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posted on 09 February 2016

Protect Yourself From China's Currency Contagion

by Michael E. Lewitt

Money Morning Article of the Week

Mainstream economists and media pundits have been telling people that problems in China are unlikely to cause serious problems in the United States. They point to the fact that China only accounts for a small percentage of U.S. trade, for example, and that the falling Chinese stock market has very little to do with our stock market. Unfortunately, they are missing the point.

China is now to the rest of the world what the U.S. housing market was before the 2008 financial crisis - it is the epicenter of global instability. And at the very heart of that instability lies the yuan.

Western investors may not realize that the yuan has appreciated by nearly 70% against the yen over the last five years, delivering a blow to China's export position vis-à-vis Japan. And that creates a ripple effect that will be felt in multiple markets.

Here's where the yuan is headed - and how you can protect yourself....

China's Getting Crushed Under its Debt Load

After seeing its debt quadruple from $7 trillion before the financial crisis to more than $30 trillion today, China is left with massive overcapacity in its commodity industries. As a result, it is exporting cheap commodities to the rest of the world and pushing down global prices to levels that are bankrupting the global commodity complex.

And since China accounted for 75% of global economic growth since the financial crisis, that is a big problem - for everyone. Not just for the United States, but for China's Asian neighbors and for Europe, with whom it conducts most of its trade.

Much of China's $30 trillion debt was invested in unproductive assets such as ghost cities and ghost factories that can never produce the income necessary to service or repay these obligations. Somehow intellectuals, Wall Street and the financial media believed that China would defy the laws of economics and be able to transform hundreds of millions of uneducated rural peasants into productive urban workers with the snap of a finger. That was a triumph of hope and ideology over experience and reason.

Unfortunately for them, the laws of economics and common sense and capitalism apply even to communists. China experienced the biggest debt bubble in recorded history - a bubble that will pop like every other bubble in economic history. China is not immune from the laws of economics just because it claims to operate by different rules.

Naturally the mainstream financial press and Wall Street cheered on Chinese authorities as they inflated this bubble because it helped push U.S. stock prices higher and delivered companies like Alibaba Group Holding Limited (NYSE: BABA) to the doorstop of gullible American investors. China's phony economy also allowed Apple, Inc. (Nasdaq: AAPL) to sell millions of iPhones to Chinese consumers who want to be just like their Western counterparts. But now these fairy tales are turning into nightmares. Apple stock is down 29% from its 52-week high while BABA stock is also down 36% from its post-IPO high.

All of this bullish propaganda is completely unsustainable because it contradicts the basic tenets of economics and common sense. China is coming apart at the seams.

At the heart of the problem lies China's overvalued currency, the yuan, which has appreciated over 70% against its closest Asian rival, the Japanese yen. Since 2012, the yuan has appreciated by 20% against a broad basket of currencies. Any way you measure it, China's currency is expensive. The appreciation against the yen goes unnoticed by Westerners but has placed enormous pressure on Chinese exports as a currency war rages in Asia.

The Yuan Could Move Much Lower Than Expected

Right now, China is facing serious pressure to devalue the yuan. China's economy hit a wall in mid-2014 and since then, about $1 trillion of capital has left the country. The country's $4 trillion of foreign exchange reserves has dropped to nearly $3.3 trillion as the authorities have spent hundreds of billions of dollars defending the currency.

Of its remaining reserves, only about half are liquid, so it can't continue to spend money at the rate it has to keep defending the yuan. If money kept leaving the country at the rate it did last year, its foreign exchange reserves would be depleted by the middle of 2017. Chinese citizens are permitted to move a maximum of $50,000 abroad each year; if just 5% of the population used this quota, China's reserves would disappear very quickly and liquidity conditions inside the country would tighten drastically and slow the economy even further.

Clearly, something has to change.

China is either going to have to impose stricter capital controls to keep money from leaving or stop spending its reserves to defend the yuan. If it imposes capital controls, wealthy people in China will get even more nervous about moving their money out of the country and redouble their efforts to do so. Such a move would also be a blow to Chinese view of itself as a global economic leader; but it may not have a choice. Either way, the yuan could move much lower than people expect.

The Chinese New Year celebrations extend from February 7-13, 2016. The authorities will try to keep things calm until the end of that period. The China State Council website reported that Premier Li had coffee with IMF head Christine Lagarde and said that China will defend the yuan. That is like an NFL owner giving his coach a vote of confidence. After the Chinese New Year holiday ends, there is a much greater chance that the government will let market forces take over.

If the yuan heads much lower, other Asian currencies will follow. We already know that the Japanese want to cheapen the yen in order to boost economic growth. But other currencies like the Singapore dollar are also likely to follow despite Singapore's image as a strong currency state. Singapore's banking system grew tremendously over the past five or six years but is now shrinking.

The same thing is starting to happen in Hong Kong. When China's economy began to weaken, money flooded out of China into Hong Kong, which depressed interest rates in Hong Kong. But recently money has been leaving Hong Kong, which has pushed interest rates higher there. If rates rise in Hong Kong, it will hurt the stock market and its inflated real estate market. Hong Kong has significant geopolitical implications due to its complex relationship with China, so it is important to keep an eye on the former British colony. Problems in Hong Kong could have serious destabilizing effects on global markets.

The Hong Kong dollar, which is pegged to the U.S. dollar, is also being called into question. The Hong Kong Monetary Authority has said it will defend the Hong Kong dollar but it will be increasingly difficult to do so. Both Singapore and Hong Kong are at risk of banking crises as a result of what is happening in China.

And from there, the ripples extend even further outward...

How to Profit as the China Bubble Bursts

The devaluation of the yuan is just another version of what we are seeing everywhere - the destruction of paper currencies. I frequently observe that the death of currency will go hand in hand with the Super Crash. As I have written repeatedly, the only defense against this is to buy gold, silver and other tangible assets.

There are a number of other ways that investors can profit from the unwinding of China's economic bubble, as well.

  • First, they can short all emerging markets by selling the iShares MSCI Emerging Markets ETF (EEM).

  • Second, they can short the Chinese stock market by shorting iShares China Large-CapETF (FXI), which has traded between $52.85 and $28.81 over the last year and is currently at $30.20.

  • They can also short the iShares MSCI Singapore ETF (EWS).

The worst thing you can do is fail to understand that China's economy and ours are deeply interwoven.

Free Download: "Super Crash Report:" Michael's reports are "required reading" among high net worth investors, who depended on his forecasts and advice through the 2001 and 2007 market crashes. Now he's just released his most critical update yet, and it's available to you for free. The Super Crash Report outlines in clear, express detail exactly what Michael is expecting in the next 12 months. Click here to download his report and get all of his research through Sure Money.

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