This article is a guest contribution by David Rosenberg, Chief Market Economist, Gluskin Sheff.
WHILE YOU WERE SLEEPING
The big news over the weekend was the move by China to end the yuan peg to the U.S. dollar. We are not sure of the inflation effects – after all, the currency was revalued by 20% from 2005 to 2008 and it is totally unclear what effect that had on anything except perhaps keeping the country’s export profile less robust than was already the case. It certainly didn’t sustain any inflation pressure nor did it manage to have an influence on what turned out to be the bigger story at the time, which was the bursting of the U.S. housing and credit bubble. However, what the de-link will achieve is that it will allow the People’s Bank of China (PBOC) to pursue its own independent monetary policy. The central bank will be able to use interest rates more effectively as a tool to cool off the property bubble and borrowing spree rather than the periodic reliance on an arcane set of administrative and regulatory measures to rein in overinvestment and real estate speculation.
Keep in mind that China’s current account surplus relative to GDP had already been sliced from 11% at the 2007 peak to 6.1% last year. This has gone a long way towards reducing the currency’s undervaluation gap to 24% against the U.S. dollar from 40% at the end of 2009 (see U.S. Study Finds Renminbi Better Balanced on page 3 of the weekend FT). Against a basket of currencies, the undervaluation gap is even lower at 14% (from 21%). It is also worth noting that while the U.S. still has a huge trade deficit with China, it is almost alone in this regard because Japan enjoys a $45 billion bilateral surplus with China; South Korea has a $59 billion surplus and Brazil too, at $14 billion. In fact, outside of the U.S., China is running a deficit with the G20. So it is truly uncertain as to how far the currency will shift now that it will float more freely. Also keep in mind that since the onset of the Greek crisis, the yuan has already strengthened dramatically on a trade-weighted basis, and while it had been fixed against the U.S. dollar, it rose substantially against the euro (and the euro area is China’s second largest trading partner). So this is a double shock to exports – yuan appreciation and the slowing in Eurozone economic growth.
CHINA’S CURRENCY SHIFT NOT A GAME-CHANGER
Leave it to China to take our minds off Europe.
In what is widely being described as a brilliant political gesture ahead of the G20 weekend summit in Toronto, China has announced its intention to sanction a gradual revaluation of the yuan (back to a “crawling peg”). Details pending but most China experts are looking for 3-5% appreciation on an annual basis – the currency has already firmed today to a 20-month high and the U.S. dollar is also trading at a four-week low against the euro.
In turn, this will help to ease global trade imbalances, ward off the threat of trade protectionism, alleviate domestic credit strains and inflation pressures and accelerate the Chinese shift from export-led to consumer-led growth. It also suggests that the Chinese authorities have confidence over the sustainability of the global recovery.
Rough estimates show that every 5% yuan appreciation trims the U.S. trade deficit by just over $60 billion (so it would take something like a 35% appreciation to eliminate the gap altogether – call us in 2020).
The Chinese move has ignited a rally in risk assets to start off the week -- a rally of sizeable proportions.
Global equities are riding a 10-day winning streak, the longest in eleven months, led by a 2.8% jump in the MSCI Asia-Pac index. These countries, along with several Latin American nations that compete with China are winners here. Emerging markets soared 2.5% and up nearly 10% from the lows of two-weeks ago (Chinese banks and property shares ripped overnight). European marts are now up for a ninth consecutive day -- also the longest in 11 months. Gold has hit a new all-time high this morning (the news that Saudi gold reserves are twice as much as previously estimated is adding a further thrust to bullion this morning) and both oil and copper are bid as these hard assets priced in U.S. dollars gain ground from the resulting decline in the greenback. The once-parabolic chart of the DXY has reversed course and is now about to test the 50-day m.a. of 84.7 for the first time in three months.
Meanwhile, the safe haven of government bonds has lots of allure as long-term yields back up in response and offer up another opportunity for the Treasury bulls to re-load. CDS spreads are also plunging as investors turn their attention away from the global debt challenges, which most assuredly have not gone away just because of improved Chinese FX flexibility. The view that China will be “recycling” fewer dollars is a tad strange because if the U.S. current account deficit shrinks, as it should, then we are not going to need funding in any event. The capital account and the current account have to balance so these oft-stated remarks that the rise in Treasury yields will be sustained misses two facts:
First, China has not added anything to its hoard of U.S. Treasury securities since June 2009. In fact, it has run down its holdings by a modest amount. Guess what? The yield on the U.S. 10-year note has dropped 40 basis points, to 3.3% over that period. Go figure.
Second, let's recall when China last made such a dramatic announcement with regards to the FX market, which was back on July 21, 2005 when it first moved away from the dollar peg, the consensus view then was similar: buy risky assets, sell the U.S. dollar, secure inflation protection, unload your Treasury position. In the immediate aftermath of that announcement, we admittedly had a knee jerk reaction where Treasuries and the U.S. dollar sold off and commodities and equities rallied in tandem. Over the next three years (the revaluation was terminated in July 2008), here is what happened:
The DXY did indeed go from 85 to 70, but … China’s holdings of U.S. Treasury securities never did go down – they went up to $550 billion from $300 billion.
During that three-year yuan revaluation, the yield on the 10-year T-note fell 80 basis points to 3.7%. The S&P 500 went from 1,230 to 1,260 so it was basically flat. In fact, the total return in the Treasury market more than doubled that of the equity market. And, the VIX index in that three-year period soared from 10x to 25x and had yet to come close to peaking out.
So the only correct call by the intelligentsia in the summer of ‘05 was that the dollar did continue to lose ground. In the final analysis, looking at that entire three-year period of Chinese currency revaluations (and since!) the primary trend has been lower bond yields and lower equity valuation. This was not being predicted in July 2005, and it not being predicted today.
Let’s finish off by saying that at the time, the initial Chinese revaluation was being billed as this huge “reflationary” event. Meanwhile, the core inflation rate sits today at 0.9% compared with 2.1% back then, and the headline rate was over 3% then whereas it is 2% on the nose today. It goes without saying that not even Chinese initiatives in the FX market, no matter how much they can dominate the headlines as is the case today, ultimately proved to be no panacea against a collapse in the U.S. credit and housing markets, deflationary pressures, a huge global recession and a European sovereign default crisis.
Let’s not take our eye off the ball. The global deleveraging cycle is still in full swing, is an intensely deflationary development, and as much as the Chinese revaluation will at the margin help to ease global trade imbalances, it very likely will prove to be every bit the antidote it wasn’t when it first moved to a crawling peg a half-decade ago.
WILL THE EVENTS IN CHINA TOUCH OFF A ROUND OF GLOBAL INFLATION?
The surprise move to allow the yuan to float along with the recent labour market strife that has led to higher wage settlements in China are probably not going to alter the global inflation landscape. The primary reason is that productivity in China is rising and helping contain the inflationary effects of accelerating wage growth and at the same time, companies from around the world have already been shifting their production base to other low-cost jurisdictions such as India, Bangladesh and Vietnam. The World Bank, in fact, just published a report with similar conclusions – see World Bank: Wages Can Rise in China on page A7 of the weekend WSJ.
Keep in mind that annual wage increases have been in the range of 5% to 10% in China with near consistency since 2003 and the recent trend in unit labor costs has been flat. In other words, it would probably be a mistake to underestimate China's ability to absorb wage demands without generating a cycle of sustained inflation.
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