Lucky 8 for the RMB?

If CLSA’s call is correct on the direction of the yuan currency be prepared for a turbulent period.

This year the world was surprised – but not that surprised – to find out that China had more billionaires than any country on earth. China-based wealth research firm, Hurun Report, noted that China had a sum total of 568 US dollar billionaires versus 535 in the good old US of A. Beijing surpassed New York City as billionaire central with a nice round 100 billionaires to New York’s total of 95 elite club members. While some say these numbers are overstated compared to the Forbes rich list, the Hurun team believes the true number of billionaires could be double what they estimate.

As the Hurun numbers reflect, the world has become accustomed to a relatively rich China for some time now. The swagger of the China business community is the stuff of envy from Africa to Hollywood, London to Melbourne, Toronto to Buenos Aires. Foreign reserves that once approached US$4 trillion showed the clout of an export driven dynamo that was known as the Factory the World. More recently, the rise of China tourism to the top of the global ranking, with more than 120 million visits outside China last year, shows that the trickle down affect is currently a major economic factor.

Now, if a recent report entitled RMB 8: Looming Specter published by CLSA, one of Asia’s leading equity brokerage and investment groups, a perennial top ranked research house based in Hong Kong that is now owned by CITIC Securities, is an indication, China’s peak has been reached. “What can’t go on forever must come to an end,” notes Amar Gill, Head of CLSA Asia Research, calling for the yuan to drop to 8 to the US dollar by mid-2017. “There will be much pain for the region before the gains flow through.”

Why All the Pain?

CLSA points out that China’s foreign reserves have fallen by US$800 billion since peaking in mid-2014 at US$3.99 trillion. Monthly FX reserve increases since 2H14 have been few and far between, even though large trade surpluses persist in the Middle Kingdom. The fact that China has received some nicely priced hard foreign assets for its reserves, and leads the global M&A tables in a number of areas, seems ignored to a certain extent. All the current focus is on a FX reserve decline that many equate to China’s growing economic dilemma.

“Capital is flowing out and has accelerated with the rumblings of an unhinged renminbi,” Gill points out with a sense of foreboding. “Ongoing interest-rate cuts to boost the economy, lower returns from Mainland assets, a policy of allowing the currency to decline when the US dollar is strong, plus the ongoing anti-corruption crackdown all point to continued capital flight. As China’s reserves fall below US$3 trillion, the prospect of further declines will snowball the outflows.”

CLSA believes the depletion of foreign reserves to support the currency cannot continue much longer. Its analysts expect that by 2H 2017, the central bank will allow the yuan to find its market-determined value for the first time and this will inevitably lead to a sharp drop in the currency. In a shocking prediction for some, CLSA notes the yuan could fall sharply against the US dollar to a low of 9, before it rebounds to settle at 7 against the greenback in mid-2018. CLSA has chosen a middle ground for the yuan of 8 to the US dollar by the end of 2017.

Gill notes the volatility of the yuan is likely to be drastic in the coming period. Initially, it is widely expected there will be a rush to take funds out of China when the yuan is allowed to float. In fact, smart money is already moving in that direction, one reason for rising foreign M&A activity. However, the government has taken steps to make it harder for money to flow out of China as economic policy dictates events.

HK to Deflate

Given China’s growing clout in the global economy, there is no doubt major alterations in the yuan exchange rate will have a cataclysmic impact on the world of trade and finance. The impact of a significant depreciation will devastate a good many economies in the region. Australia and North Asia, which wrack up huge export volumes to China yearly, are going to feel the greatest pain as China tightens the belt on expensive imports.

Perhaps no region in the world will be hurt as much as Hong Kong, where the deflationary forces of a yuan drop may be severe. The HK dollar peg should be maintained against the dollar as the Hong Kong authorities are unlikely to move to a renminbi peg until the fundamental value of the currency is clear. As Hong Kong becomes more expensive there will be an even sharper falloff in Mainland visitors and greater pain for retailers. Office rents will be under pressure as Mainland companies will be reluctant to open major operations in Hong Kong.

What Now?

Should the yuan head to the 8 and above mark most of the Asian economies will feel the economic impact
Should the yuan head to the 8 and above mark most of the Asian economies will feel the economic impact.

“As the HK dollar remains high while the yuan and regional currencies fall, we expect a replay of the turmoil seen in 1997,” remarks Gill. “The HK peg will come under attack, which will result in a spike in interest rates as the HKMA buys local currency to support the unit, in that process taking HK dollars out of the commercial banking system. Rising rates will exacerbate the deflationary pressures of holding up the currency: we estimate residential property prices could fall a sharp 15% to 20% very quickly.”

Nor should one underestimate the psychological impact of the coming period of instability if CLSA is right about its currency view. China has grown proud of its elite businessmen and billionaire wheeler and dealers, the likes of which play a starring role in the China Dream. They characterize a world where hard working entrepreneurs go from zero to billions in no time.

In many ways, a country measures its strength by the power of its currency. For eight years now the world has become accustomed to a yuan below 7 to the US dollar. China has not seen the yuan above 8 for almost a decade. Now, when China has emerged as one of the world’s top two economies, heading for number one if World Bank predictions are correct, we are suddenly faced with a currency that may hit 9 and could well level off at the “lucky” 8 number once again.

Why in fact is this instability necessary? And, what about the impact on US-China relations? Has the US not pushed China hard to strengthen its currency all these years? What will happen when the opposite happens in a major way, dragging down an entire region in the process? Few can forget the 1997 Asian financial crisis precipitated by a massive drop in the Thai baht. At the time, China’s ability to hold the line on its currency was considered the saving grace of the region, if not the world economy.

It seems none of that history seems to matter at the moment. The world of macroeconomics is bent on changing the face of Asia, and it will do so by making sure the yuan is devalued. Well, let us hope CLSA is wrong for the sake of all us Asiaphiles. After all, CLSA did call for the yuan to go to 5 to the dollar in 2008 and 2010, and we never quite made it there. Nor do all those holding yuan want to see their US dollar purchasing power decline by 25%. Though one can imagine those lucky Chinese investors who have stocked up on foreign assets may see things differently.