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Over the past half dozen years we have had various countries attempt to conduct prudent monetary policy in the midst of the quantitative easing avalanche that is engulfing the global financial system. Yet each time they have done so, they have found themselves bitten by a vicious downturn that eventually causes them to cry “Uncle.”

First it was Japan. When the other major Central Banks engaged in balance sheet expansion to combat the 2007/8 credit crisis, the Bank of Japan at first held tough.

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As the Federal Reserve, the Bank of England and the ECB expanded their balance sheet aggressively in the 2008–2012 period, the Bank of Japan did not follow suit with the same sort of expansion. This caused Japan to have the tightest monetary policy on a relative basis. Even though Japan was suffering from the devastating effects of the tsunami disaster, the Yen rallied.

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Eventually the deflationary pressure proved too much for the Japanese people. They elected a new leader, Prime Minister Abe, whose main platform was to reverse the secular slide. Abeconomics was born. Since then the BoJ has gone from being one of the tightest Central Banks to one of the loosest.

The next country that tried to conduct conservative monetary policy in the midst of all this expansion was the ECB. The ECB expanded their balance sheet aggressively to combat the European credit crisis of 2011. As the panic subsided, the ECB let the expansion roll off and the balance sheet contracted quickly during 2012 and 2013.

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This balance sheet contraction by the ECB while the Fed was in the midst of its aggressive “QE infinity” and the BoJ was ramping up their expansion, made European monetary policy the tightest of the large economies. This caused the Euro to rally, especially compared to the Yen.

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Draghi finally hit his “puke point” when the BoJ instituted their second round of balance sheet expansion. The move to 150 in the EURJPY was too much for Europeans to bear. They were already importing all the world’s deflation, and not responding with their own QE, risked pushing European into a deflationary vicious spiral.

And it’s not just the big major economies that have tried to conduct prudent monetary policy only to quickly have to reverse course. Have a look at his chart from BCA Research.

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Everywhere you look there are countries that have tried to combat the avalanche of easy money but eventually had to give in and print with the rest of them. No one has been able to withstand the pain.

Therefore China’s recent economic policy is especially interesting. We all know that they are in the midst of trying to rebalance their economy away from an exporting sweatshop. China’s President Xi has also made the stamping out of corruption a top priority. Between these two major initiatives, the Chinese economy is in the process of being dramatically transformed.

Given these policies, even in a robust global economic environment you would expect the Chinese economy to de-accelerate. This rebalancing is akin to China trying to swim with their clothes on. But when you combine China’s monetary policy into the mix, you get a situation where China is the next Central Bank to make the mistake of refusing to join the printing parade.

China has a soft peg against the US dollar. That has its positives and its negatives. When the Fed was aggressively expanding their balance sheet in the aftermath of the credit crisis, this meant that China was tied to a weak currency. Now that the Fed has stopped expanding its balance sheet, and is about to actually raise rates, China suddenly finds itself with one of the strongest currencies in the world.

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As you can see, CNY is basically flat lining against the US dollar, while all the rest of the world is depreciating. This is the same situation that Japan faced five years ago and that Europe struggled with last year.

We can’t track China’s balance sheet, but they report their foreign exchange reserves. The pace at which they been accumulating FX reserves has been slowing lately.

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Now some of you will no doubt be saying to yourself, “good for them – it is madness to follow all these other Central Banks down this path.”

That is in fact the message that former Morgan Stanley economist Stephen Roach argued in his recent article for Project Syndicate:

Steady on the Renminbi

NEW HAVEN – Currency wars are raging worldwide, and China is bearing the brunt of them. The renminbi has appreciated sharply over the past several years, exports are sagging, and the risk of deflation is growing. Under these circumstances, many suggest that a reversal in Chinese currency policy to weaken the renminbi is the most logical course. That would be a serious mistake.

In fact, as China pursues structural reforms aimed at ensuring its continued development, forced depreciation is about the last thing it needs. It would also be highly problematic for the global economy.

On the surface, the situation certainly appears worrisome – especially when viewed through the currency lens, which captures shifts in Chinese prices relative to those in the rest of the world. According to the Bank for International Settlements (BIS), China’s real effective exchange rate – an inflation-adjusted trade-weighted average of the renminbi’s value relative to the currencies of a cross-section of China’s trading partners – has increased by 26% over the last four years.

China’s currency has appreciated more than any of the other 60 countries that the BIS covers (apart from dysfunctional Venezuela, where the figures are distorted by multiple foreign-exchange regimes). By comparison, the allegedly strong US dollar is up just 12% in real terms over the same period. Meanwhile, China’s emerging-market counterparts have experienced sharp currency depreciations, with the Brazilian real falling by 16%, the Russia ruble by 32%, and the Indian rupee by 12%.

