Sara Salim's picture

China’s devaluation dilemma

In my previous article ‘The weak Renminbi explains the Chinese stock market sell-off’, I pointed out that weakness and volatility of the CNY was the main driver behind the equity sell-off episodes we have witnessed at the beginning of 2016. To prevent such volatile affairs from happening in the future, the Chinese authorities will have to address the markets’ concerns on the policy direction of the Renminbi.

The majority of market observers had assumed that the drain of FX reserves swiftly succeeding the initial devaluation of the CNY back in August 2015 would be temporary while a new equilibrium rate was found. Instead, the drains in reserves have unexpectedly accelerated right to the end of 2015. The Chinese authorities were possibly holding on to the hope that the market would see the lower CNY fixing in the beginning of 2016 as a mere function of the currency now tracking a basket of currencies, as opposed to only tracking the (really strong) USD. The equity sell-offs in the markets that followed shortly sought to exacerbate investors’ worries, which confirmed to them that CNY devaluation is a stock market red flag. Moreover, the weaker CNY impacts earnings for companies that are exposed to foreign exchange losses. Downgrades on Chinese equities only accelerated alongside rapid weakening of the CNY.

The unfortunate reality is that movements in the CNY is the main source of turbulence in Chinese stock markets. The CNY is faltering due to persistent capital outflows, FX reserve draw downs and downward pressure as a result of long-term overvaluation. These factors are playing out against a backdrop of likely monetary easing which will only cause the CNY to fall further against the USD. Theoretically if the fall in the value of the CNY is managed in a consistent manner with transparent guidance provided to the market, the impact on the stock prices should be minimal. This is currently wishful thinking since Chinese FX policy is (still) riddled with ambiguity.

We should take a step back and look at this problem from the perspective of the Chinese authorities. They are aiming toward: (i) A prominent reserve currency with functioning liquidity; and (ii) Economic growth that is reasonable. These goals are unfortunately mutually exclusive. There is a risk of a vicious cycle: if growth continuously undershoots expectations, it puts more downward pressure on the CNY.  Only when the CNY has traded at its much weaker equilibrium level, will this cycle be disrupted. So the ‘easy’ solution seems to be to let the CNY plunge to this equilibrium level. But to allow the CNY to plunge (instead of gradually depreciating), the Chinese authorities will be compelled to remove tight capital controls it enforces, which will cause an acceleration of capital outflows, consequently jeopardizing aim (i). Admittedly, China’s liquid reserves are more than adequate to control the CNY value in the near term, but if the weighty depreciation spirals out of control (which it usually does), the next round of equity market volatility will begin, and both aims (i) and (ii) are will be jeopardized.

If we witness another round of sell-offs, I believe it will be far more brutal than what we would have seen in previous episodes. Investors will exploit this opportunity to rapidly reduce exposure to Chinese equities as although the valuations are not approaching 2008 financial crisis lows, it is still historically cheap. Typically rallies of this sort should indicate a ‘buy’ signal. But since we are now witnessing the highest selling pressure over the past 15 years (excluding the period of the 2008 financial crisis), we can expect a short-term rebound at some point. What is certain is the need to compromise on ‘reasonable’ economic growth, because there will not be financial market (and economic) stability without Renminbi stability.


Sara Salim's picture

The weak Renminbi explains the Chinese stock market sell-off

Shortfalls in the Renminbi are agitating markets, while Chinese authorities struggle to contain massive stock market sell-offs amidst concerns of a Chinese slowdown. Current economic drivers are negative toward the Renminbi vis-à-vis the currency not being the steady, tightly controlled currency it once was. It is more market-driven, with less official intervention and investors must accept that Renminbi volatility is the new normal. There are two Renminbi rates – the offshore CNH used internationally which is effectively a proxy for the fears of the events in the Chinese economy, and the onshore CNY which trades in a band dictated by the PBoC's daily rate. The PBoC has been loosening this band and while weakness is expected, the pace is surprising - far faster than markets expected. The CNH and CNY rate has widened, which is upsetting the International Monetary Fund since the aim is to unify the two after the decision on 30 November to add the CNY to the Special Drawing Rights basket.

