Is the Chinese Yuan the new Deutsche Mark?

There are many reasons why cryptocurrencies are becoming more prominent, but one key driver is central banks’ race to the bottom in terms of interest rates, driving down the value of their own currencies. This has led many investors to look for alternative stores of value. Gold was a natural beneficiary, but cryptocurrencies offered benefits that gold could not – speed and security of transfer, and ease of storage. However, in today’s world, we believe that the Chinese Yuan (CNY) can play a significant role in a client’s portfolio, especially as China’s asset markets open up to foreign investors.

The value of currencies is significantly determined by relative interest rates and inflation. Interest rates have been on a structural downward trend since the 1980s. This environment was sustainable because inflation was also declining, which also made people worry less about the potentially reduced purchasing power of currencies. In the face of unprecedented and sustained monetary and fiscal stimulus since the Global Financial Crisis, a key question for investors is whether this structural inflation downtrend is going to continue or reverse and, if the latter, which currencies are likely to benefit from such a trend reversal.  

To us, the approach of different central banks to the situation is critical. The European experience may be instructive.

Before the arrival of the Euro in 1999, investors viewed the German central bank  as very ‘hawkish’ i.e. protective of the value of the Deutsche Mark, even at the cost of substantial short-term economic pain as they reacted to the slightest whiff of inflation by tightening policy significantly.

Further south, the Bank of Italy had a different view of the world. Realising that tight monetary policies were economically painful, it had a greater skew to being dovish and used its ability to print more of its currency, allowing the economy to run hot and inflation to pick up before tightening policy. The net effect: the Deutsche Mark appreciated against the Lira from 465 at the end of the 1970s to peak over 1200 in the mid-1990s.

Fast forward to today, and central banks face the same dilemma: do I focus on supporting growth or do I worry about inflation? A year ago, the answer was obvious to all as the COVID-19 pandemic unfolded. Today it is less so. We are rapidly emerging from 2020’s recession, supported by vaccination-triggered economic re-openings and massive policy stimulus, especially in the Developed Markets. Historically, such a rapid recovery would at least lead to questions about when central banks should start easing off the policy accelerator.

However, high debt levels complicate the policy response. Debt levels were high going into the pandemic, and have surged further globally as government deficits widened dramatically and companies raised debt to bolster cash reserves in an attempt to stave off bankruptcy amidst a collapse in revenues. Higher debt levels mean economies have become significantly more sensitive to any rise in interest rates.

In the US, the Fed has managed this quandary by pressing the monetary policy accelerator to the floor, trying to cap funding costs. This means printing more and more US dollars, perhaps hoping to drive up inflation so that the debt becomes more manageable. Of course, increasing the supply of anything (in this case dollars) should reduce its value versus other currencies and goods. The saving grace is that most other major central banks are doing likewise in trying to devalue the purchasing power of their currencies. This is encouraging people to increase their allocation to gold or explore various cryptocurrencies.

However, we believe there is an alternative. One central bank that is standing out in this global race to the bottom, in our opinion, is the People’s Bank of China (PBoC). While China is also saddled with a huge amount of debt, this is a consequence of what many government officials believe was excessive policy stimulus in the wake of the 2008-09 Global Financial Crisis. Therefore, in an attempt to avoid repeating the ‘mistakes’ of the past, the PBoC is already guiding the market towards tighter policy settings.

We believe China’s policy conservatism will make the CNY a more attractive store of value, bolstering its role in global investment portfolios, especially as China’s onshore equity and bond markets become more accessible to offshore investors. Of course, this is not to say that China does not have its challenges, but the world of currencies is inherently a relative play, and in that regard the CNY is a potential outperformer over the coming years.