Zulauf and Chandler on Currency Wars, Banking Crises, and Stock Market

Thoughts from our recent Big Picture podcast, Currency Wars and the Chinese Devaluation, featuring guest experts Felix Zulauf and Marc Chandler, which you can listen to in full at Financial Sense here or on iTunes here.

Many investors are wondering whether the recent move by the Chinese central bank signals the start of a new currency war. Will it be the start of another banking crisis and market collapse, as some predict, or are these fears overblown?

Flood of Liquidity Moving Back West

Felix Zulauf sees the flood of liquidity and investment that once found its way into China and other emerging markets now in the process of heading back towards the West. Zulauf reminds us just how important this is given that China experienced the “biggest investment and credit booms in mankind’s history,” which is and will continue to have major repercussions on global markets as the Chinese economy slows down.

As many others, Zulauf believes China is growing much slower than official figures suggest and cites 2% as a possible number—far less than the official 7% growth figures. Because he sees further weakness ahead, Zulauf is very confident that the total renminbi devaluation will eventually reach at least 20% against the US dollar in the years ahead.

Zulauf is concerned about several potential risks associated with this: Enormous capital outflows from investors seeking a more stable currency is one possible risk; another is a lack of domestic liquidity caused by the Chinese central bank selling dollars; and still another worry is the deflationary impacts this will have on markets around the globe. Zulauf believes most outsiders have been “brainwashed” to believe Chinese economic propaganda claiming that China is in a stronger position globally than is in fact the case. If investors or other economic actors all of a sudden change their mind, or lose confidence in the strength of the Chinese economy, the fallout could be difficult to contain.

Banking Crisis

Zulauf laid out the following scenario as a sort-of worst case scenario:

“What we haven’t seen yet is a banking crisis…You have tremendous carry trades in the Asian financial centers. The Singaporean banking industry has grown its loans from 70-80% of GDP to 160% of GDP in the last 5-6 years and the same has been going on in Hong Kong. A large part is geared to China. They are in a carry trade…. If currencies move more than expected you usually have fallout and victims…. All of a sudden some of the banks may come up and say, ‘Listen guys we have non-performing loans on the order of 20% [of capital].’ Once that hits the newswires, then I think the world may wake up and realize that perhaps we have more than a 2 or 5% devaluation on our hands. Maybe we have systemic risk here...[since] banks in Singapore, Hong Kong and China are interlinked with banking systems in the western world.”

Zulauf qualifies this pessimistic assessment, though, by admitting that the US dollar and US stocks are likely headed higher after an initial deflationary scare. He feels this way in part because of similarities to the Asian currency crisis of the late 1990s: in that instance, even with all of the volatility caused by a surprise collapse of the Thai baht, the response of western central bankers helped many markets—especially the Nasdaq Composite—to surge relentlessly higher. Yet, as was the case at that time, the bull market was selective: it excluded most commodity names, as well as emerging markets. Zulauf feels investors should keep that example in the back of their minds over the next several months when dealing with the consequences of the Chinese devaluation.

Not a Currency War...Yet

Marc Chandler, Global Head of Currency Strategy at Brown Brothers Harriman, told Financial Sense that it is unlikely we are looking at the beginning of a much larger currency war or doom-and-gloom type scenario since China’s recent devaluation was less a desperate move to boost exports but a logical and welcomed event. Here’s what he told Financial Sense listeners in Saturday’s Big Picture podcast:

"I think what China did this week is very important but I don't think it portends horrible things in the world... What is China trying to do? I would suggest it's not really going to boost exports. There's very little value-added that China actually does in RMB terms... the purpose of what China's doing isn't about gaining export advantage... I would suggest the real motivation is that the timing of it, first, is because it’s ahead of the Federal Reserve's tightening; secondly, it comes on the back of a lot of weak economic data; and, thirdly, what is China playing for? It wants to be part of the special drawing rights—that's that basket of currencies that the IMF uses to settle accounts—official money. And when the IMF issued a report last week, they said that China has done a lot of important measures in recent years to get its currency to be more accessible. They said, even though they've done a lot of hard work, more work is needed. And one of the things they needed to do was let the market have a greater sway in determining their currency [which means]...it would probably fall and could fall sharply."

Thus, to Chandler, the recent decline in China’s currency is not the beginning of a major currency war to boost exports, but a logical and necessary response, which, he points out, was welcomed by both the US Treasury Department and the IMF as a signal that the Chinese are moving to liberalize their capital markets.

He does admit though that a larger devaluation on the order of 10 to 15% would have a greater impact on the markets and, because investors hate uncertainty, the market will overreact to smaller moves in trying to anticipate long-term future outcomes.

Greenspan Conundrum Redux

As such, when considering these impacts of monetary policy and currency movements on the stock market, Chandler questions whether we'll go into tailspin because the RMB moves 3-5% or because the Federal Reserve raises interest rates by 25 basis points (one quarter of a percent). Here, he says:

“I can see why some people may be concerned that this is a top in the stock market though I'm not as convinced partly because...even though the Federal Reserve is raising rates I think they are going out of their way to tell the market that it's going to be done very slowly and it'll be very limited. But not only is that happening in the US, but the ECB, the Bank of Japan, and China are all still providing lots of stimulus into the economy—stimulus like monetary policy, and some of that is going to leak into the US. What I think most likely will happen is a sort of repeat of what's called the Greenspan conundrum...which was foreign capital coming into the US, keeping long-term yields down even while the Fed was raising rates in the short-end. And so I think that is going to help [and]...could also elongate the investment cycle.”

Listen to this full audio broadcast with esteemed market strategists Felix Zulauf and Marc Chandler on our site here or on iTunes here. Subscribe to our weekly premium podcast by clicking here.

Subscribers can access the full 48-minute interview with Felix Zulauf by clicking here.

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