In last Tuesday’s Rum Rebellion, I wrote an essay entitled ‘China: Debt, FX Reserves and the Ticking Time Bomb’.
The gist of it was that China has created so much yuan-based debt over the past decade that they are at risk of losing control over their currency. If that happens, look out.
I also pointed out that the Middle Kingdom’s US$3 trillion hoard of foreign exchange reserves is nowhere near enough to defend the currency.
This is why Trump has the upper hand in his economic war with China. As I’ve told you many times, he is not bluffing. He is attempting to fundamentally change the US/China trade relationship, which will weaken China’s economy.
On Sunday, a previously promised 15% tariff on a range of Chinese goods went into effect. At the same time, Trump tweeted:
‘Peter Morici, Economist: Tariffs will not impact American consumers that much because the Chinese currency has gone down, which gives our importers a discount. Importers can find suppliers outside of China. Absolutely worth it, we don’t want to be servants to the Chinese! This…
‘…is about American Freedom. Redirect the supply chain. There is no reason to buy everything from China.’
And on Friday, the Financial Times published an op-ed that expanded on the topic of China’s financial fragility. Written by Arthur Budaghyan, chief emerging market strategist at BCA Research, the article is downright scary.
To give you a sense of the problem, it’s worth quoting from extensively. I’ll then take a look at how Australia is placed in all of this.
‘Over the past 10 years, Chinese banks have been on a credit and money creation binge. They have created Rmb144tn ($21tn) of new money since 2009, more than twice the amount of money supply created in the US, the eurozone and Japan combined over the same period. In total, China’s money supply stands at Rmb192tn, equivalent to $28tn. It equals the size of broad money supply in the US and the eurozone put together, yet China’s nominal GDP is only two-thirds that of the US.
‘There are clear downsides. Helicopter money discourages innovation and breeds capital misallocation, which reduces productivity growth. Slowing productivity and strong money growth ultimately lead to rising inflation — the dynamics inherent to socialist systems.
‘In the long run, more stimulus in China will entail more money creation and will heighten devaluation pressures on the renminbi. As we all know, when the supply of something surges, its price typically drops. In this case, the drop will take the form of currency devaluation.
‘As it stands, China’s money bubble is like a sword of Damocles over the nation’s exchange rate. Chinese households and businesses have become reluctant to hold this ballooning amount of local currency. Continuous helicopter money will increase their desire to diversify their renminbi deposits into foreign currencies and assets. Yet, there is no sufficient supply of foreign currency to accommodate this conversion. China’s current account surplus has almost vanished.
‘As to the central bank’s foreign exchange reserves, at $3tn they are less than a ninth of the amount of renminbi deposits and cash in circulation. It is inconceivable that China can open its capital account in the foreseeable future.’
In other words, China cannot defend its currency with its FX reserves. But we already knew that, didn’t we?
The smart money wants out. Which asset do you think will be the biggest beneficiary of this escaping Chinese capital?
How Australia is placed in all of this…
My guess is, in no particular order; land (in non-socialist political systems, of course), US dollars, gold and euros.
The impact on equity markets is likely to be bearish. The last time China explicitly devalued its currency, in August of 2015, the ASX 200 (see chart below) fell 14% over the following six months. The ASX Resources index fell a hefty 35%.
As the chart shows, the market had already fallen from its peak earlier in the year. This was on concern that the Chinese economy was already slowing.
Remember, at that time, commodities were in the midst of a nasty bear market. Oil prices had cratered in 2014, while coal, iron ore and gold were all down heavily from their peaks.
China’s devaluation confirmed fears about the state of its economy, and stocks continued to fall thereafter.
This time around, the resources sector is only just starting to slow. Although it’s not definitive yet, the chart of the ASX 200 Resources index, below, is a little worrying.
From the July peak to last week’s low, the correction was just over 12%. That saw the index momentarily break through support (the upper green line), although last week’s relief rally delivered a much-needed bounce.
But the moving averages are about to cross to the downside. That, along with the taking out of support and a new six-month low, suggests the tide is changing for the resources sector.
There are a few key differences between now and 2015. Back then, commodities were already in a lengthy bear market. China’s devaluation was actually a buying opportunity. After falling for another six months or so, commodities entered a very strong bull market.
This time around, the charts are telling you that the bull market may be over for the Aussie resources sector. Any devaluation or yuan weakness may be a signal to get out, not buy.
Also, gold is in a bull market now, not a bear market as it was in 2015. So I would expect bearish news for the yuan to be bullish for gold.
But, all is not lost for the Aussie economy. Tomorrow, I’ll have a look at where you might be able to make some money this year…
Editor, The Rum Rebellion
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