The trading world is short the yuan, expecting a substantial devaluation of the yuan as the Chinese spend down their foreign exchange reserves. The financial press and blogosphere are filled with predictions of devaluation. Such unanimity of opinion gets SLL’s contrarian juices going, and here’s an article from Alasdair Macleod that provides intellectual underpinnings for the contrary case. From Macleod at goldmoney.com:
Last Sunday (31 January) Zero Hedge ran an article drawing attention to the big names in the hedge fund community who are betting heavily that the yuan will suffer a major devaluation any time between the next few months and perhaps the next three years.
The impression given is that this view is universal, almost to the exclusion of any other.
A market cynic would point out that when everyone is short, there is no one left to sell, so it is a good time to buy. This may indeed be true, and gives the Chinese authorities the opportunity to squeeze the bears mercilessly should they so choose. However, as Zero Hedge points out, some bear positions are in the form of put options rather than naked shorts, so hedge fund losses in this case would be limited to option money if the trade goes wrong. Instead, whoever sold the options to them will ultimately absorb the losses to the extent they have not hedged their corresponding positions in turn.
The advantage of buying long-dated OTC put options is that you can wait for a financial strategy to come right. The motivation for buying them is therefore less to do with market timing, and more to do with economic expectations.
At its simplest, the common view appears to be that China is suffering from the debt problems that follow an excessive expansion of bank credit, the unwinding of which is expected to lead to crippling deflation. This view is variously informed by the findings of Irving Fisher in his analysis of the 1930s depression, and perhaps the Austrian school’s description of credit-driven business cycles thrown in. To these can be added the experience of modern credit bubbles, particularly the aftermath of the sub-prime crisis of 2007/08, which remains fresh in hedge-fund managers’ minds. It amounts to a rag-bag of impulsive thought, and consequently it is assumed a large devaluation will be required to reduce the prices of China’s exports, so that China’s labour force will remain competitive and employed.
There are many empirical examples that disprove the idea that devaluation is the route to export success, so it is something of a mystery why it should be seen as a certain outcome for the yuan. The root of the idea that devaluation for China is an economic cure-all is the supposed improvement it gives to the balance of trade. And here the mystery deepens, because the fall in prices for imported commodities has actually increased China’s trade surplus, so much so that the trade surplus for all of 2014, which was $382bn equivalent, was exceeded by just the last seven months of 2015, while at the same time the economy was supposed to be collapsing. The total trade surplus for 2015 at $613bn was a record by a very large margin. A devaluation is definitely not required on trade grounds.
Instead, China’s trade surplus is a secure platform from which to pursue market-based reforms. And here the objective is more about permitting the population to build personal wealth, increasing the numbers of the middle class instead of destroying it. This is an alien concept to western macroeconomists, leaving them uncomfortable with their anti-market, pro-interventionist ambitions. They have a monetarist and Keynesian notion that devaluation counters the price deflation they think China faces, encourages moderate inflation, and stimulates animal spirits. This depends on the broad question as to whether or not a retreat into monetary manipulation actually solves anything, and more importantly, whether or not the Chinese authorities also believe in these theories.
To continue reading: Shorting the yuan is dangerous