This currency shift is, of course, the functional equivalent of a large hike in the price of Chinese exports. Add to that continued sluggishness in global demand, and the once-powerful Chinese export machine is suffering, with total exports down by 3% year on year in January. For an economy in which exports account for about 25% of GDP, that is not a trivial development.

At the same time, a stronger renminbi has made imports less expensive, putting downward pressure on China’s price structure. Unsurprisingly, this has exacerbated the fear of deflation, with the consumer price index (CPI) rising by just 0.8% year on year in January, and the annual decline in producer prices steepening, to 4.3%. While these trends are undoubtedly being amplified by plummeting world oil prices, China’s core CPI inflation rate (which excludes volatile food and energy prices) was near 1% in January.

Against this background, it is easy to see why many anticipate a tactical adjustment in China’s currency policy, from appreciation to depreciation. Such a move would certainly seem appealing as a way to provide temporary relief from downward pressure on growth and prices. But there are three reasons why such a move could backfire.

First and foremost, a shift in currency policy would undermine – indeed, undo – the progress that China has made on the road to reform and rebalancing. In fact, a stronger renminbi is consistent with China’s key objective of shifting from export-intensive growth to consumer-led development. The generally steady appreciation of the renminbi – which has risen by 32.6% against the US dollar since mid-2005 – is consistent with this objective and should not be reversed. It strengthens Chinese consumers’ purchasing power and reduces any currency-related subsidy to exports.

During the recent financial crisis, the authorities temporarily suspended China’s renminbi-appreciation policy, and the exchange rate was held steady from mid-2008 through early 2010. Given that current circumstances are far less threatening than those in the depths of the Great Crisis, the need for another tactical adjustment in currency policy is far less acute.

Second, a shift to currency depreciation could inflame anti-China sentiment among the country’s major trading partners – especially the United States, where Congress has flirted for years with the prospect of imposing trade sanctions on Chinese exporters. A bipartisan coalition in the House of Representatives recently introduced the so-called Currency Reform for Fair Trade Act, which would treat currency undervaluation as a subsidy, allowing US companies to seek higher countervailing duties on imports.

Similarly, President Barack Obama’s administration has just brought yet another action against China in the World Trade Organization – this time focusing on illegal subsidies that China provided to exporters through so-called “common service platforms” and “demonstration bases.” If China intervenes to push its currency lower, US political support for anti-China trade actions will undoubtedly intensify, pushing the world’s two largest economies closer to the slippery slope of protectionism.

Finally, a renminbi-depreciation policy would lead to a sharp escalation in the global currency war. In an era of unprecedented quantitative easing, competitive currency devaluation has become the norm for the world’s major exporters – first the US, then Japan, and now Europe. If China joined this race to the bottom, others would be tempted to escalate their actions and world financial markets would be subject to yet another source of serious instability.

Just as China resisted the temptation of renminbi depreciation during the Asian financial crisis of 1997-98 – a decision that may have played a pivotal role in arresting regional contagion – it must stay the course today. That is all the more important in a disorderly climate of QE, where China’s role as a currency anchor may take on even greater importance than it did in the late 1990s.
Strategy is China’s greatest strength. Time and again, Chinese officials have successfully coped with unexpected developments, without losing sight of their long-term strategic objectives. They should work to uphold that record, using the strong renminbi as an incentive to redouble efforts at reform and rebalancing, rather than as an excuse to backtrack. This is no time for China to flinch.

Roach’s article wasn’t as much a forecast as it was an opinion piece. He might well think that staying the course is the correct path, but be doubtful that this is the fork the Chinese will choose. I don’t know how he would handicap the outcome.

But I know the chances of China following his advice are low. There is no doubt they want to rebalance their economy, but at the end of the day the Chinese will not sit idly by as Japan, Europe and every other nation depreciates their currency against the US dollar. The only question is how much pain they will take before they pull the trigger.

Many other countries thought they could hold out. The delay in acting only made the needed adjustment all the greater.

Last night Premier Li Keqiang warned that China may face more economic difficulties in 2015 vs 2014 and downward economic pressure is still growing. He lowered their growth target from 7.5% down to 7%. China’s economy is slowing quickly. They have already taken steps to ease monetary conditions by lowering reserve ratio requirements and overnight interest rates, but they will need to do more.

It is only a matter of time until China follows the other countries down the road of aggressive balance sheet expansion. To accomplish this, China will have to untie their currency to the US dollar. I know that Roach counsels against it, but this predicament reminds me of all the scenes in movies where the captor says, “you might as well talk, everyone does in the end…”

Thanks for reading,

Kevin Muir

the MacroTourist

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