This grave worry is resonating throughout the world, and is behind the current Chinese stock market plunge. China was the consumer or investor of last resort over the last few years, keeping things in order when other countries were too weak. Today, there is no obvious replacement. Traditionally, it was US, but this stopped post financial crisis. For many years now, Chinese authorities have been trying to widen equity ownership for its people but it is easy to go too far- just like the US' effort to expand home ownership that brought about the 2008 financial crisis. Too far has China gone, creating today’s current unsustainable economic situation. Diminishing marginal returns has set into the economy. Chinese companies are not able to flood international markets with its cheap products to support more expansion, causing its economy to lose its once important source of growth and employment. Naturally, this comes with the erosion of the government's capacity to meddle with markets through price distortions. China is mirroring what crisis-struck nations resorted to after the financial crisis. The US depended on expansionary monetary policy with near-zero interest rates which weakened the USD, giving exports a boost. We witness a similar scenario in the Eurozone, where the European Central Bank is still engaging in quantitative easing.

However, the crucial difference here is that China needs to balance its domestic economic interests with the aftermath its actions have on the international economy. For instance, Central Banks in the (currently weak) emerging markets of Asia’s monetary policies will be more aligned to policy cycles in China compared to previously where they closely followed the US Federal Reserve. Asian exports are now more reliant on Chinese domestic demand, with share of exports to China being on par with the US. A slowdown in China offsets any potential boost from the US' recovery. Weaker Chinese investments further impact Asian economies via weak commodity prices such as industrial metals, which are main exports of these economies. As China’s industrial exporters move away from exporting cheap consumer durables to exporting high-tech machinery, economies like Korea and Taiwan will feel the pinch by being “crowded out” by China should the weaker Renminbi translate into cheaper Chinese exports.

There will come a time when the Renminbi is on the same footing and esteem as its peers in the IMF's Special Drawing Rights basket of currencies. The Renminbi will find acceptance that it truly is a (or even, is the) major currency in global markets. China’s domestic and international responsibilities are more likely to be aligned and they will be greatly obliged to maintain global financial stability. The time, however, is not now, and this weakness is for the medium-term. 

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Calling all Fireflies in London!

The Project-Firefly London Chapter Meeting was a superb learning and networking experience. I met exceptional individuals (students and professionals) who were enthusiastic about sharing insights and advise relating to the financial industry. I met Daniel Garraty (co-founder of Project-Firefly) who spoke about networking techniques, particularly around reaching out to a professional in an area you are interested in. You should thoroughly research him/her and express just how much respect and admiration you have for his/her achievements. Promote yourself by connecting your aspirations and qualities with theirs to encourage enthusiasm in the conversation. You would have left them feeling positive about the encounter, and by extension they would feel positively about you too.

Jorge Palomeque (Current HOLT Valuation Challenge participant), shared his experience as a Masters in Finance (MiF) candidate at London Business School (LBS). He stressed on the flexibility to acquire either a generalist or specialist approach, with him aiming for the former. He previously held a position in M&A advisory where his clients expect their trusted advisers to have a broad exposure in all aspects of finance. Narendra Sousa, (one of the top performers in the 2013 HOLT Valuation Challenge) agreed with this sentiment as he spoke about his advisory role at a Boutique Investment Firm, where he must have enough understanding on a spectrum of financial products to effectively address his clients’ bespoke needs. If more specific knowledge is required, advisers are required to be the “middleman” between their clients and the respective subject matter experts. On the other hand, many post graduate students who come in with professional experience either want to gain knowledge to move laterally into another area of finance, or hope for a promotion by acquisition of in-depth expertise in their current area. Candidates like Alexander Kostyra (The Emerging Leaders 2014 Competition winner) leveraged his MiF at the London School of Economics (LSE) to gain more skill in the quantitative side of finance, which has helped him in his role as an IBD analyst covering the pharmaceuticals industry at Citi.

In assessing whether pursuing an MiF was a choice to consider for me, I was curious to know when the perfect time was to do so. Jorge mentions that he is one of the youngest in his cohort and often is left to compete with colleagues who have had experience in areas like management consultancy, corporate finance, and engineering. The average years of work experience can be as high as five years in applicant pools of hiring programs that require applicants to have a post graduate qualification. If you are still quite fresh out of undergraduate school with minimal work experience, you would be an outlier. If you do decide to pursue it earlier, you will need to differentiate yourself and stand out by ‘compensating’ for the lack of experience. Participation in competitions organized by Project-Firefly, among other involvements, are a good way to stand out through receiving recognition from its esteemed Academic Review Board and Corporate partners.

