On China: Why the Real Risk is CNY 5, Not 9

In Macro investing, it’s critical that I have a roadmap of where we’ve come from and where I think we’re going. Of course, many things in Macro take far longer to play out than my chosen investment timeline of rolling three-year periods. That means that much of my roadmap is somewhat outside the immediate scope of my investments, but that doesn’t mean that I can be oblivious to what’s coming. If anything, because it’s a bit beyond my timeline, it’s even more important to have a view of the future, as timelines can frequently accelerate—particularly during moments of market stress.

With that out of the way, sometimes someone tells me something that I just hadn’t really thought through before—not due to laziness on my part, but because I had never even considered that my world view was simply consensus. At that moment, I’m instantly shocked into the realization that I’m missing a piece of the landscape that shapes my roadmap. Hence, I’ve felt compelled to share the following posting, in full and with permission, from PauloMacro’s Substack (I highly recommend subscribing).

Paulo has done an incredible job of taking a late-night WhatsApp conversation between himself, Louis-Vincent Gave of Gavekal, Kevin Muir and myself, editing it slightly for clarity, and then putting it into a coherent, free-flowing format.

I think all of you should stop what you’re doing and read it. If you’re like me, you’ll sort of nod as your worldview is challenged, take a break, think about it a bit, then come back and give it another try. Then, when the realization lightbulbs go off, you’ll forward it to every friend of yours and force them to also think through the consequences. Louis-Vincent challenges much of what we in the West, take as granted—namely that the Chinese will be forced to devalue their currency. If Louis-Vincent is correct about this, then everyone’s roadmap is pointing in the wrong direction.

It’s rare that I have that “ah-ha” moment, especially when I wake up in the morning with 200 missed texts, but it was really quite stunning when it all finally came together for me. I hope you’ll have a similar realization on your part.

If you want to follow Louis-Vincent’s work, go to GaveKal.

“You know you have a special person in your orbit when he pushes back with a well-reasoned argument which lands so squarely at the heart of your concerns that — even though you’re still uncomfortable while processing the details — you realize you really just feel like James Carville in the Old School debate scene against comedian Will Ferrell — “we have no response… that was perfect.”

That was my experience in an exchange overnight and into this morning with the incomparable Louis-Vincent Gave of Gavekal on the subject of China. Beyond possessing a serious intellect for macro, he is an all-around great guy who indulges lesser minds like mine while doing it in the nicest possible way. With his permission, I am pasting our exchange here…

PauloMacro:

Man the deflation in China is intense. HK banks are literally scrambling for yuan. Here is 1m CNH Hibor:

Something has to give here. Chinese money is just too fuking tight. LVG bro — Thai rates went bananas juuuust before the deval in 1997. I get the arguments on why it’s different but now rates are getting into the game and it looks like a fricking duck… 🦆 beware the pato. Everyone was obsessed with BTC being Naz 3x but they didn’t stop to think if BTC + the cmdty bid just reflected Chinese money circumventing capital controls, getting out/moving in front. Probably nothing, but seriously wtf…

A thought exercise. Putting aside any other maybes/its different/initial conditions/etc. Scenario is this:

We wake up next Monday and China has taken the CNY to 9.

What do you expect in terms of an initial and 3mth reaction in:

• Oil
• Gold
• 30T
• SPX

Fwiw for context this is 3m CNH Hibor going back 10yrs:

Louis-Vincent Gave (Gavekal):

RMB suddenly at 9 would mean US has won its Cold War with China, and that Xi is throwing in the towel on his hopes of making RMB a credible trade and financing currency for EM. Not sure Xi would survive this politically. It basically would throw out all his program of OBOR, Silk Road, Asia infrastructure investment bank etc…

Not saying it’s impossible. Saying that it would be a profound reversal in the current political rhetoric. Moreover, it would have to be a political decision since:

1. Foreigners own no Chinese debt
2. Foreigners own no Chinese equity (or practically none)

At this stage, the only thing foreigners own is some real estate (through funds) and some private equity. Highly illiquid stuff that they can’t liquidate anyway.

So, a big move in the currency would have to be either a political decision or a massive exodus of domestic capital. But how do you get the latter given capital controls? It would have to be a political decision. A massive change of course by the Chinese leadership. Why would they do that? Why would they bail out the US through a big deflationary wave at precisely the moment the US “feels” like it may be starting to crack?

The only reason I could think of is a power shift at the top. Xi either dies or steps down and is replaced by someone more “US compatible.” But the CIA already made their color revolution play in 2019, and it failed. Of course, they could try again. But China is now way more paranoid about such maneuvers. The days when the US consular staff could just meet with the leaders of the students who tried to storm the HK parliament in the restaurant of the JW Marriott are well behind us now (imagine if the Chinese ambassador had met with the Jan 6 buffalo head guy and the lectern guy… that’s what the US did in HK!)

Anyway, all this to say that if RMB is at 9, then USA wins, and China loses. For me this means:

1. A lower oil price: to the extent that a U.S. win means a unilateral world, with fewer risks of conflicts, a greater Pax Americana etc… then lower need for oil inventories all around. Also, if RMB is 9, China can no longer just load up on inventories has it has been doing in recent years.
   
