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September 01, 2015 at 10:24 AM
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.