Through the London Chapter Meeting, I made new friends with similar interests, who have been a tremendous help in instances where I needed their thoughts and feedback on articles that I am working on. They have also introduced me to useful contacts that can help in my career progression. This event allowed me to evaluate my current position vis-à-vis other successful Fireflies, giving me a better idea of where I want to be in the near future, and most importantly, the best way to get there. 

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The Fed’s worries cannot be solved by interest rates.

Fed Chairwoman Yellen highlighted her confidence in the US economy, particularly improved labor market statistics during her December 2nd speech at The Economic Club of Washington. She signaled inclination toward a rate rise in the upcoming December 2015 FOMC meeting, but my prime argument is that the Fed’s main concerns (that lie beyond the borders of the US) that prevented a rate rise for the past three months can no longer be addressed through the interest rate tool. Hence the Fed might as well raise interest rates now.

The difference in the FOMC’s statement on September 17 versus October 28’s is the omission of sentence “Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term”. Despite this omission, the committee still noted on October 28 that they will be “monitoring global economic and financial developments”. The Fed is now however at a point where these “developments” that prevented a rise in September, October and November will not be contained by the Fed’s next move. These “developments” refer to external economic weakness particularly in emerging markets that is strengthening the USD with the impact of driving down demand for US exports, slowing GDP growth and lowering inflation expectations. 

Back in September, The Fed was worried that if it raised interest rates, the USD will appreciate, decreasing import prices and lowering domestic inflation expectations. Commodity price shocks at the time meant that commodity exporters (mainly emerging markets) saw their currencies weaken further against the USD. These countries accumulated foreign currency debt, primarily denominated in USD from the boom years which became unsustainable not only because of their weaker currencies, but also due to lower revenues from lower commodity prices. At the time, China was also pushing for CNY inclusion in the SDR basket of currencies which started the process of liberalizing the currency. In the process, the PBoC shocked markets with a sudden devaluation of the CNY (the first step towards a more market-determined currency regime) in August, which caused a rush of capital outflows from China, forcing interventions in the form of asset sales of US financial assets, including US Treasury bills with the effect of strengthening the USD.

Now as we approach December, the Fed cannot prevent further appreciation of the USD because finally, the IMF confirmed on November 30 that the CNY will be included in the SDR basket of currencies.  It is thus no longer possible for China to consistently utilize large amounts of its foreign reserves to maintain the exchange rate of the CNY vs USD, like it has historically. Therefore, in light of China’s slowdown in growth and its current cyclical position (requiring loose policy) and the relatively strong performance of the US economy (requiring tightening), the Fed’s and the PBoC’s monetary policy will sharply move in opposite directions. The USD will continue to appreciate vs the CNY, whether the Fed raises interest rates or not.

The Fed’s “global economic and financial developments” excuse is tossed out of the window. But if that does not bring us to a definitive decision to raise interest rates, what will? History! Alan Greenspan slashed interest rates in light of the dotcom crash of 2000 to avoid a short to medium-term recession. However, he planted the seeds of the subprime mortgage bubble that eventually burst 7 years later and ushered in the financial crisis of 2008. His successor Ben Bernanke, 5 years in the run up to this crisis only raised interest rates very slowly with the objective of promoting economic growth. On hindsight, this must have further inflated the mortgage bubble. When this bubble burst, it set a precedent of close to zero interest rates across the developed economies right to this very day and exposed them to series of volatile boom-bust cycles across financial assets. I trust that Janet Yellen feels it is worthwhile to sacrifice her 2-3 year growth objective by increasing interest rates now, for the sake of longer term stability. A really close eye is being kept on the Fed’s every move so this unpopular decision will be popular soon enough. The Fed might as well raise interest rates now. 

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Panic and euphoria in China

The markets are in panic mode for the first time since 2012 according to Credit Suisse analysts. There has been a slight uptick in global industrial production, but this is overshadowed by investor nervousness about China’s continuous declining growth. Although there have been announcements of easing measures, there remains uncertainty surrounding the quality and reliability of China’s economic data. On top of that, financial risks in Brazil appear to be a worse threat than China given its external deficit and huge foreign currency debt. As the Brazilian real falls to an all-time low, Brazil’s debt is spiraling out of control. Overall, emerging market currencies are weakening in light of domestic problems and tightening dollar liquidity that will intensify if the Fed moves toward a rate hike by the end of this year. With the backdrop of a strong dollar, exporters are seeing their trade revenues fall and at the same time the growth in export orders are at its slowest since the recession in 2009. Slowing emerging markets are feared to present deflation to developed markets.

