I think the Chinese government will devalue the Yuan in the coming months. That’s an easy call, and it is by no means unique. There are many strategists and high profile hedge fund managers who have come to the same conclusion. But I have another more off the wall idea for you to consider…

Before we venture down that road, let’s go over the most likely outcome for the Chinese Yuan.

During the 1980s and 1990s the Chinese aggressively devalued their currency to encourage economic growth.

The move from 3.75 in 1987 to 8.25 by 1994 was a monster devaluation that ushered in a wave of economic growth the likes of which the world has never experienced. Of course there were other factors contributing to this growth, but the pegging of the Yuan at this artificially cheap level definitely contributed to the barn buster growth of the Chinese economy in the subsequent decade.

As the Chinese economy grew from a developing nation that made cheap trinkets to a more sophisticated economic powerhouse that was eroding American jobs, the calls from US officials to let the Yuan float freely grew in intensity. For many years the Chinese resisted the pressure, but then in 2005 they allowed the Yuan to slowly appreciate. It went from 8.25 all the way down to a little more than 6 in 2014.

But recently the Chinese reversed this strengthening trend and allowed the Yuan to weaken back to 6.40. The reason for this change of direction is simple. The US dollar has become the strongest free floating major currency in the world, bar none.

For the Chinese, having a soft peg against the US dollar when the Federal Reserve was the most aggressive Central Banker out there and the greenback was struggling, was especially convenient. Coming out of 2009, the Chinese were able to piggyback on the easy US monetary policy as the rest of the world recoiled in horror as Ben Bernanke instituted QE program after program.

Think back to this period. It wasn’t long ago the rest of the world was chastising America for the US dollar being too weak! In 2010 the Brazilian Finance Minister Guido Mantega complained about the US engaging in a currency war. In his first trip to China as a Secretary of the Treasury, Timothy Geithner was openly laughed at by students about the safety of the US dollar. I know it seems quaint now, but five years ago the world worried more about the collapse of the US dollar than anything else.

This US dollar weakness was a boom for China. But now having flipped from extreme weakness to unbearable strength, it is proving a terrible headwind.

Over the past few quarters the Chinese have allowed their currency to weaken from 6 to 6.40, but that is small potatoes when compared to the massive declines seen by other currencies.

Take for example the Japanese Yen versus the Chinese Yuan:

The cross rate has gone from 12 in 2012 to 20 in 2015. That’s a gain of 66% for the Chinese currency.

Now maybe you will say the Japanese Yen is a special case. It was overpriced to begin with. Although the Yuan’s increase versus the Japanese Yen is more dramatic, it is the same story with most other currencies. The trade weighted Yuan is exploding higher:

In this day and age of limited economic growth with too much indebtedness, currency strength is a death sentence for an economy. Japan tried to weather the currency strength after their tsunami disaster, but they eventually changed leaders to usher in a new monetary policy to weaken the Yen and break the back of deflation. Then Europe tried to withstand the monetary avalanche from Japan and America, but the Euro strengthened to a point where Draghi had to tap out and institute QE. Now we have the US riding down this same road, and although they will also eventually be forced to the same outcome, the Chinese monetary tie to America will break first.

The Chinese economy is imploding at a fierce rate. It cannot withstand this massive currency strength.

All currency pegs eventually break, and to think the Chinese will somehow be able to manage this split better than other countries is naive. The only question is what has taken the Chinese so long?

The Chinese government is keen to have the Yuan included in the IMF’s Special Drawing Rights basket. The last thing they need is the currency imploding right in front of the decision on whether it should be added. However it looks like this long awaited decision will be finally made on November 30th. At that point the IMF will officially recommend the Yuan for inclusion in the SDR basket. The changes will not take effect until next year, but in a week’s time the decision will be complete, and then the spotlight can come off the Yuan.

The Chinese might wait until the new year, but in the coming month or two, they will once again devalue the Yuan. They simply don’t have any choice. They have been patient until now because of the SDR decision, but that excuse won’t hold water any longer. The Chinese need to get that Trade Weighted Index down from 139 to 120 at a minimum.

Maybe they will use the Fed’s December raising of rates as an excuse to abandon the peg. Maybe they will simply walk it down slowly. But make no mistake – the Yuan has to go down.

I think that is an easy call. I know some hedge funds are long CNY volatility as the soft peg has created the illusion of stability. Pegs never last, and betting on increased volatility is probably a great trade. There is a new era of a more independent CNY trading regime approaching, the only question is how it is ushered in.

SDR plan?

All this talk about SDRs got me thinking about the problems facing the global financial system. We have too much debt, with not enough growth. There is not much chance we will ever grow our way out of this mess, so the only question is whether it implodes with an Austrian style credit destruction depression, or whether the Central Banks are able to create inflation to inflate the debt away the old fashioned way.

I don’t think there is any political will for an Austrian style credit event, so I am dismissing this option. Which leaves only the inflation option.

The problem with inflation is that as one Central Banks prints, it creates all sorts of distortions in the global financial system. We saw this effect when the US engaged in overly aggressive QE in 2010 and the world struggled with the low US dollar.

What we really need is some sort of world Central Bank to print money to create inflation equally. Wait, we kind of already have that.

The IMF according to their website was:

…. conceived at a UN conference in Bretton Woods, New Hampshire, United States, in July 1944. The 44 countries at that conference sought to build a framework for economic cooperation to avoid a repetition of the competitive devaluations that had contributed to the Great Depression of the 1930s.

The IMF’s responsibilities: The IMF’s primary purpose is to ensure the stability of the international monetary system—the system of exchange rates and international payments that enables countries (and their citizens) to transact with each other. The Fund’s mandate was updated in 2012 to include all macroeconomic and financial sector issues that bear on global stability.

Think about their mandate. If the greatest problem the global economy is facing is deflation, then wouldn’t it be completely in their perogative to combat this force?

Central Bankers face a tough sell instituting QE. Whether it is the Tea Party in the US, or the Germans in the EU, there are always difficulties pushing the policy through. It often takes a crisis to enable any real change.

But the IMF is barely accountable to anyone. Not many understand the inner workings of the IMF. These SDRs are more complicated than most of the derivatives Goldman pawns off on their clients. There is probably no better way to print money without anyone truly understanding it than having the IMF do it. They could issue SDRs in the guise of helping stabilize the global financial system.

It isn’t going to happen overnight, but I suspect the plans are being put into place. The inclusion of the Yuan into the SDR basket is a necessary condition to getting all the big financial players on board.

When the next crisis occurs, Central Bankers will not blindly just repeat previous mistakes. There will be new ideas that try to fix the problems from past programs. Watch for the IMF to play a larger role in combatting the deflation. My suspicion is the IMF could be the missing ingredient that eventually pushes us from deflation into inflation.

Thanks for reading,

Kevin Muir

the MacroTourist