What If the Yuan Strengthens?

What If the Yuan Strengthens?

Everyone and his brother and his brother’s cousin’s hairdresser – are expecting the Chinese currency to weaken. But what if it doesn’t? There are three reason’s why it is in China’s best interest to have a strong currency:

1.) Capital Flows
2.) Inflation
3.) Trump

The outflow of capital has been well documented and with FX Reserves below $3 trillion China is perilously close to a currency crisis. The IMF estimates that a country of China’s size needs approximately $2 trillion in reserves to operate the economy. This means the cushion for China is less than $1 trillion – this may seem like a lot, but with $100b month outflows it would take less than 10 months for China to reach a crisis. In short, China needs a strong currency to stem capital flows.

With inflation picking up China may indeed get a strong currency. The most recent reading on both CPI and PPI show inflation at 5 year highs.

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To stem the tide of rising prices, China may need to raise interest rates – which could result in a strong Yuan. Moreover, a strong Yuan would help keep import prices down and in turn could reduce inflation.

Finally, with the approval of Steve Mnuchin as Treasury Secretary, the door is wide open for Trump to declare China a currency manipulator. The claim would be that China has been artificially keeping its currency weak. Of course, the opposite it true, but alternative facts are in vogue. If China strengthened its currency then there would no basis for a Trump attack.

What would this mean for asset prices? Gold would likely be the biggest beneficiary as a weak dollar would be the order of the day. Equities and commodities would also benefit. But there is a dark side to a stringer Yuan. China is in the middle of a credit bubble – if rates increase then the entire bubble could pop.