Source: Credit Suisse on

This panic episode is more formally established when the Credit Suisse Global Risk Appetite Index falls below -3 which happened on the 27th of September 2015. In the simplest sense, the index measures if investors earned additional returns over the past six months by skewing portfolios toward risky assets away from safe assets. The graph indicates that the two previous panics were caused by worries of a Eurozone break-up back in 2011-2012 and the fall of Bear Sterns during the global financial crisis in 2008. Market participants respond adversely to shocks, and while sometimes the reaction is appropriate, it usually is an overreaction to short-term events. If it is an overreaction, there is opportunity for investors to purchase risky assets at a discount. Investors however believe current evidence justify a bleak and muddled long-term view with the possibility of further panic with no investment opportunity in sight.

I believe it is not all doom and gloom as markets are overreacting. Stabilization is likely because policy makers outside of the US will provide stimulus for risky assets in the fourth quarter of 2015.  The Chinese authorities are aggressively easing conditions with increased lending, lowered interest rates and reduced reserve requirements, which would lead to stabilization even if large rebounds are not seen. In Europe, extended quantitative easing is likely to last till September 2016. Furthermore, developed markets have relatively limited spillover effects from emerging market weakness. Chinese import demand as a share of GDP of Developed markets is low - In the EU it is 1.0% and in the US it is 0.7% and Chinese financial markets are largely closed off to the rest of the world.

From the graph above, the trend indicates that episodes of panic precede euphoria, not necessarily immediately but will eventually. Euphoria is when the index level hits 5 and above. I don’t think the Index will fall further below -3 similar to previous incidents of panic. Instead it will move towards 0 by the end of this year. What happens next depends on what happens in China. The Chinese authorities are diligently reforming toward economic liberalization to achieve its geopolitical ambitions. Although economic growth is in structural decline, annual growth in discretionary consumption is predicted to exceed 7% between 2010 and 2020, in the context of annual aggregate household income of $5 trillion [1]. Profits in consumer industries like furniture, electronics, food & beverage grew from early 2015 to date. Westpac-MNI’s monthly consumer survey claims that the Chinese are more confident about their finances and the business environment – the most optimistic since May 2014. The average individual Chinese consumer is not perturbed by aggregate national statistics. Soon, it will transition from an export-oriented economy to an urban consumption-focused economy with market-determined exchange rates. Its weakness in exports and the industrial sector will have a diminishing impact on income and spending. When China (and global markets) successfully perseveres with these painful Chinese reforms and enjoy the fruits of labor by the next 3-5 years, we will be in the next euphoria.


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Prepare for a Sino-American currency oligopoly

Reserve currencies are usually issued by economies that hold large amounts of global output and trade. They offer highly liquid financial markets and are able to capture large shares of international market transactions. IMF’s latest report on FX reserves state that 62% of known allocated reserves are in USD, which is largely unchanged since the EUR’s creation in 1999. The EUR, which is the second largest reserve currency, only accounts for slightly above 20%. Further, in the last decade the BIS estimates in 2013 that almost 90% of global FX transactions involve the USD with the figure remaining stable for the last decade while other currencies are left behind – EUR, JPY and GBP only have a share of 33%, 23% and 12%.

At the moment, we do not see a correlation between China’s increased share in output and trade with the use of the Chinese Renminbi (CNY) as an international reserve currency. We can trace the root cause of the lack of correlation to the managed float regime that reflects the previous unwillingness of the Chinese authorities to liberalize the CNY. More recently, the Chinese government shocked markets as they realize economic reforms were necessary for their own economic and geopolitical interests. Back in August 2015, The People’s Bank of China (PBoC) announced a reform in their rigid fixing rate mechanism by stipulating that it now will take into consideration the closing level of the USD/CNY spot rate of the previous day to allow for greater market-determined movements in exchange rates.

