China’s Surprise Currency Gambit

What It Means for Your Investments

By Seth Van Brocklin

  • Is China’s bold move a precursor to war or an opportunity for investors?
  • Deflationary forces gather as world economy slows…but don’t write off inflation threat just yet.

Chinese officials sent shockwaves through financial markets in August by devaluing their currency against the dollar. The yuan (also known as the renminbi) experienced its biggest decline in years. It may fall further as China seeks to make its manufactured goods cheaper on the world market and put U.S. products at a competitive disadvantage.

China’s gambit is the latest escalation of ongoing global currency wars. It has profound implications for geopolitics, for the global economy, for U.S. monetary policy, and for your investments.

Fiat currencies are racing to debase against other fiat currencies. China’s debasement of the yuan drew howls of outrage from U.S. politicians, both Republican and Democrat. China’s currency lost value, and it’s Americans who are upset about it.

China Moves to “Trump” America

If these currency wars all seem counterintuitive to you, you’re not alone. When Chuck Todd of NBC’s “Meet the Press” interviewed presidential contender Donald Trump recently, Todd got confused. (Chuck Todd is no Tim Russert!) He mistakenly thought that The Donald’s tough talk on China meant he wanted China to allow its currency to depreciate. In fact, Mr. Trump (and many others) complain that the yuan’s value is being artificially held down.

The billionaire mogul said on August 11, “I think you have to do something to rein in China. They devalued their currency today. They’re making it absolutely impossible for the United States to compete…”

Why would American leaders be upset about China weakening its own currency? Doing so effectively makes our own dollars more valuable in terms of their ability to buy Chinese goods.

The Revealing Fight Over Which Power Has the Weakest Currency

And why would the nations of the world all be vying to make their currencies worth less? Wouldn’t a strong nation want a strong currency?

A strong currency is indeed a national asset, but those schooled in Keynesian economics don’t see it that way. They lament that when money gains value, people tend to hoard it rather than spend it. They view a depreciating currency (inflation) as a form of stimulus and an appreciating currency (deflation) as that which can never be tolerated.

Central Banks Always Stand Ready to Reinflate

The Keynesians who devise policy at the U.S. Federal Reserve view it as their mandate to engineer a positive rate of inflation (currency depreciation). Today, inflation, at least officially, is barely positive. Europe is struggling with deflationary forces. China aimed to stave off any deflation threat by devaluing the yuan.

Chinese officials saw the writing on the wall. Chinese exports fell 8.3% year over year. Its stock market suffered a mini-crash. The Baltic Dry Index, a measure of demand for bulk shipping, plunged to multi-year lows. Crude oil, base metals, and other economically sensitive commodities did likewise. World trade volumes are plummeting. In short, the global economy appears to be turning down.

What do you when nominal asset values and economic indicators move in the wrong direction? If you’re an interventionist who wants to create the superficial appearance of recovery, you debase your currency. Flooding the system with more yuan (or dollars) creates more nominal demand. It also enables foreigners to buy more of your goods denominated in the depreciating currency.

Currency Wars Can Escalate into Shooting Wars

In a sense, China is “stealing” demand away from foreign competitors by cheapening its own currency. So now the question is, How will the United States respond?

By reprimanding Chinese leaders for their currency manipulation? That would be just a tad bit hypocritical coming from a country that orchestrated the largest bank bailouts in history rather than let market forces take their course.

By imposing trade restrictions on China? That would surely ratchet up the geopolitical tension between the two powers a notch or two. Independent Living founder Lee Bellinger warned in the July 2015 edition (“Obama’s Drift to War With China”) that tensions with China would escalate in the final months of President Obama’s second term in office.

A currency and trade “cold” war could be the precursor to a military “hot” war over Beijing’s disputed claims in the South China Sea. As Lee noted, “China is not fooling around. Now is not a good time for a passiveaggressive U.S. foreign policy.”

Chinese Go for Gold – Should You?

That’s the geopolitical backdrop. As for the investing backdrop, the risk level has also ratcheted up a notch or two. China’s currency gambit caused volatility to jump in world financial markets. U.S. stocks got hit. But precious metals finally managed to rally as the Federal Reserve’s plans to raise rates got called into doubt.

At some point gold will reemerge as a premier safe-haven currency. It’s not clear yet whether China’s yuan devaluation will be the proximate trigger. Gold doesn’t always respond to events the way gold bugs think it should. But underlying supply/demand forces are gathering in gold’s favor.

China will be a big factor going forward for precious metals – and not just because of the potential for it to spark geopolitical strife and competitive currency devaluations. China, as it happens, is a big buyer of the yellow metal. The People’s Bank of China recently announced a massive 600-ton increase in its gold bullion reserves.

Regardless of what gold detractors may say about it, gold remains the ultimate money for central banks, for kings, for the super-rich. Gold’s cousin silver is the metal of the masses. And that may be where the best opportunity is for ordinary individual investors.

When gold prices rally, silver prices can be expected to move in an amplified manner. Silver’s volatility has worked to the detriment of investors since 2011. All the silver gurus who tried to call bottoms now have egg on their face. But the upside to a down market is that there is now tremendous value in silver. And investors are taking advantage of it.

Silver’s Woes Conceal Behind-the-Scenes Physical Buying Frenzy

Falling spot prices haven’t dissuaded buyers of physical bullion. In fact, demand for Silver Eagles and other popular bullion products was so brisk in July and early August that the U.S. Mint and other government and private mints couldn’t keep pace. Dealers ran out of inventories. As a result of the scarcity, premiums soared.

That’s an advantage of holding physical bullion as opposed to ETFs or other derivative products that are tied to precious metals prices. The value of your physical bullion in the coin market can rise even when silver as quoted in the futures market isn’t. Ultimately, physical shortages will force spot prices higher.

Mines are going bankrupt or radically scaling down operations in order to survive because metals spot prices are below all-in production costs. In the months and years ahead, the consequence will be diminished supply.

So hang on to what you have, and buy more at these low prices if you can. Be patient and don’t get down. Gold and silver will rise again.

China’s Ramshackle Markets Represent High-Risk/High-Reward Opportunity

Investors may also find attractive opportunities in China-related equities. They fell hard this summer, and there is certainly the potential for them to fall further. Investing in Chinese equities is somewhat of a faith-based proposition. You often don’t know exactly what you’re getting due to lack of transparency and limited financial disclosures.

You also never know what the Chinese government will do. But it does at least seem to want its markets to stabilize. Amidst the recent sell-off, it tried to prevent shares from free-falling by intervening and banning large institutional selling.

I wrote about the opportunities and risks I saw in China in the June 2014 issue (“Investing Insights from a Westerner in the Far East”). I shared my insights after spending a few days walking the streets of Beijing and Shanghai. Some parts of China’s cities are as modern and advanced as any in the Western world. But in other ways, they remain primitive and backward. The same contrasts can be found in China’s government (capitalistic in many ways, authoritarian in many others), its culture, its economy, and its markets.

Your Long Term Bets

I believe that in the long run, China will continue down the path of economic modernization. I see nothing to stop it from ultimately overtaking the United States as the world’s preeminent economy. And I see far greater opportunity in China-region stock markets (including Hong Kong, Singapore, Korea, India, Vietnam) than in overvalued U.S. markets. But in the near term there is also greater risk.

It’s best not to concentrate your risk in a single country. You can get broad exposure to emerging Asia through SPDR S&P Emerging Asia Pacific (GMF). It is weighted 36.0% in China; 27.6% in Taiwan; 16.8% in India.

As always, investors must weigh the opportunities against the risks for themselves.