The Renminbi vs. Western Currencies: An Inflationary “Paradigm Shift” Perspective

14
Aug

As an economist, you oftentimes risk ridicule for the mere mention of the word “inflation” among your peers, for the simple reason that in the recent and relatively recent past, deflationary rather than inflationary forces needed to be tackled. Over the past not decade but (two) decades, we have witnessed a downright collapse in the velocity of money and despite the fact that central banks have “printed” trillions upon trillions of currency units in the aftermath of the Great Recession, runaway inflation is nowhere to be found.

Are we in a “new paradigm” which involves inflation being a relic of the past?

Most likely not.

We are simply in a context where monetary base inflation did not lead to consumer price inflation but rather asset price inflation at best, with many economists making the mistake (in our view, at least) of viewing things through the lens of predictability and expecting linear developments. Just like a chef adds a little bit of seasoning until the taste is just perfect, it is expected that central banks will keep expanding the monetary base until “just the right amount” of inflation manifests itself.

In the opinion of the ChinaFund.com team, this perspective is nothing short of delusional. When referring to markets, expecting manic-depressive behavior rather than extreme predictability is always recommended, with pretty much any longer-term asset price chart representing an eloquent example to that effect.

To put it differently, while nobody can predict when we transition from a deflationary to an inflationary environment, we strongly believe the process will be anything but smooth and predictable. On the contrary, we expect “chaos” to be the operative word and for the now-unthinkable to occur: a significant loss of confidence in even the strongest Western currencies, including… of course, the dollar.

Where does that leave China and the renminbi?

Time and time again, we try to make it clear that just because China and the proverbial West are let’s say economic adversaries who are fighting for relevance and influence, it doesn’t mean that whenever the West loses, China wins, especially not as far as short-term perspectives are concerned. On the contrary, given the extreme economic interconnectedness which represents the norm in 2020 (despite a massive build-up of frustration, but that goes beyond the scope of this article), China is actually likely to not only catch the proverbial cold from the West but develop worse symptoms.

Let us not forget that the number one holder of dollar reserves is none other than… drum roll, please… China. As such, it would be short-sighted at best and naïve at worse to assume that China would be greedily rubbing its hands when the dollar loses value. On the contrary, the Chinese renminbi would most likely be in even worse shape at that point in time.

Why?

Simply because whether one analyst or another agrees with this, the United States still represents the world’s number one safe haven destination (the destination frightened investors flock toward during risk-off episodes), whereas China doesn’t even represent a safe haven destination at this point, with Chinese assets firmly in risk-on territory.

Yes, it is true that in just one year of post-Great-Recession easing, the Federal Reserve added more to the monetary base than had existed from 1913 up until the Great Recession. But it is just as true that since then, demand for US dollars has gone up rather than down. While it is correct that the euro has had a good run over the past couple of months, it is still considerably lower relative to its US counterpart than it was prior to the Great Recession.

Let’s just say that until the market grants China its much-desired safe haven status, it would be premature to state that China celebrates weakness in “competing” currencies and on the contrary, it is likely to be worried by them because unlike the Federal Reserve and the European Central Bank since the Great Recession, their Chinese counterpart (the PBOC) also has to worry about inflation every now and then. To put it differently, inflation is (even if not always and even if it isn’t exactly the norm) a CURRENT rather than potential PBOC concern and as such, it would be unwise to believe China is longing for a more inflationary environment.

Finally, there are also those who noticed that China has been adding gold reserves over the years and therefore believe it isn’t as worried about inflation when it comes to Western currencies as we have stated. But in terms of (and this is very important) orders of magnitude, China is nowhere near protected enough by its gold holdings to sleep tight at night while the West were to battle inflation, not by a long shot.

A few important conclusions therefore arise:

  1. The demand for dollars should not be underestimated because no matter how aggressively the Federal Reserve eases, there will be no runaway inflation unless and until dollar demand takes a significant hit. Until now, that hasn’t happened but, of course, past performance does not guarantee future results
  2. China is not yet considered a safe haven destination by the market and until that happens, not only would is it vulnerable should weakness manifest itself when it comes to Western currencies, the renminbi is also likely to fare considerably worse than the currencies in question
  3. While there have been measures taken by China to distance itself from the dollar (from the previously mentioned gold reserves to negotiating renminbi oil deals and establishing renminbi ties to other economies), a fair case can be made that it is still considerably (over-)exposed to the dollar
  4. However, conclusions #1 to #3 are not set in stone in terms of the (very) long-term picture and on the contrary, it is anything but impossible for game-changers to occur