Almost ever since the IMF has agreed to include the Chinese Yuan in the Special Drawing Rights basket at the end of November, the Chinese Yuan has been declining.

The Yuan’s weakness has been steady, and it is not a great leap to deduce the move has been orchestrated. Some of the ZeroHedge types are making a big deal about this “supposed” devaluation.

I am hard pressed to call the recent decline a “free fall.” Have a look at the chart for the past year:

The CNYUSD rate is approaching the panic high levels reached during this summer’s actual devaluation. But when you zoom out to a longer term picture, the recent Yuan weakness is minuscule:

This long term currency strength is having a detrimental effect on the Chinese current account. Have a look at the spread between the Onshore and Offshore Chinese Yuan:

It continues to widen as capital leaves China.

And this capital flight is a problem. The Chinese have pegged their currency to the US dollar, which wasn’t an issue when the US was engaging in buckets of quantitative easing. But as the Federal Reserve reverses their exceptionally easy monetary policy and becomes the most relatively hawkish major Central Bank out there, the Chinese find themselves chained to the strongest currency in the world.

The Chinese has been slow to disentangle their soft USD currency peg in fear of messing up their inclusion into the IMF Special Drawing Rights basket. But that hurdle has been overcome.

The market realizes the Yuan has been kept artificially strong during this period, and that is why they are taking advantage of the currency strength to sell CNY.

Recently, after the official announcement of the Yuan being included in the SDR basket was confirmed, the PBoC have permitted the CNY to decline in the face of all this selling.

But herein lies a problem. This steady decline is only encouraging more selling. I stumbled on this great tweet by Ben Rabidoux that sums up the situation perfectly:

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I couldn’t agree more. China needs to either let the Yuan float freely, or devalue dramatically lower.

Over the past half dozen years we have seen many countries try to withstand the pressure of a strong currency. Japan’s unbelievable Yen strength after the Tsunami disaster eventually ushered in a new Prime Minister elected on a platform of reversing the deflationary wave that had enveloped the country. For a while Europe tried to resist the urge to engage in QE to lower the value of the Euro, but in the end Mario and the rest of the ECB over ruled the Germans. Since the credit crisis of 2008, every time a country has experienced a currency appreciation due to relatively tight monetary policy, they have eventually succumbed to the deflationary cloud that descends on their economy and panicked. China will be no different. And make no mistake, the pressure on China is immense. Have a look at this chart of the Yuan versus the Yen, Euro and US dollar:

The rest of the world has devalued against the US dollar, and China has been stubbornly trying to hold out while the fate of the IMF SDR decisions was up in the air. This has cost the Chinese economy.

I continue to believe the Chinese Yuan needs to decline a lot lower than the recent weakness from 6.40 to 6.44. That move is less than 1%! ZeroHedge might call that a free fall, but I think it is a rounding error.

The Yuan needs to move down 5% or 10% or even 20%. Look at the numbers above. A slow drip of a percent or two isn’t going to cut it. If it were me, I would float the Yuan this week-end, right in front of the US first rate hike. It would probably instantly skid below fair value, but that’s better than being stuck walking down an overvalued currency bit by bit while capital flees. Although there would be some market disruption, the American rate hike would soon take centre stage.

Whatever the timing, make no mistake – the Yuan has to go lower, and I am not talking 6.44 to 6.50 lower, I am talking significantly lower…

Thanks for reading,

Kevin Muir

the MacroTourist