Markets are still digesting last week’s Chinese devaluation that sent the Dow crashing over 700 points last Monday.
And as everyone knows by now, the Trump administration labelled China a currency manipulator.
The ironic part of it is that China has been manipulating its currency to strengthen it against the dollar.
Here’s the dynamic you need to understand…
The Chinese yuan is softly pegged to the dollar. To maintain the soft peg, the People’s Bank of China (PBoC) sells dollars and buys yuan.
That props up the yuan. It’s basic supply and demand economics.
One of the primary reasons China tries to strengthen the yuan is to prevent capital flight out of the country. If the yuan depreciates too rapidly, massive amounts of Chinese money would look to flee abroad where it can get much higher returns.
After all, would you want to hold a rapidly deteriorating asset that constantly loses value? Or if you were a Chinese investor, would you try to convert your money into a currency that holds its value?
That’s the question Chinese investors have been facing.
A capital drain could devastate the Chinese economy, which badly needs the capital to remain in China to support its massive Ponzi schemes, ghost cities and overinvestment.
That’s why the PBoC has been trying to support the yuan, even though a cheaper yuan helps Chinese exports.
That’s the conundrum China faces. It wants a cheap yuan — but not too cheap.
I wouldn’t call last Monday’s devaluation the sort of “max devaluation” I’ve warned my readers about before. That would have been a devaluation of 5% or more in a single day, and that’s not what happened last week. I would classify it as a “red line” devaluation.
The yuan temporarily broke through the 7.00:1 “red line” dollar peg. It has since returned to normalized levels.
It’s actually ironic that China is being labelled a currency manipulator, if manipulating your currency means cheapening it.
That’s because China was manipulating its currency to strengthen it against the dollar. And when the yuan/dollar exchange rate crossed the 7.00:1 “red line,” that meant China temporarily stopped manipulating its currency higher.
If China didn’t manipulate the yuan higher, it would depreciate even more against the dollar. And the exchange rate stabilized last week when China resumed the manipulation. In other words, when China strengthened the yuan.
Welcome to the currency wars! They take on a logic all their own. In many ways it’s a race to the bottom.
I explained it all years ago in my 2011 book Currency Wars.
As soon as one country devalues, its trading partners devalue in retaliation and nothing is gained. China’s case is complicated by its desires for both a strengthened and weakened yuan.
But the ultimate reality is that currency wars produce no winners, just continual devaluation until they are followed by trade wars. That’s exactly what has happened in the global economy over the past 10 years.
Currency wars and trade wars go hand in hand. Often they lead to actual shooting wars, as I have repeatedly pointed out.
Let’s hope the currency wars and trade wars don’t turn into shooting wars as they have in the past.
But below, I show you why China is more of a paper tiger than an actual one. Why do I say that? Read on.
for The Daily Reckoning