WHY DO CURRENCIES MOVE?

Hello my curious friends! Welcome back.  Today, I wanted to take a little detour into the wild and crazy world of currencies, and more specifically what in the world is going on with the Renminbi.

Detours are always a great deal of fun in my opinion.  You can see and learn things you normally never would have.  New insights blossom.  New pathways open up.  Getting lost is the only way to finding your true self.  I’m a Zen Buddhist Monk in my spare time.  Just roll with it.

But, seriously, currency movements and speculation is a very interesting aspect to the markets, and I wanted to try and understand it a little better.  So I did some research.  And here is what I’ve learned.

Why do Currencies move?

By and large, currency move based on supply and demand.  Rallies are demand driven.  There is a need for that currency, and the reasons for that need can be varied (i.e. speculation, hedging, conversion, etc).  Excess supply depreciates a currency. So, I know what you’re thinking, if you want to know where a currency is headed just predict the supply or demand.

Not so fast.  Predicting supply and demand can be very tricky, and on a fundamental basis one can look at myriad factors, including budget deficits, capital flows, balance of payments, debt levels, debt cycles, etc…

Current Account

A country’s Current Account Balance is a quick way some analyst assess the respective country’s economic strength, and is essentially the difference between a country’s savings and its investments.

Current Account is made up of 3 components: (1) Balance of Trade (exports – imports); (2) Net Income from Abroad; and (3) Net Current Transfers.

A Current Account Surplus, by and large, means that a country is healthy and saving more than it is spending.  A Current Account Deficit, by and large, means the opposite, that a country is spending more money than it is saving.  When a country does this is has to borrow from other Current Account Surplus countries.  Thus, you get Debtor Countries (think, US and UK), and Creditor Countries (think China)

Typically, when a country is running a Current Account Surplus you will see that country’s currency appreciate.  When a country is running a Current Account Deficit, by and large, you see that currency depreciate.

Inflation

By and large, countries that experience low inflations, should see their currencies appreciate.  The opposite it typically true as well. Typically, an overvalued currency leads to a large decline in domestic economic activity, which forces an easing of monetary policy, and eventually brings about the decline in the currency. Seems like a cycle to me.

Monetary Policy

Monetary policy is important when considering short term moves in a currency.  A country that pursues an expansionary monetary policy will, by and large, see its currency weaken, and that is likely due to rates moving lower which leads to outflows of capital, or it could be because of an expansion of domestic economic activity, which leads to a deterioration of the trade imbalance. By and large, an expansionary monetary policy leads to a weaker currency.  And a restrictive policy strengthens the currency.

Fiscal Policy

Here the effect is not as certain. An expansionary fiscal policy will typically lead to higher rates, which leads to a rise in the interest rate differential (the difference between the interest rates in the 2 countries in the currency pair), which will drive the currency higher.

However, this does not last forever.  Expansionary fiscal policies create huge budget deficit, which cause the risk premium on that debt to grow.  This happens because countries that run deficits can only do so by finding willing investors to buy the debt it issues.  Investors won’t buy the debt unless they are compensated.  And as a country has more and more outstanding debt, the higher the risk of default, by and large.  This pushes up the risk premium on new issues.

China

So, let’s pull some of the above together and apply it to the largest (or 2nd largest…does it really matter at this point??) economy in the world.

The Bear Case

China is roughly a $10 Trillion economy.  Bank assets are in the neighborhood of $30 Trillion.  So, 3 times GDP.  How much of that is bad debt that will have to be restructured???  There has been research suggesting that bad debt could be in the area of 24% of bank assets, or roughly $7.2 Trillion.  Which then presents a situation with Bad Debt to GDP of about 68%!! FX Reserves are depleting in China, and stand at $3.2 Trillion as of this month.

What they need to do is devalue the currency enough so that foreign investors can sit at their desks and say, oh, nice, China assets are cheap now, let’s pile in.  However, to do that will likely bankrupt some large Chinese companies that might have borrowed in Dollars or Euros in the last few years.

The Bulls

So, by and large, a devaluation will likely result in a number of domestic bankruptcies in China.  Are Chinese officials ready for that mess??? Also, it is a political problem for China.  China wants to be part of the IMF bucket of reserve currencies and is scheduled to join it on October 1st of this year.  If China were to devalue by a large percentage the IMF could pull that, and that would be a large slap in the face from China. China has also put a great deal of faith in its peg, and after the amatuer hour that was the recent stock market debacle in China, I don’t think officials want to look bad again.  So they are being very careful with each and every move.

So they are fighting the devaluation.  They try to prop up the off-shore renimibi.  They spend.  Investors attack it.  Its a back and forth where money keeps seeping out of the country and reserves decline. If you look at China as a whole, it has very low foreign debt, and a current account surplus. Additionally, I have a feeling that with all this market turmoil and currency fluctuations going on in the renminbi, exporters in China have been hoarding Dollars, and not converting them back into Yuan.  When they do that, which I think will be relatively soon, you will start to see the renminbi appreciate.

As well, as China’s financial system matures, foreign investors will start to realize that China has the 3rd largest bond market in the world.  And they will definitely want to play in that pond.  In order to do so they will need some Renminbi.  This will also cause the currency to appreciate.

Bottomline

First off, let me just say, that I think speculating on the Renminbi is a dangerous game unless you know what you are doing.  The consensus view at the moment is that China is going to have to devalue the currency in the near future.  Some large players are betting the farm on that trade.

However, I like to be a bit of a contrarian.  First off, the bull points I raised above are real.  As well, I think there is a strong emotional component to everything in investing.  And at this stage in China’s growth story, I suspect that Chinese officials will perceive a further devaluation of the Renminbi as an embarrassment.  I think that emotional story will be a huge part of what happens with the currency.  How will the rest of the world view China if they have to devalue their currency?  Will Chinese officials stand for that?  Or do they want to project a strong image, and a free market?? Only time will tell.

But the one thing I have learned for certain is that, by and large, when everyone is in agreement that an asset will move one way, look for it to flip on ya…and do the exact opposite.