One of the persistent myths in the market is that August is a ‘quiet month’ with bankers and policymakers on holiday around the world.
The view is that nothing important can happen with all of the elites on the beach. Many analysts believe that things will get back to normal in September when the power brokers return to their desks.
Ironically, that viewpoint is a myth.
The list of earth-shaking events that have occurred in August is a long one.
It includes the end of the Second World War (1945), Saddam Hussein’s invasion of Kuwait (1990), the attempted coup d’ètat in Russia (1991), the double embassy bombings by Al Qaeda (1998), the Russian default and Long-Term Capital meltdown (1998), and Hurricane Katrina (2005).
There are many other examples. Suffice to say, August is actually one of the most treacherous months on the calendar.
China just added to this infamous litany by breaking a temporary truce in the currency wars.
They broke the peace with a point-blank, double-barrelled shotgun blast aimed at US markets.
A currency earthquake
After a long period of pegging the Chinese yuan to the US dollar at about 6.1 to one, China devalued the yuan in a sneak attack on 11 August. They devalued again twice last week.
The total devaluation was almost 5%, the biggest yuan devaluation in over twenty years.
Bear in mind that traders measure daily volatility in currency markets to five decimal places. A move of 0.05% happens on a choppy day. 5% is an earthquake.
Aussie stocks have cracked down over the past week. Meanwhile, gold broke out of its slumber and has moved up nicely.
Investors are rightly concerned about what all of this means for their portfolios, super funds and retirement savings.
Here’s a quick summary in Q&A format.
What did China actually do?
China does not have an open capital account, so we have to put ‘devaluation’ in a different context.
Most major currencies float on foreign exchange markets. The market sets the cross-rate between any pair.
Central banks can intervene, but that’s rare for the major G-7 currencies. The last time was in March 2011 after the Fukushima disaster when Japan needed a lifeline.
The Chinese yuan does not ‘float’ in the same way. The People’s Bank of China (PBOC) keeps the rate within a band.
Until 11 August, China held the band steady.
If the yuan went to the lower end of the band on one day, the following day would start again in the middle of the same band. The PBOC would just intervene. They’d do whatever it took to make this happen.
Starting 11 August, they changed the rules.
From now on, if the yuan trades at the bottom of the band, the next day’s trading will start at that level (instead of the middle of the old band). It can trade down to the bottom of this new band.
This process will continue indefinitely, so you should expect more devaluation.
The technical name for this is a ‘dirty float’ or ‘moving peg’.
Technicalities aside, it’s a shock to the US dollar, which is now stronger.
Why did China do it?
Simply put, their economy is imploding.
In July, exports and imports both collapsed. In June, their shadow banking system (a big part of China’s credit market) completely dried up. There was zero net new lending.
This kind of slowdown is not just an economic problem in China. It’s a political problem.
If the Communist Party cannot create jobs, civil unrest and riots are sure to follow. The Communist Party has put survival ahead of good relations with the US.
As the saying goes: ‘timing is everything’.
China has been labouring under a strong currency all year, and their growth has clearly slowed.
But China has another goal. It wants the yuan included in the IMF’s world money called the Special Drawing Right (SDR).
The market expected the IMF’s decision on the SDR in November 2015.
The US expected China to maintain the yuan peg to the dollar as part of the price of admission into the SDR ‘club’.
China was playing along.
But two weeks ago, the IMF extended the deadline for a decision on the SDR basket to 30 September 2016.
China knew that if they kept the peg until then, their economy would sink even deeper. The Chinese stock market was already crashing and the cost of a strong currency was too much to bear.
So China took advantage of the breathing room the IMF gave them. They devalued just one week after the extension announcement.
China can go back to good behaviour next year. For now, they’re going for bad behaviour (good for them, bad for us) in the currency wars.
Does the IMF care about what China did?
The IMF is OK with what China did.
They don’t care about the cross rate as much as they care about open capital accounts and market mechanisms.
Technically, what China did is a step in the direction of letting markets determine the exchange rate rather than the PBOC.
The fact that the market took the yuan down is highly convenient for China, but both China and the IMF are acting under cover of ‘market forces’ instead of manipulation.
In any case, the process of including the yuan in the SDR is still on track. It will happen before President Xi of China hosts the G20 meeting in China next year.
Xi is the President of the G20 in 2016, in addition to being President of China. So, 2016 will be the ‘Year of Big Xi’ and the Year of China. The IMF is fine with this.
What happens next?
I believe China’s actions are about to make things very interesting.
I’ll reveal what happens next, the most important date of the year, who will be the biggest loser and how you can protect your wealth in my advisory service, Strategic Intelligence.
The currency wars are providing opportunities for early investors to make big, fast gains. You’ll find out where you can make them, and how to take action, in Strategic Intelligence.
For The Daily Reckoning, Australia
James G. Rickards is the strategist for Strategic Intelligence, the newest newsletter from Port Phillip Publishing. He is an American lawyer, economist, and investment banker with 35 years of experience working in capital markets on Wall Street. He is the author of The New York Times bestsellers Currency Wars and The Death of Money. Jim also serves as Chief Economist for West Shore Group.