The trading year kicked off with a decline in Chinese equities and a fall in Chinese Yuan (CNY). The news that China had allowed its currency to fall further since the depreciation last Aug triggered further declines in global equities. Aggravating the worries was news that China's foreign exchange (FX) reserves had declined by a record USD108 billion in Dec alone and by USD513 billion in 2015. Having experienced the Asian Financial Crisis (AFC) in 1997/98 where regional currencies depreciated significantly and set off a recession and a deep bear market in equities, I started to worry whether there would be a repeat of AFC.
The news flow is worrying enough. As mentioned earlier, China's FX reserves had declined by a record USD513 billion in 2015 to USD3.33 trillion, which represented a decline of 13.3%. Yet, CNY had not depreciated against USD by much. A year ago, the exchange rate was 1 USD to 6.2556 CNY. A year later and with a 13.3% decline in FX, the exchange rate is 1 USD to 6.5788 CNY, which is a much smaller decline of 4.9%. Even though China has the largest FX reserves in the world (the next largest FX reserves is Japan's at USD1.23 trillion), it set me thinking whether China has sufficient reserves to defend its currency from further depreciation. Add on the news in Dec that China had created a CNY exchange rate index referencing to a basket of currencies instead of solely to USD, it further suggests that China is prepared to depreciate its currency against USD further. All these are truly worrying news.
|Fig 1: 1-Year Movement in USD:CNY|
A very intense analysis was carried out over the weekend to determine whether there would be a repeat of AFC. Looking back at AFC, countries that faced large capital outflows had several options (other than seeking assistance from the International Monetary Fund):
- Allow its currency to depreciate
- Raise interest rates
- Impose capital controls
- Do any combination of the above
In China's case, raising interest rates is out of the question, as doing so will further cause its economy to slow down. In fact, it is doing the opposite to stimulate its economy. China, however, has capital controls in place. The big question then is how tight and effective are the capital controls in stemming the outflow. Since I am no expert in macroeconomics, I turned to the internet to search for answers to this question. The answers were found in an article by The Economist at Capital flight from China: Flow dynamics. A crude assessment suggests the article to be correct, since if the capital controls were weak, China would risk aggravating the outflow by lowering interest rates. In any case, China could always tighten further its capital controls should present ones be insufficient.
Having resolved the biggest risk, I started to wonder why was I not aware of the CNY depreciation in 2015 given that it was such a big news. Was it because I had focused so extensively on US' interest rate rise in the West that I became oblivious to the emergence of an even bigger risk in the East? The answer can be found in the CNY:SGD exchange rate movement below.
|Fig 2: 1-Year Movement in CNY:SGD|
The CNY:SGD exchange rate had barely moved in 2015! A year ago, it was at 1 CNY to 0.2149 SGD. A year later, it is now at 1 CNY to 0.2171 SGD. Despite all the news about CNY depreciation, CNY actually appreciated against SGD by a very slight 1%! The figure below shows the relative movement of CNY against the major currencies of Euro (EUR) and Japanese Yen (JPY). A positive figure means that CNY rose against the competing currency.
|Fig 3: 1-Year Movement in CNY Against Major Currencies|
Compared to a year ago, CNY declined by 1.1% against EUR and 4.8% against JPY, in addition to a 5.0% decline against USD. The recent decline against JPY in Jan was due to investors rushing into JPY to seek a safe haven. However, as late as Nov, CNY had appreciated against EUR and JPY, notwithstanding the widely announced CNY depreciation in Aug that triggered a global equities rout that month! The figure below shows the currency movements from USD's point of view.
|Fig 4: 1-Year Movement in USD Against Major Currencies|
With the exception of JPY, USD had appreciated by 5.2%, 4.1% and 6.3% against CNY, EUR and SGD. So, really, the much talked about CNY depreciation against USD has as much do to with USD strength as well as CNY weakness! If it were solely CNY weakness, we would expect it to depreciate by similar margins against EUR (and other currencies like SGD) as well, but it did not. On the other hand, it is quite clear that USD is appreciating against almost all major and regional currencies. Yet, financial news choose to focus on CNY weakness rather than USD strength.
Also, it was not too long ago when EUR and JPY had depreciated significantly against USD. See the figure below for the 5-year movement of USD against major currencies.
|Fig 5: 5-Year Movement in USD Against Major Currencies|
Nobody raised any concerns when EUR depreciated by 26% or when JPY depreciated by 45% against USD over the 5-year period, but when CNY depreciated by 5.2% in Aug and Jan, it became extremely big news. Even though China's slowing economy and CNY weakness pose important risks to the global economy, there is no need for financial news to be so dramatic!
To conclude, there are several lessons that I learnt from this episode, namely:
- Financial news can be more scary than things really are at times.
- I should not focus exclusively on a much heralded risk and become oblivious to the emergence of a much greater risk.
- A position of weakness (i.e. overexposure to stocks due to a tactical bet on the January effect) can affect rational thinking.
Lastly, I leave you with a quote from Peter Lynch, "There is always something to worry about. Avoid weekend thinking and ignore the latest dire predictions of the newscasters. Sell a stock because the company's fundamentals deteriorate, not because the sky is falling.".