The Solid Ground fortnightly – China – A Country Matures, An Exchange Rate Declines

Rusell Napier writes in this masterpiece on monetary economics why we will first see deflation and then Inflation.

The ability of China to extend the cycle has come to an end as the current account surplus has all but evaporated – a natural consequence of extending the growth cycle by keeping money too loose when the external account deterioration dictated that it should be kept tight. It has come to an end as the capital account is at best in balance rather than surplus. It has come to an end because the RMB is primarily linked to a strong currency in the form of the USD. It has come to an end because the Fed is both raising interest rates and destroying high-powered money to the tune of USD360bn a year (see Q1 2018 report Crowding Out: Higher US Real Rates and Lower Inflation). It has also come to an end because Jay Powell has warned China, and other emerging markets, that he will not alter the course of US monetary policy to assist with any credit disturbances outside his own jurisdiction.
And if that were not enough, it has come to an end because the US runs small current account deficits, by its own historical standards, and the President of the USA seems determined to make them even smaller. Investors now need to ask a bigger question when considering the future for Chinese, and thus emerging market, monetary policy. Why would anybody want to link their currency to the USD?

The initial shift to a more flexible Chinese exchange rate is deflationary and dangerous. The USD selling price of Chinese exports will likely fall, putting pressure on all those who compete with China – EMs but also Japan. The USD will rise, putting pressure on all those, particularly EMs, who have borrowed USD without having USD cash flows to service those debts. With world debt-to-GDP at a record high, such a major deflationary dislocation can easily trigger another credit crisis and The Solid Ground has previously focused on where such credit events are likely.
However, following the great dislocation, China will be free to reflate the world, for such will be the potency of the monetary policy of such a large economy relaxed about running a current account deficit. Investors should not bet on this happy outcome. There will be deflationary pressures and a potential credit crisis to navigate first. At any time in this process very unpredictable political feedback could delay or prevent China’s move to its new role. So, prepare for the deflationary consequences of this shift in the global monetary system, and expect as well as hope that it too will end as China helps the world to inflate away its debts. (Subscription required)

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