There is one currency that investors must watch next year more than any other: the Chinese yuan. And that's not because, as many erroneously still believe, the People's Bank of China (PBOC) may suddenly decide to devalue the yuan vs. the U.S. dollar in order to boost exports.
On the contrary: it's because the yuan is weakening, and there isn't much the PBOC can do to stop it. If it weakens too much, this could end up hurting U.S. investors, as the yuan-induced volatility demonstrated back in August.
Today's data -- showing Chinese exports surprising on the downside while imports were better than expected -- contribute to the dilemma. Exports shrank by 6.8% on the previous year, vs. expectations that they would decline by a more modest 5%, but imports fell by "only" 8.7% -- dismal, and yet not as bad as expectations of a slump of nearly 12%.
This is good news and bad news at once, because it means the Chinese yuan must be like the famous Schrodinger's cat in the 1935 hypothetical quantum mechanics experiment: simultaneously dead and alive for the experiment to be a success. For the Chinese economy to rebalance perfectly, the yuan, or renminbi as the currency is also known, must be weak and strong at the same time.
A weak yuan would help maintain China on the growth path it's already accustomed to -- making goods cheaply, from clothes to electronics, and selling them around the world. A stronger yuan would help the economy to rebalance toward the new growth path that the communist party envisages: increased domestic consumption. With cheaper imported goods comes affluence.
Lately, the PBOC has been making desperate efforts to stop the currency's slide. Reserves fell by 2.5% in November from October, to $3.438 trillion, as the central bank kept throwing hard currency into the market to counteract capital flight.
However, as Luis Kuijs, Asia analyst at independent advisory group Oxford Economics, points out, the export data for China for November also suggest "that the large depreciations of many currencies against the U.S. dollar, including the euro and the yen, have worsened the competitive position of the Chinese manufacturing."
In other words, in the near future the PBOC may have to reverse course and either let the yuan depreciate, or even nudge it down a bit itself for China to regain some of its lost competitiveness on the global scene.
What this means for investors is that increased volatility is ahead. Some have argued that the yuan is now a reserve currency, and therefore it will not be allowed to fluctuate wildly. In fact, if anything, the Chinese currency's introduction in the reserve currency basket will hurt, rather than help, the PBOC's chances to maintain the renminbi on a stable footing, because the central bank will have to allow the market more say in the exchange rate from now on.
The market will have a hard time reconciling the two contradictory needs of the yuan, and will do what it does best: overshoot in one direction or the other until balance is restored. Brace for turbulence.