2. It likely means a lower gold price. If RMB is at 9, usd is king. Why bother owning anything else. Initially, gold may go up for a month or two as Chinese retail panic buy more. But longer term, why bother with gold? USD is obviously king…
   
3. It means lower UST yields. RMB at 9 is a massive deflationary shock for the world.
   
4. It means higher SPX. Strong dollar and lower yields are the stuff US growth bull markets are made of. In this scenario, maybe US becomes 80% of global market cap!

On my side, I don’t believe that a country like China — whose trade surplus at US$70bn+ per month is now bigger than the combined trade surpluses of Japan + Germany AT THEIR PEAK — will devalue meaningfully. That would be an act of mercantilist warfare such as the world has never seen.

This is the total return on Chinese Govt Bonds vs UST (all maturities, in USD). This is the chart the CCP leadership cares about:

The CCP will sacrifice everything for this chart. This is the path to de-dollarization and thus to freedom. Getting out from under the USD’s dominance will finally mark the end of the “century of humiliation” in which foreign powers dictated their way to China.

I don’t think foreigners get Xi’s desire to be a “great power” once again. China will likely be the first great civilization that collapsed, dusted itself off, and came back. Rome didn’t do it. Neither did the Ottomans. Or the Egyptians. Or the Persians….

But you can’t be a great power with a weak currency. And you definitely can NOT be a great power if you settle your trade in your rival power’s currency.

Xi is playing for keeps. He will impose all the pain in the world on the Chinese economy before devaluing meaningfully. Not that a devaluation solves anything anyway. China already has a massive trade surplus, and other countries are putting up trade barriers because it is so competitive.

PauloMacro:

So we are on the same page, Xi will do everything to avoid devaluation, including throw his people into a new era deflationary great depression. He has the world’s greatest bond market because his economy is intensely contracting. He is in effect absorbing the world’s deflation that he would otherwise be blowing in America’s direction were he to devalue. Parting question/thought:

So, the way pretty much every country throughout history has eventually been forced to address this type of crisis when a peg existed was by devaluing the peg (gold 1934 comes to mind). But in your view, China would undergo history’s greatest deflationary bust and not devalue. I follow your logic and appreciate everything you laid out so well above.

So, the other mechanism by which they could address the domestic crisis is to turn the world’s greatest bond market into an outright global asset where big foreign money (non-US money) can park — it has to be liquid and deep like USTs for it to be considered a “big money parking spot.” In other words, they roll up much of the funding/bank/provincial liabilities that enabled the real estate excess of the past and take it onto the central govt’s balance sheet. This was the Bridgewater prescription in 2008 as part of the “beautiful deleveraging” scenario. But Xi has shown significant resistance to this. Do you think they ultimately go down this path and roll the debt up to the public balance sheet? As you say, foreigners don’t own it anyway, so it’s not a bail out of them. It would be a bail out of wealth management products and other local saving pools. Ultimately it would enable the central government to exact greater control over the provinces whose LGFV’s enabled so much of the real estate insanity of the past 20 years there. Is this where all this leads?

Louis-Vincent Gave (Gavekal):

I disagree. Emerging markets do not get to have the world’s best bond markets for meaningful periods of time. Eventually the currency gives in. But not in China. This is what westerners have completely missed and continue to miss.

I have been saying this for ten years but the PBoC is the new Bundesbank. Westerners complain that the PBOC doesn’t ride to the rescue of their stocks. But that’s not the game Xi is playing. Xi wants the RMB to be the Deutsche Mark of emerging markets. You don’t get to be that by bailing out the stonk monkeys. You get to be that by having a strong bond market and a strong currency. People have had China wrong for ten years and continue to do so because they can’t imagine a world in which the central bank doesn’t bail out the stonk monkeys.

If you think Xi cares about anything but making China great again, you are not listening to him. The great thing about China’s leaders is they say what they do and do what they say.
The risk for the world is not that RMB goes to 9. It is that it goes to 5.

Once inflation reaches double digits in the US, China will pounce and kick UST and USD when it’s down. That’s why the anti-fragile hedges for a portfolio are:

1. Energy
2. ⁠Gold
3. RMB bonds
4. Perhaps Latam bonds

Basically, only assets that will be negatively correlated to other assets when Kuppy’s “Project Zimbabwe” unleashes. The strength in RMB bond markets is not a bug. It is the feature of our changing world.

PauloMacro:

But how do they pivot to where the Yuan can actually be a reserve FX? You can’t run massive trade surpluses and expect a deep Yuan denominated external bond market. I guess you are saying the trade surpluses need to go away to become the Bundesbank, and thus 6 is more likely than 9.

Louis-Vincent Gave (Gavekal):

China is using same playbook as US post 1945:

• Marshall Plan = Silk Road fund/OBOR
• Asia infrastructure investment bank= World Bank
• WTO = BRICS

First you lend the people the RMB they need to buy your capital goods (in 1945, it was Caterpillar, today it is LongHe machinery). Then you tell them that they can earn the RMB they need by either selling you cheap assets (ie: JP Morgan buying its headquarters on the Place Vendôme for a song in 1958) or by selling you cheap goods. When the latter happens, you start to move into a trade deficit. But that’s way down the line…

As you can see, it’s important to have friends way smarter than you! Hope you enjoyed — if you want to check out LVG’s work at Gavekal, he’s at https://web.gavekal.com …he did not ask me to plug his work, but I figured you should know where his work in the unlikely event you don’t know him already!

As always, kindly yours,
Paulo aka Cloudbear”