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| The People Bank of China (PBOC) engineered a sharp devaluation in the Chinese Yuan, triggering much speculations on their intentions Photographer: Tomohiro Ohsumi/Bloomberg |
The problems which caused a sharp correction during January seem to have disappeared overnight and the Western stock markets rose sharply during the later part of February to capture its recent peak. These problems will come back later in the year to haunt the market, but for now, people who have missed last year's US stock market super run are contented to pile in on the sight of any market correction without regard of the macro or valuation environment. On the Asian front, the devaluation of the Chinese Yuan by the Chinese government took the headlines and every single analysts in the world took a shot at trying to interpret the real intention behind this move. The Chinese Yuan has been the best performing emerging market currency and has risen more than 30% against the USD since 2005 and had every major money manager betting on its continued rise in recent years.
Official Speculation (From China Controlled Media): Just Routine!
The Chinese government is increasing the managed band of the currency controls from 1% to 2% to facilitate China's transition into a major trading currency.
Mainstream Speculation: Anti Speculation Policy
The Chinese government is signalling to forex traders not to expect an uninterrupted upward trend so as to interrupt the continued hot money inflows into the Yuan market. Analysts explain that for China Yuan to become a truly international trade currency, it has to have its up and down days and it's the Chinese government way of telling the market that they are loosening their control and to prevent hot money flow.
Alternative Speculation: Currency War!
There are many speculation that the Chinese government is seeking to lower the Yuan so as to make its exports more competitive. China exports have become uncompetitive as its emerging market neighbors saw a massive fall in their currencies in the recent days. Even Japan, as a result of Abenomics, has seen the Yen depreciated more than 20% in the past one year. Pressured by rising domestic inflation and rising Yuan, the Chinese government is trying hard to maintain their export competitiveness which has provided the China growth miracle.
The China Yuan Conundrum: My Speculation
During the 1990s, the Chinese government embarked on an ambitious project to lift the country out of poverty, using 3 simple formula: Cheap Land, Cheap Labor, Cheap Yuan.
That worked well until the Global Financial Crisis in 2008 when a massive recession in the western economies dimmed their appetite for Chinese made goods. As factories started to close down in China and social unrest starting to stir as a result of people losing their jobs, the Chinese government unleashed a $600 billion stimulus project. On top of that, the Chinese banks created another 14 trillion of credit through bank lending. The plan worked and China continues to grow and unemployment remains low. However, the bulk of the money that was generated was used to build infrastructure projects, which produce few innovations or projects that are able to produce a long term income stream.
The Chinese authorities later realize that this situation cannot continue infinitely and they have to build a balance between export competitiveness, domestic consumption and infrastructure spending. Domestic consumption takes time to grow and reckless infrastructure has to stop as the resulting credit bubble is threatening the stability of the country. Going back to the export model while slowly popping the credit bubble and letting consumer spending rise over the years seem like the best policy at this point of time, potentially cushioning any major economic fallout that may occur due to the credit bubble.
However, the Chinese government now has a problem. The credit bubble has pushed land prices and wages so high that they have became uncompetitive as compared to the new emerging manufacturing nations such as Vietnam, Philippines and even Mexico. The sharp fall in the USD, Euro and Yen in recent years has made export model less profitable as compared to a decade ago. On top of that, the fall of emerging market currencies as a result of the US Fed Tapering has made it more difficult for the Yuan, which has been appreciating every year, more difficult to compete in the international arena.
The irony is, a government orchestrated Yuan devaluation may not even work. In order to devalue the Yuan, the Chinese Government needs to sell Yuan and buy USD. However, the majority of the Chinese Government reserves are made up of USD denominated assets and in order to sell Yuan, the Chinese Government will probably have to print more Yuan, leading to further increase of land prices and wages, resulting in little improvement in their export competitiveness.
This is one big mess that the Chinese Government will need to resolve.
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| Emerging Markets continue their underperformance |
Portfolio Strategy
The strong rally in the past 2 weeks has made the portfolio lag behind global equity benchmark again as we move into a more defensive position. That doesn't mean that we should just switch track and chase after returns. I have learn my lessons over the years that chasing after returns in the face of mounting macroeconomic troubles and stretched valuation is a recipe for disaster. There was a similar story last year when I made a defensive switch in March and the equity markets still continued to hit record highs, until it crashed in June, 3 months later. Of course that doesn't mean that I will maintain my stance of being defensive, should the macro economic environment improves over the next few months. The world of investing is no place to have an ego trip!
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