China's market has weakened severely in recent weeks. (Photo: AP)

The markets have a lot to say about where the Chinese economy is headed, and strategist Axel Merk has a lot to say about the role of China’s currency in all of this.

“Once you think of China as a teenager in her ‘awkward stage,’ it may become easier to understand the unfolding dynamics,” the president and chief investment officer of Merk Investments said in his latest Insights commentary. “When it comes to foreign exchange, China’s latest move may be best explained by her desire to play with the grown-ups. This may have implications that go far beyond the U.S. dollar and China’s yuan (CNY) or also the renminbi (RMB).”

The recent devaluation of the currency has given the markets “a little drama,” he says, “but let’s first debunk these headlines” about China instigating a currency war.

The U.S. was the first major country to pursue quantitative easing, or QE, and the Europe and Japan followed suit.

“If China were really breaking this line of  ‘global economic defense,’ we would see a 20% or more deduction,” according to Merk. 

The investment firm he leads views China’s currency as substantially appreciated on a trade-weighted basis (vs. its peers). Plus, the recent declines are not likely to have a major impact on the country’s economy in the short term.

While comparing the currency shift to President Richard Nixon’s abandonment of what was left of the gold standard may be going too far, the significance of the yuan shift is historically “relevant,” Merk says.

Nixon’s move involved throwing in the towel “after much gold had left U.S. vaults. China, in contrast, holds about $1.5 trillion in Treasuries, … [and] we see no sign of desperation; details of major foreign holders of Treasury Securities are available at Treasury.gov.

China is courting the IMF so its currency can be included in the organization’s Special Drawing Rights, which are considered an international reserve currency. If the RMB becomes part of the IMF’s SDRs, central bank managers are likely to add the yuan to their holdings, which “may show the world that China’s currency is ready for prime time, i.e. that it plays in the same league as the U.S. dollar, euro, the British pound, and the Japanese yen,” explained Merk.

The IMF welcomed China’s recent moves, he adds, and it stated that “a more market-determined exchange rate would facilitate SDR operations in case the renminbi were included in the currency basket going forward.”

What the IMF is focused on, he explains, is China’s continued opening of its capital account, meaning that it allows more cross-border capital flows.

Furthermore, the IMF is not demanding that a currency be freely convertible to be in the SDRs. However, it must be “freely usable.”

China Fears

China’s exchange rate has two market prices, Merk points out: “one for onshore yuan trading (CNY) and another for offshore yuan trading (CNH). While CNY and CNH are the same currency, due to capital controls, the value of the currency can vary.”

Earlier, China’s central bank would allow CNY to deviate from a fixed rate, which was up to 2% until recent weeks. If this threshold was reached, central bankers would intervene or move the fixed rate closer to the market price.

But all this changed on Aug. 11. Now, the central bank is moving the price towards where the market is, unless it chooses to intervene. “Now re-read the previous two sentences a couple of times until you are thoroughly confused, and you have an indication why the market was confused,” Merk stated.

The new regime seems to indicate that the market price now has the priority, though the central bank reserves the right to “closely manage the exchange rate.”

Of course, speculators immediately tested the new system and pushed the value of the currency below the fixed level announced on Aug. 11. “Rather than fight it, though, the People’s Bank of China obliged and moved the fix; and so it has in the days since. Once speculators realized the PBoC is in no mood to fight, a two-way market appears to have been established, meaning the currency has had both up and down days since,” the currecy expert explained. Growth Pains

The country may not want to embrace an entirely free-floating currency quite yet, given restrictions on cross-border capital flows. But “an easing of capital controls is the logical next step,” Merk stated, adding that he expects the offshore CNH and onshore CNY become one.

“In a nutshell, this has nothing to do with an attempt of China to debase its currency, but everything to do with moving towards a more market-based economy,” he said.

As for China’s intervention in the stock market, Merk compares that to Tulip Mania in the Netherlands, calling it “an episode for the history books.”

Looking Ahead

China’s regime shift in the currency markets, he points out, “may usher in a new era” for both China and the global economy.

Investors are interpreting the devaluation as admission by China’s government that its economy is slowing down, which indeed it has been.

“However, we believe it is a myth to assume that a currency must weaken simply because economy growth is weak. Many other factors affect a currency; just think of Japan where the yen has historically been strongest when growth was weakest; or the eurozone where the euro had been stubbornly high despite weak economic growth,” explained Merk.

The expert urges investors to keep in mind the fact that weak growth in China “won’t automatically translate” into a weak currency.

Such a scenario will depend on other policies, such as the creation of an environment “where investors want to invest,” including a liberalized banking sector that can set interest rate “according to the risk profile of borrowers.” If such changes occur, “[W]e believe an entrepreneurial boom could be unleashed,” Merk said.

“The initial shockwave appears over; going forward, as the initial spike in volatility has settled, we expect the Chinese yuan to be more volatile than it was before the regime shift,” he concluded.

— Check out Merk Pleads: Stop the Fed! on ThinkAdvisor.