The initial depreciation shock raised concerns that the Chinese authorities were embarking on a policy of outright competitive depreciation as it frequently did in the past. However, the end goal now is to be part of the IMF’s Special Drawing Right (SDR) basket of currencies whose current member currencies (USD, EUR, JPY, GBP) dominate global bond markets and financial transactions - a natural consequence of SDR membership. The PBoC’s new parameters of the CNY managed float linking the current day fixing to the previous day’s spot closing rate will mean that as time passes, a freely-floating RMB is a very realistic possibility. The potential benefits for China are enormous such as reduced borrowing costs and contracts in major commodities can be priced in CNY. China’s large foreign exchange reserves can also be used more efficiently, since reserve currency countries usually have lower currency reserves relative to GDP.

It appears as though we have discounted the EUR that is the second largest reserve currency. The EUR’s further expansion as a reserve currency is limited given its recent sovereign debt crises. Essentially the government debt market of the Eurozone is fragmented and contained at the country level so there will be no single government debt issue that could rival the US Treasury market. Over time, as China’s reforms progresses, the CNY will become the second largest alternative to the USD, overtaking the EUR. The CNY will probably not overtake the USD in the short term but give it another two decades and we will confront a world of Sino-American currency rivalry. If China manages to accomplish this, America and China might compete to increase attractiveness of their own currencies by engaging in responsible and disciplined fiscal and monetary policy. America’s days of cheap credit will be over. The USD’s political leverage will diminish and sanctions against countries (like Iran and North Korea) will lose effectiveness and exclusion from the US financial system will no longer be a threat. In the meantime however, China must work on the transparency of its financial, political and legal institutions to acquire the faith of global investors, which the Americans have been enjoying (and exploiting) thus far.

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Fixing the plumbing of liquidity in financial markets

It became very clear that liquidity was the blood of the financial system during the financial crisis of 2008 – large injections of liquidity were necessary to save bleeding banks. Regulations were enacted to prevent such crises from reoccurring, but the irony is that we have just discovered the negative side effects of regulation on market liquidity. Corporate bonds now have to be backed by healthy amounts of capital and collateral to endure a more stressful Fed stress test. The Volcker rule further restricts proprietary trading causing banks’ failure to provide near-term client demand for market-making activities, leading to bigger volatility in market prices. Moreover, in search of safe investments, large institutional investors have become major players in the fixed-income space in light of low interest rates. These safe investments are usually illiquid but investors can redeem them overnight via open-ended Exchange Traded Funds. When the Fed moves toward interest rates normalization eventually, large holdings in bond funds are very vulnerable to redemptions as bond prices fall.

Dealers will not be able to act as shock absorbers in the event of one-way traffic out of bond holdings. I feel it is imperative that regulators look at new rules collectively, not in isolation. If regulation impedes ‘business-as-usual’ trading activity, investors are highly unlikely to trade in times of crisis. Regulators must allow some flexibility amidst stricter balance sheet rules. Some trades weigh on balance sheets in the shorter term but might be very low-risk and able to act as the missing ‘shock-absorbers’. Though we cannot just merely blame regulation – in times of crises dealers equally participate in fire sales of their bond inventories. It is normal for liquidity to be present when markets are healthy and disappear when it is most needed. In the long run, there will definitely be some adjustments by dealers to adopt more client-tailored trading activities. Robert Michele of JPMorgan Asset Management has stated that market participants will need to be investors again rather than just traders. Prior due diligence and research is even more crucial and emphasis has to be put on bond exit strategies as a pay-off as opposed to an emergency exit plan. Fund managers / traders must make it a point to examine an investor’s liquidity needs when purchasing ‘liquid’ securities in an environment of illiquidity.

Renowned economist Nouriel Roubini has gone as far as to say that the combination of illiquidity factors we discussed and loose monetary policy is a ticking time bomb. When external shocks (Fed rate hike, commodity price volatility, Emerging markets’ currency shocks) occur, “herding in the opposite direction” happen and dealers who largely absorbed these shocks on their once unrestricted balance sheets are no longer in the picture. Maybe he is right to say that this bubble will eventually burst with catastrophic impact on the wider economy, but the markets will evolve vis-à-vis the status quo. We are just not sure of the speed of the market corrections so in the meantime it is important that market participants acquaint themselves with the idea that they can no longer depend on dealers to provide liquidity in markets and while dealers should adopt more client-oriented strategies, issuers must be aware of consequences of market conditions on their debt burden. Regulators must find this delicate balance between the cost and benefits of their new rules. As we fix the plumbing of the financial markets, a positive outcome we can hope for is greater investor discipline and risks being better spread out throughout market participants so that the economy is not totally reliant on "too-big-to-fail" banks.