China’s yuan shift: Is it really a game-changer?

David Rosenberg

Leave it to China to take our minds off Europe.

In what is widely being described as a brilliant political gesture ahead of the G20 summit in Toronto, China has announced its intention to sanction a gradual revaluation of the yuan.

This will likely help to ease global trade imbalances, ward off the threat of trade protectionism, alleviate domestic credit strains and inflation pressures, and accelerate the Chinese shift from export-led to consumer-led growth. It also suggests that the Chinese authorities have confidence in the sustainability of the global recovery.

The Chinese move has ignited a rally in risk assets to start the week – a rally of sizable proportions. Global equities are riding a 10-day winning streak, the longest in 11 months, and emerging markets soared in reaction and are now nearly 10 per cent higher than the lows of two weeks ago. European marts are now up for a ninth consecutive day – also the longest rally in 11 months.

Gold has hit a new all-time high, and oil and copper are firming as these hard assets priced in U.S. dollars gain ground from the resulting decline.

Meanwhile, the safe haven of government bonds has lots of allure as long-term yields move up in response and offer another opportunity for the Treasury bulls to reload. Credit default swap (CDS) spreads are also plunging as investors turn their attention away from the global debt challenges; however, rest assured that these problems have not gone away just because of improved Chinese foreign exchange flexibility.

Moreover, this view that China will be “recycling” fewer U.S. dollars is a tad strange because if the U.S. current account deficit shrinks, as it should, then the United States is not going to need as much external funding. The capital account and the current account have to balance, so the oft-stated remark that the rise in Treasury yields will be sustained misses two facts: First, China has not added anything to its hoard of U.S. Treasury securities since June, 2009. In fact, it has run down its holdings by a modest amount – and guess what – the yield on the 10-year note actually dropped 40 basis points to 3.3 per cent over that time frame. Go figure. (A basis point is 1/100th of a percentage point.)

Second, when China last made such a dramatic announcement – back on July 21, 2005, when it first moved away from the dollar peg – the consensus view was similar: Buy risky assets, sell the dollar, secure inflation protection, and unload Treasury positions.

Admittedly, in the immediate aftermath of that announcement, we had a knee-jerk reaction: Treasuries and the U.S. dollar sold off and commodities and equities rallied in tandem. Well, over the ensuing three years (the revaluation was terminated in July, 2008), this is what happened: The U.S. dollar index (DXY) did indeed go from 85 to 70, but China’s holdings of U.S. Treasury securities never went down; they rose to $550-billion (U.S.) from $300-billion. The expected runoff never happened.

The yield on the U.S. 10-year Treasury note fell 80 basis points, to 3.7 per cent, and the S&P 500 stock index was basically flat. In fact, the total return in the Treasury market more than doubled that of the equity market.

Volatility (as measured by the VIX index) soared from 10 times to 25 times and had yet to come close to peaking out.

So the only correct call by the intelligentsia in the summer of 2005 was that the U.S. dollar would continue to lose ground. In the final analysis, looking at that entire three-year period of Chinese currency revaluations, the primary trend has been lower bond yields and lower equity valuation. This was not being predicted in July, 2005, and it not being predicted today.

Back in 2005, the Chinese revaluation was being billed as this huge “reflationary” event – Wal-Mart was no longer going to have the ability to continue to cut prices, didn’t you know. Meanwhile, the core U.S. inflation rate sits today at 0.9 per cent compared with 2.1 per cent back then. The headline rate, meanwhile, was over 3 per cent at the time, whereas it is 2 per cent on the nose today.

It goes without saying that the Chinese initiatives in the foreign exchange market ultimately proved to be no panacea against a collapse in the U.S. credit and housing markets, deflationary pressures, a huge global recession and a European sovereign default crisis.

Let’s not take our eye off the ball. The global deleveraging cycle is still in full swing, is an intensely deflationary development, and, as much as the Chinese revaluation will, at the margin, help to ease global trade imbalances, it very likely will prove to be every bit the antidote it wasn’t when the country first embarked on a crawling peg a half-decade ago.

David Rosenberg is chief economist and strategist for Gluskin Sheff + Associates Inc. and a guest columnist for Report on Business.