Why China's Currency Is Not a One-Way Bet

Why China's Currency Is Not a One-Way Bet

It's looking like it might turn out to be quite an interesting week. China kicked things off yesterday with the news that it is going to reform its RMB exchange-rate regime to allow a little more flexibility.

The markets were pleased – globally, pretty much everything moved up for a bit. Most other Asian currencies had a good day too – which is nice, given that we've been suggesting that you diversify into them for a while now.

But there is something interesting going on here. One of the things that has been bothering us over the last few months has been the utter lack of consensus in the markets. Investors and analysts appear to be neatly divided into inflationists and deflationists, double-dippers and V men, deficit "slash and burners" and "monetise the debt" men.

But on the RMB there is no such division: everyone thinks that removing the peg that linked the Chinese currency to the dollar means that the RMB will rise. That's supposed to be good because it raises the price of Chinese exports to the rest of the world and cuts the price of its imports. That in turn should help out the ailing West (by encouraging the Chinese to buy more of our stuff) and rebalance the Chinese economy too (easing inflation to keep interest rates low and forcing it to find an economic driver beyond exporting toys and buttons).

But what if it doesn't work like this? What if the RMB is not massively undervalued – Credit Suisse says it needs to rise 50% against the dollar to hit fair value – but massively over valued? Let's not forget that while it has been pegged to the dollar it has nonetheless already appreciated massively against the euro and the pound this year. And in trade-weighted terms it has risen 13% or so since the peg was first loosened back in 2005.

It's also worth noting that, according GMO's Edward Chancellor, China currently displays pretty much every single characteristic of a massive bubble. It started with a compelling growth story; it comes with a "blind faith in the competence of the authorities" (how many times have you heard people say that Chinese growth won't fall because "the government won't let it"?); there is a general increase in often misallocated investment: the money supply is growing far too fast; interest rates are too low; credit growth is rampant; and there is strong evidence of rising corruption, spurred on by the real estate boom.

Real estate investment currently makes up around 12% of total GDP. The Chinese economy has been compared to the film Speed in which a bus is planted with a bomb set to detonate if it slows below 50 miles an hour. This seems apt, says Chancellor. "Were China's economy to slow below Beijing's 8% growth target, bad things are liable to happen. Much of the new infrastructure would turn out to be otiose; excess capacity would linger in many industries; the real estate bubble would burst and the banking system would face a rash of non-performing loans. Investors who are immersed in the China Dream ignore this scenario. When the China juggernaut eventually stalls, they face a rude awakening."

The timing of this potential rude awakening is of course impossible to see. But nonetheless, look at China through Chancellor's eyes and it is hard to keep arguing that the RMB is 50% undervalued: there may be more risk in it than the consensus opinion likes to think.