The Beginning of the End of the Yuan-Dollar Peg

Bloomberg News had a headline this week that may foretell what is coming down the pike:

“PBOC’s Reserves Decline by Record on Intervention, Euro’s Slide.”

 If I were an interest rates bear, it would give me a reason to pause and rethink my strategy.

The story states that the People’s Bank of China’s (PBOC) reserves dropped by $113 billion to $3.73 trillion in the past three months, the most on record and the third straight quarterly decline. The essence of the story is quite straightforward: PBOC is fighting a losing battle. To maintain the yuan’s dollar peg while capital is flowing out, PBOC is spending billions to support the dollar peg.

I am always reluctant to draw too many conclusions from reported PBOCnumbers, as they are highly suspicious. In this case, however, given the weakness of every other currency relative to the dollar, and the PBOC’s desire to maintain the yuan’s peg versus the dollar while the Chinese economy is slowing and capital is looking to get out, it makes sense to me that this is a problem for the PBOC. This upside down policy scenario can be maintained only with a significant amount of intervention by the PBOC.

If that judgment is indeed correct, the net consequence is that the PBOC is effectively tightening policy in China while the economy is slowing down. To make up for that policy tightening, it has to ease in other places to make sure the economy does not crater.

Selective easing is one thing. Making sure the money flows into the sectors you, as a policymaker, want is something different altogether, as the Federal Reserve can attest to on the basis of its 2002-2007 experience. In one form or another, since investments are going down and consumption is slow to pick up the slack, the money will end up in the deregulating capital markets. That is precisely what is going on in China.

End Game?

The real question is: How does it all end?

 For now, the PBOC and Chinese policymakers can maintain their current regime, which will lead to gradually higher equity markets. However, as we go through the rest of the year and as the Fed moves closer to tightening – I don’t think that is the right thing to do but they will do it anyway – the pressure on the dollar and therefore the pressure on the yuan peg will continue to increase.

At that point, Chinese policymakers will have two choices:

1. Either get rid of the peg, or
2. Accept a slowing economy and massive rise in equity prices.

 Since they know very well how option (2) ends – they have been studying Japan for years – my bet is that they’ll choose option (1).

And the day they choose option (1), the re-export of deflation from emerging market countries will begin all over again and take U.S. interest rates to an even lower level than they are today.

While these assertions all hang together quite logically, at least in my humble opinion, the trick for an investor is to wait until the situation becomes even more painful for current Chinese policy before putting on a position that would benefit from a further decline in U.S. interest rates.

You never want to be too early

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