Like a UFC fighter unmercifully pounding his barely conscious opponent, the US dollar rally against emerging market countries continues unabated.
The Mexican Peso hit a new all time low against the US dollar:
And the Russian Ruble has, for the lack of a better word, completely shit the bed.
We are now well through the lows hit in the midst of the Ukraine conflict. Think about the plight of an ordinary Russian. At the start of 2014, the Ruble was trading for approximately 32 versus the US dollar. Since then it has dropped more than 60%. In the space of two years, the average Russian has seen his real net worth more than cut in half.
But at least these economies have free floating currencies that allow the exchange rate to cushion the blow through increased exports and all the other adjustments that come along with a cheaper currency.
The real problem lies with countries whose currencies are pegged to the US dollar. When the US was busy flooding the world with liquidity with QE1, QE2, Operation Twist and QE3, these countries were happy to bask in the good times of easy money. However those times have come to an end.
And all that newly created debt overhangs these emerging market economies. Even worse, the debt was often denominated in US dollars. As these emerging market economies roll over, their currencies also decline, increasing the cost of the debt.
The market realizes these US pegged currencies are overvalued as compared their other non-US free floating currency competitors. In response, capital flees. Like rats from a sinking ship, investors exit their positions. And why not? If a currency peg is unsustainable, why keep your capital in an overvalued asset? Not only do investors take out their money, but speculators soon jump on the trade. They short with both fists. Next thing you know, you have a currency crisis.
At this point you might say; “so what? I have seen Central Banks successfully defend pegs.” And you would be correct… to a certain degree. When a Central Bank defends a peg of a currency that is undervalued, they theoretically have unlimited ammunition. The market is demanding the cheap currency but the Central Bank can print as much as they want. Obviously there are some practical limits as the country would experience massive inflation with too much printing. But if the Central Bank was determined enough, they could peg their currency at an undervalued level forever. The same cannot be said about pegging a currency at overvalued levels. At a price that is too high, the market demands the Central Bank buy domestic currency and sell US dollars. Foreign Central Banks do not have unlimited US dollars. Although most hold sizable foreign exchange reserve positions, they are not unlimited. Just like when George Soros broke the Bank of England, eventually the Central Bank runs out of ammo.
Over the past couple of weeks as the global economic rout has worsened, and the US dollar rallied even more, speculators and investors have set their sights on the currencies whose peg to the US dollar have made them completely uneconomic.
The first to gain attention was the Chinese Yuan. Although the Chinese government had devalued by a small amount last summer, the Chinese currency was still massively overvalued versus the rest of the world. Don’t believe me? Well, have a look at the rate at which capital has skedaddled out of China.
Due to the fact that official capital flows are tightly regulated, most of this flight occurred in the offshore markets. This caused the rate between the onshore and offshore market to explode.
Although it must have taken a lot of ammo, the Chinese government was able to quell the speculation and regain control of their currency market.
They certainly had to waste a lot of reserves defending their peg, but the Chinese have over $3 trillion of foreign exchange reserves. George Soros and his Connecticut pals have deep pockets, but that is a big number even for them. Yet the important thing to understand is that, in the long run, this exchange rate is unsustainable. The PBoC can stabilize the situation for a while, but they need to eventually devalue.
I don’t expect the Chinese government to devalue in the midst of a crisis. Saving face is too important. But they are much shrewder traders than the market gives them credit. My suspicion is they will let things settle down, and then in one fell swoop, revalue it lower.
Last week there was a famous hedge fund trader who gave an interview for RealVisionTV who forecasted a 50% devaluation. He argued if the Chinese don’t devalue enough, it will simply encourage more speculation. Although I agree with most of his analysis, I think 50% is a little much.
His main argument is that the Chinese devalued by more than 50% in 1990, so why can’t they do it again? I think 1990 was a much different time for the Chinese economy. They are now such a bigger portion of the global economy, they cannot afford the political backlash to devalue by this much.
I suspect instead of moving CNY from 6.58 to 10, they will move it up to the low 8s. If they do it quickly, they will still have plenty of ammo to defend the new level if speculators attack. I am shorting some CNY (going long the rate) expecting a devaluation in the coming months. Although over the past few days markets have settled down a little, this problem is not so easily fixed. The Chinese need to devalue, and the longer they take, the worse the problem. I think this trade is a great risk reward short.
Tomorrow I will talk about the other currency peg speculators are trying to break…
Thanks for reading,