Why the Chinese Yuan Could Crash by 25% in 2017

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I’m not a fan of Trump’s trade policy.

Not one bit.

My colleagues might be surprised to read that, as they know I’m a Donald Trump fan. I have been for years.

I remember watching the first season of The Apprentice. Apart from the trademark ‘You’re Fired’ catchphrase, Trump said that ‘Business is business and friends are friends.

Indeed, there are no friends in business. It’s all about the bottom line. If it’s not working out, it’s time to try something different.

Ironically, the saying can be applied to modern-day politics. Establishment politics haven’t been working. For that reason, US citizens rejected the party line, and instead went with something different — a ‘third party’ candidate.

Donald Trump isn’t a career politician; he came to the election with fresh ideas. Unfortunately, while lots of them are good, his trade policy isn’t one of them. It’s not good for business or making friends — especially with China.

The Financial Times reported on 7 January:

Mr Trump has put a tougher stand on trade at the centre of his economic policy and appointed a team of China hawks and avowed protectionists to oversee his trade policy.

He has pledged to label China a currency manipulator and threatened to impose punitive tariffs of up to 45 per cent on Chinese goods, although incoming members of his administration have played down both commitments since the election. 

Mr Trump and his advisers argue that ever since China’s 2001 entry into the World Trade Organisation it has been competing unfairly and has caused the loss of millions of American jobs, particularly in manufacturing.

I don’t know about that. Trump believes that China’s ‘manipulating’ its currency lower.

While devaluing the yuan may be a plan they’ve got up their sleeve yet, that’s totally incorrect at the moment…

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The truth behind China’s currency ‘manipulation’

The People’s Bank of China pegs the yuan to the US dollar, allowing it to fluctuate within a 2% band. The goal is to promote a stable currency for business and investment purposes. China wants cheaper imports, via a stronger currency, to create cheaper goods.

Trump should know that’s smart business.

The West has been brainwashed by socialism. Minimum wages and government-supplied benefits are the name of the game. It’s difficult to compete with a country that implements none of the above. China offers cheap labour. The combination of cheap inputs (imports) and labour equals cheaper Chinese goods.

So, while a cheaper currency can increase exports in theory, the stable currency has promoted more business investment. That’s supported economic growth. China has become an economic powerhouse for that reason.

Furthermore, China needs a strong currency. A lot of its iron ore, coal and steel producers are bankrupt — not that you’ll hear that from them. The insolvent producers need cheaper imports to keep costs under control and pay back some debts. If the currency depreciates, it’s going to cost more to import coal and iron ore. That could put a lot of steel manufacturers out of business. That won’t promote business investment — it could in fact destroy the country’s economy.

Indeed, Trump is totally wrong by calling China out for pushing its currency lower.

True, China’s strong currency has come at the expense of millions of American jobs — particularly in the manufacturing sector. But it’s undercutting the market with lower prices in order to keep its economy from falling apart.

The yuan is destined for new lows

The yuan peg — as explained above — will break in time, especially as the greenback gains more momentum. The US dollar is locked in a major bull market, rising against every currency — not just the yuan.

The US dollar should scream higher into 2018. That’s based on rising geopolitical tensions and conflicts, US domestic economic policy, rising US interest rates, and the dollar’s continuing role as the global reserve currency. When it happens, naturally, the Chinese yuan should move significantly lower under pressure.

I wouldn’t be surprised if the currency drops by 20–25% this year. Reuters elaborated on 9 January:

Yu Yongding, a former advisor to the People’s Bank of China was quoted in media reports on Monday saying that China cannot let its yuan currency depreciate more than 25 percent against the dollar in 2017.

Media reports did not specify what year Yu was using as a baseline comparison.

“If the yuan depreciates too much, China can step up capital controls, we have a large amount of foreign exchange reserves, and ultimately, we have a bottom line, we cannot allow the yuan to depreciate more than 25 percent,” Yu, a former member of the central bank’s Monetary Policy Committee, said, according to a transcript posted on Chinese news portal Hexun.

Imagine what Trump would say if the yuan falls by 25%! You might want to get your kids out of the room.

Get ready for the biggest yuan devaluation in history

The yuan fell by 7% against the greenback last year — the biggest move since 1994.

The yuan is down 10% from its 2014 high, when the greenback started to move higher.

This is just the start of the US-dollar bull market…

China’s currency remains relatively strong for now. But it’s become a question of how long it will remain stable.

If China devalues its currency by 20–25% in one swift move, you’ll see massive volatility across financial markets. China would devalue its currency to prevent additional large capital outflows. Wealthy Chinese businesspeople are moving their capital outside of the country, fearing that it would be worth less in the future. That would be the case if the yuan was devalued.

I suspect the yuan could move down to 10 or so to the US dollar when the time comes. It’s trading at just under seven yuan to the US dollar today. Initially, that’s likely to cause a nasty reaction across financial markets. But, in the medium term, a swift currency devaluation would probably reduce the outflows. It would limit the speculation of an imminent devaluation — punters would likely have more confidence about the future.

Remember, Chinese authorities are tightening domestic monetary policy in an attempt to stem capital outflows. But tighter liquidity is leading to a spike in corporate defaults.

Last year, 55 corporate Chinese defaults were recorded — more than double the number in 2015.

2017 will probably see more defaults. More than 5.5 trillion yuan (US$800 billion) in corporate bonds will mature this year — that’s 1.8 trillion yuan more than in 2016, according to China Chengxin International Credit Rating Group.

A major currency devaluation would likely trigger more defaults. That’s because the country’s competitiveness would decline — it would become more expensive to import goods. That said, a stronger currency is slowly bleeding the country dry. Capital is pouring out of the country, which could be used for investment purposes within the country.

It’s a double-edged sword…

At the end of the day, it’s better to get the damage over and done with. At least the country has plenty of firepower (i.e. reserves) available to soften the defaults. It could also ease capital restrictions, making it easier to service debts.

Of course, a major Chinese currency devaluation would probably cause panic across the world, kick-starting another major stock-market correction. Stay tuned…

Regards,

Jason Stevenson,
Editor, The Daily Reckoning

PS: As China’s reserves keep falling, its currency should head lower. It will cost a fortune for the Chinese to keep propping up their currency. That’s why the country is bleeding itself dry. China has already spent US$1 trillion holding up its currency. It has about US$3 trillion in reserves remaining. Perhaps, when reserves go under US$2 trillion, the peg will break. Our in-house strategist, Jim Rickards, has talked about this at length before. He’s banking on an Australian recession, which will be impacted by China’s declining economy. To find out how you can sit back and watch your portfolio grow as the ASX takes a dive, click here.

Jason Stevenson

Jason Stevenson

Jason Stevenson shares his extensive knowledge of Australia’s mining sector as The Daily Reckoning's dedicated resource analyst. Whether it’s iron ore, gold, copper or lithium, you can rely on Jason to give you in-depth analysis of the biggest and most important sector of our economy. Jason provides in-depth research to Resource Speculator, Australia’s premier resource investment advisory.
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