financial assets, moving in decidedly a non-linear and choppier manner. For instance, I think that say 5% RMB decline is a relatively reasonable prediction. However, I would say something more like: there is a 90% probability of a 5% decline with a 10% probability of a 40% decline. Let me emphasize: this is not my prediction, I am only trying to give an example of how I view this process and the movement processes at play. Furthermore, the more the PBOC moves the RMB down, I see the pressure build on the RMB for additional weakening and additional pressure for rapid and violent movement. I see the incremental downward movement as adding incrementally to the probability of a sudden dislocation.
- I had someone email me about how a trader might profit from this and part of the strategy, to me depends on what type of strategies you like. However, let me give two examples. First, I think there is a very low probability the RMB will start appreciating. Consequently, as a low risk strategy, one strategy might be shorting the RMB with leverage near the end of the day, especially if the trading day has seen a downward drift, and closing out after next morning fix. Second, buy long dated out of the money options on the RMB say at 7 RMB/$ playing the less likely probability of a large RMB movement at some point in the next 6-12 months.
- Pressure continues to build.