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INVESTMENT INSIGHTS ARCHIVE
Originally posted in August 2015

"It doesn't matter if the cat is black or white as long as it catches mice."
Deng Xiaoping, 1904-1997

On the 1st January 1994, the PBoC moved from a dual-track currency system to one transparent reference rate for the renminbi against the USD, the Hong Kong dollar and the Japanese yen based. This was based on the weighted average price of foreign exchange transactions of the previous day’s trading, marking a new stage for the exchange rate regime. China had taken both its first major foreign exchange wager and step to Yuan liberalisation.

Over two decades later, on the 11th August 2015, the Yuan experienced another sudden depreciation. The PBoC lifted the daily USD/CNY exchange rate fixing to 6.2298 – a 1.86% devaluation compared to the fixing of 6.1162 on August 10th. To put this in perspective, just in case we get lost in the hyperbole, the 1994 dual-track system amalgamation of the official rate of 5.8 and the swap market rate of 8.6 was effectively equivalent to a rather hefty 33pc decline of USD/CNY. So it's not so much the magnitude of the devaluation that interests us this time but the cause and intent.

Has the PBoC signalled what could be the final step in a well thought out, two decade long exchange rate management process before it fully liberalises and floats the Yuan? Or has this move been an unavoidable step of economic pragmatism (panic). rather than true reform? And is it part of a veiled attempt to appease IMF officials for SDR inclusion?

The Communist Party (CP) is desperately trying to keep China's economic growth from falling precipitously. They seem to be acting reactively rather than along a continuum of proactive policy making. Reading the clarity of decision-making is comparable to observing the Air Quality Index (AQI) of Beijing – it’s foggy and toxic.

Chinese leaders have seemingly escalated their panic gambling to keep their country on the 'rails'. Our recent July HindeSight Investor Letter – ‘Another BRIC in the Wall’ – documents our analysis of these wagers to rebalance SOEs debt-for-equity by propagating and encouraging stock market investment. It failed spectacularly, as the stock mania they cheer-led flamed out with debt-for-debt accumulation, rather than debt-for-equity. To add fuel to the fire, their dictat to arrest the fall in their stock markets caused a searing backdraft, which is now burning stock gains down to ashes.

Rather alarmingly, we see this currency move coming hot on the heels of a series of other policy gambles. We say 'policy', as if this infers there was some game plan, we don't mean it to. It would appear they are 'all-in-gambles' and the CP and PBoC have sadly resorted to age old 'fixes' by devaluing the Yuan to prop up exporters. Some habits are just too hard to break. It is true though that in opening up to markets in a period of such instability, they are now at the mercy of the very markets which they aspire to join. The transition was never going to be easy from a command economy to a more market-based economy. In our opinion, they have remained closed for far too long and now their ecosystem is too unstable to handle the realities the market will meter out to them.

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