By Ivan Martchev
Idioms are defined as fascinating phrases that add color to otherwise more complex discussions — a way to make them more understandable to a broad audience.
In this case, the appropriate idiom for China’s latest move is the concept of a “silver bullet.” According to Merriam-Webster, a silver bullet would be the appropriate description for “something that acts as a magical weapon,” especially “one that instantly solves a long-standing problem.”
If the Chinese devalue the yuan, they think they may win the trade war and fix their horrendous debt overhang that otherwise is guaranteed to cause a massive recession. Such a contraction could be as serious to China as the 2008 Great Recession or the 1930s Depression in the U.S.
Japan, as you may know, has had some very serious issues with long-term deflation, a shrinking and aging population, credit bubbles, a busted financial system and a Nikkei 225 Index that is still just half the peak level it registered in 1989 — 30 years ago. That is the kind of future China could face.
In that light, Sara Sekine, a Nikkei reporter, saw a story I penned about the likelihood of a “hard landing” in China, so she called our corporate office and got my cell phone and contacted me the next day. As a good reporter, Sekine asked me some hard and pointed questions. The hardest, and the one that I could not precisely answer, was this: “When is this Chinese hard economic landing going to arrive?”
I could not answer this question because I do not believe it is possible to answer it with precision, yet I do believe the recession, when it comes, will be absolutely brutal due to the monstrous debt overhang that has built up in the Chinese economy over the past 20 years. Whether it ends up like the Great Recession of 2008 or the 1930s Great Depression will depend precisely on the Chinese government policy response.
The Great Depression, starting in 1929, could have been only a bad recession if it were not for the collapse of global trade caused by the 1930 Smoot-Hawley Tariff Act. The longer name of this disastrous Act was: “An Act To provide revenue, to regulate commerce with foreign countries, to encourage the industries of the United States, to protect American labor, and for other purposes.”
While there has been no “Donald Trump Tariff Act” that has passed Congress, the president is disrupting U.S.-China trade relations and it could get a lot worse before it gets better. His policies sound eerily similar to the long title of the Smoot-Hawley Tariff Act. As hopeful as this situation looked two weeks ago, it now looks like tariff tensions could last for a long time.
Despite the similarities with Smoot-Hawley, the key difference is that the tariffs are not a response to a deteriorating economy in the U.S., but due to predatory trade practices by China. The Chinese buy on purpose more from neighbors and key partners to increase their political influence and purposefully less form the U.S. In that regard, President Trump is 100% right to make trade an issue with China.
Sun Tzu-style maneuver
Unlike the 1930s, it is unlikely that a bilateral trade war can cause a recession in the U.S., although a heightened degree of uncertainty can disrupt the savings and investment cycles, which would ultimately disrupt economic activity. In China, however, there is too much debt in the system and too much reliance on exports. As Trump has pointed out so often, China exports more than $500 billion to us, but we export just over $100 billion to them, so “they” have a lot more to lose in a prolonged trade war.
The other problem in China — which has nothing to do with the trade war — is the monstrous debt bubble. Due to their infamous lending quotas of state-run banks and their loosely regulated shadow banking system, the total debt is hard to calculate, but we know that it has ballooned in the past five years. By credible estimates, China’s total debt-to-GDP ratio has grown from 100% to about 400% in the past 20 years, if one counts the shadow banking system omitted from official statistics.
Could it be that the Chinese never intended to make a serious trade deal? Could it be that the only way to inflate away a (big) part of their mountain of debt is to devalue the Chinese yuan /zigman2/quotes/210561991/realtime/sampled USDCNY +0.2009% , and the only way the world financial community would accept such a devaluation would be as a response to a 25% U.S. tariff? It sure could, as such a calculated failure of the trade negotiations would be a maneuver worthy of true Sun Tzu disciples.
The yuan was once devalued by 34%, in December 1993. Such a devaluation today would put it near 9.31 per dollar (see chart ). It closed Friday at 6.95. Such a devaluation, if it comes, would be a profoundly deflationary event for the global financial system, after which I would expect the 10-year Treasury /zigman2/quotes/210369575/delayed TY00 -0.23% to drop below 1%. The 34% overnight drop capped a period of yuan devaluation that had started in 1989 when the dollar-yuan was 3.73 and ended up at 8.73 in January 1994.
Devaluing the yuan is inflation thievery. Such a devaluation, if it comes, would cause a deflationary shock in the global financial system and cause inflation in the Chinese domestic economy to surge. In the infamous 1989-1993 yuan devaluation period, inflation in China reached almost 30%. At last count China’s CPI is rising at an annual rate of 2.5% (see chart ).
It is key to remember that coupon payments on debt are made in nominal yuan, while inflation in China is directly related to a number of policies, one of which is the management of the exchange rate. A devaluation would create the necessary nominal yuan to service their mountain of debts. If they had used such devaluation policies aggressively in the 1989-1993, who is to say they wouldn’t use them again?
To the disappointment of the Nikkei reporter who called me after I discussed these same issues six months ago, I do not believe that the exact sequence of such events can be predicted ahead of time with precision. The trigger here is the yuan devaluation, brought on by a cracking financial system and a faltering Chinese economy due to the pressure of trade frictions. Many of these events are contingent on policy decisions that are yet not known to have been made with a high degree of certainty.
Only a select few around Chinese President Xi Jinping know if such a decision on the yuan has been made, and they are not talking. Still, I do believe the chances of a yuan devaluation are high and that such a devaluation may happen soon if the trade war with the U.S. intensifies, as it seems to be doing at this very moment.
Ivan Martchev is an investment strategist with institutional money manager Navellier and Associates.