China’s Yuan: No Room For Complacency On Devaluation

By John Richardson

IT IS comforting to think that the China Yuan devaluation story is all but over. But only three months ago, most people thought there was nothing that wrong with the Chinese economy and just look where that has got us.

One reason for comfort on the Yuan story is being derived from the above chart, which shows that to date China’s currency, on an inflation adjusted basis, has only fallen by 1.5% against the US dollar since the devaluation story first broke on 10 August.  As you can also see from the chart from the Wall Street Journal, other currencies have fallen by more than that against the greenback.

One interpretation out there is that if China really wanted to boost its exports through a Yuan devaluation, then to date the extent of that devaluation would have been a lot greater.

So some people argue that the paltry 1.5% inflation adjusted fall proves that what the real intention behind liberalising Yuan trading was purely and simply about trying to win favour with the IMF so that China’s currency would gain “special drawing rights status”.

In other words,some people believe that this was a carefully thought out plan to internationalise China’s currency. This unfortunately generated lots of adverse noise because of the temporary slowdown in China’s economy. Hence, the flawed theory that this  really was about boosting export competitiveness.

But if any chemicals company adopts this as their only scenario for the next 12 months, they could be in big, big trouble. Here are my arguments why:

1. China has been burning through its reserves to prevent the Yuan from devaluing by more than 1.5% in inflation-adjusted terms.  For example, in August its foreign-currency reserves fell by $93.9 billion in August, the biggest monthly fall on record.
2. A common belief is that China has vast foreign-currency reserves to continue throwing at this problem. But in reality, its domestic liabilities have long been more than these reserves – and these liabilities are rising as it tries to rebalance its economy. For instance, China says it needs to spend at least $1 trillion per year over each of the next five years to clean up its environmental mess.
3. So a few more months of burning through reserves like this and China may take the less painful decision of allowing the Yuan to fall substantially in value.  James Gruber, the Melbourne-based former fund manager, has long argued that a substantial devaluation would be the less painful route for China because of the unwinding of its carry trade. In effect, what he has been arguing since last November is that China will opt for a big devaluation. His reason is that instead of being flush with cash, it can no longer afford to fund itself.
4. ‘But” I can still see hear you say, “even if you are right on China’s reserves versus its debt, it has vast levels of personal savings”. True, but nobody is going to spend enough of those savings to lead China down the right path unless rebalancing isn’t first of all successfully completed. For instance, as I said, China must at first foot the massive bills for its environmental clean-up or more and more of those savings will move overseas, as China’s rich middle classes seek a better life for themselves and their children.  High savings rates are, in effect, only wealth on paper that China has yet to realise – and is at risk of perhaps never realising.
5.  And last but certainly not least, the Fed will eventually have to raise interest rates. As I discussed on Friday: There has been a big increase in foreign funding to Chinese banks over the last six years. And so when Fed rates increase, this will close the door to this route to capital for Chinese investors. So China would have to start regularly liquidating its $1.27 trillion of US Treasuries. This would cause US borrowing costs to rise even further, thus adding to US dollar strength and problems with emerging market currencies and debt repayments etc. Doesn’t this give China another motive, if it wants to avoid the above outcome, of letting the Yuan fall in value by say 10% in real inflation adjusted terms – or perhaps by even more?

Sure, you can argue that this would be contradictory to economic rebalancing as a much-cheaper Yuan would give significant export support to the very industries that China wants to restructure. These industries include steel, aluminium, cement and some chemicals and polymers where oversupply is huge – along with, of course, debts – and where the environmental damage being inflicted is big. Further, these types of industries, even if they were not so oversupplied and environmentally damaging, are not adding the kind of economic value that China wants as it tries to escape the middle-income trap.

But getting from Point A to Point B – a reformed economy – has to be achieved without too many job losses and so social disruption. And there may, anyway, be some people within China’s senior leadership who will continue to effectively resist reforms by keeping some of these old industries going.

So a scenario you have to build into your strategic planning is for the Yuan to go down by 10% or more in value over the next year.

Then you have to think what this means for specific sectors of the chemicals industry.

In polypropylene, we have already seen exports rise by 38% this year, even without a major Yuan devaluation, as China vastly expands its local capacities.

The story in polyvinyl chloride (PVC), however, is very different. In January-July of this year, exports totalled 70,196 tonnes, according to China customs data. This compares with 104,685 tonnes during the same seven months of 2014 – and so we have seen a 32.9% fall in exports.

But China’s nameplate PVC capacity will total 31.7 million tonnes/year in 2015 as against consumption of just 16.5 million tonnes, according to ICIS Consulting.

So, based on things as they stand at the moment, we expect production of only 16.7 million tonnes, which would be an average operating rate of 53%.

What would happen, though, if as I said, the Yuan falls in value by 10% of more? Would operating rates and exports significantly increase?

It is important that every chemicals company with exposure to China should therefore look through its product portfolio and do a similar “What if?” analysis based on a steep depreciation of the Yuan.

Further, there is obviously a need to look downstream. Even if we reach the conclusion that, say, China’s PP exports will remain pretty much flat for the rest of this year and 2015, what about the goods made from PP resins?

If China starts exporting a lot more auto components say, or carpets made from fibre-grade PP, this could eat away at PP demand in a producer’s home market.