China May Soon Shock the Market

Is China preparing to devalue its currency again? The fate of the market may hang on the answer…

China last devalued between December 2015 and January 2016. The result? U.S. stocks kicked off the year to their worst start ever. And that was only a 2% devaluation.

China previously devalued 4% in August 2015. That was enough to send the Dow plunging 508 points in one session — the Dow’s eighth-worst single-day crash in its history. It looked like it may have led to “the big one” so many have been expecting.

But the Fed managed once again to yank another rabbit out of its hat. The day of reckoning was averted — or at least postponed.

Could the Fed pull it off again if China devalues? But why would China devalue… when the last two occasions sparked massive financial panics?

The answer: It might have to in order to defend its domestic economy…

The muscular U.S. dollar has hung China on the hooks of a dilemma. It’s true China wants a weak currency to spark its export economy. Weak, yes. But not too weak…

A freefalling yuan sucks the lifeblood from the Chinese economy. Literally. Capital’s already fleeing China in buckets, heading for the safer and greener (literally) vistas of the U.S. dollar. That sets in train a vicious cycle. More capital flight out of China leads to more weakness as investors dump yuan for dollars.

So China must put a floor under the yuan to end the capital flight.

That means the Chinese central bank been dumping dollars to steady the yuan. But here’s Catch-22: To defend the yuan, it’s been selling dollars at such a gait… that it’s burned a gaping hole through its dollar reserves. It’s unsustainable.

China’s reserves fell nearly $320 billion last year, to $3.01 trillion. That’s piled on top of a record loss of $513 billion in 2015. $3 trillion in reserves may sound like a lot. But for China, it’s less than you might think…

In fact, Jim Rickards says China’s going flat broke…

“China is going broke. This statement comes as a shock to those who have heard over and over that China is a rising economic superstar and will soon be the greatest economy on Earth, surpassing the U.S. in the No. 1 role.”

How can China be going broke? Jim peeks beneath the surface:

China started 2015 with about $4 trillion in hard currency reserves. About $1 trillion fled the country in 2015 and 2016 based on fears of yuan devaluation. That’s classic capital flight.

Another $1 trillion is relatively illiquid, including direct investments in mines and natural resources through sovereign wealth funds such as China Investment Corp. That’s wealth, but it’s not money that can be used in a liquidity crisis.

Finally, $1 trillion has to be held as a precautionary reserve to bail out China’s insolvent banks and Ponzi-style “wealth management products.” Failure to bail out the banks… could lead to social unrest that would topple Communist rule, so that won’t be allowed.

“That,” says Jim, “leaves only $1 trillion of the original $4 trillion in liquid form.” And if it keeps jettisoning dollars at this rate, “China will be devoid of useable liquid assets by late 2017.”

Those are the stakes. Which brings us back to another possible devaluation…

China’s recently enacted regulations limiting the ability of individuals and businesses to move money out of the country — capital controls, in other words — while denying they were capital controls.

But capital controls, admitted or not, can only go so far. If folks are bent on getting their money out, they’ll find a way They might even make things worse.

As Jim explains, “History shows that weak capital controls may be worse that no controls because they send a message of ‘no confidence’ while not really stopping the outflows.”

So… If the yuan’s going to depreciate anyway and capital controls are shams, how does China manage the problem without further depleting its dollar reserves?

Devaluation.

Just flat out devalue the yuan. That way they don’t have to keep torching dollars to try to prop it up. It’s a wasting asset regardless. It might hurt in the short run but it’s better to get it over with and have done.

As Reuters explains it, “If [China] continues to burn through reserves at a rapid rate, some strategists believe China’s leaders may have little choice but to sanction another big ‘one-off’ devaluation like that in 2015, which would likely roil global financial markets.”

Yes, it might roil global financial markets. But answer this question: Is China’s leadership more concerned with the U.S. stock market… or its domestic economy, social stability and thus its own rule? The question answers itself, no?

Finally Jim gives a foretaste of what could be next: “Yuan devaluation is happening in baby steps, but that may soon turn into a one-time ‘maxi-devaluation’ of 30% or more to stop the bleeding.”

The last times China devalued 2% and 4% the stock market practically collapsed. What happens if it devalues 30%? And what if the Fed can’t pull another rabbit out of that tired old hat?

What if, indeed? But it would sure send Trump a message: “You want a trade war? You’ve got one. Happy Inauguration Day!”

Regards,

Brian Maher
Managing editor, The Daily Reckoning