Peter's Perspective
25th February 2016 by Peter Churchouse

What has 3 legs… but can only stand on 2?

This weekend I’m heading off to Seattle. I’ve been invited to speak at the University of Washington’s Foster School of Business.

I was invited by my friend Keith Ferguson. He was originally a client of mine back in my Morgan Stanley days. He sat on the board of my real estate hedge fund. And now he is the Chief Investment Officer for the university’s US$3 billion endowment fund.

Keith is an outstanding asset manager. His endowment returned a hugely impressive 6.80% in 2015.

To put that in perspective, the average hedge fund returned just 1.56% according to Eurekahedge… and the Harvard endowment did 5.80%.

I’m really looking forward to catching up with him and getting his views on markets. Like I said, he’s a smart guy and I know he’ll have valuable insight (some of which hopefully I might be able to share with you if appropriate).

Not surprisingly, the university have asked I talk about China. Specifically China’s capital markets and the real estate sector.

Below is a topic I will certainly touch on. It’s highly relevant today. I hope you’ll find it useful.

“The impossible we do immediately. Miracles take a little longer.”

So goes the old adage.

In the case I am looking at here, not even the impossible will happen let alone the miracle.

No way.

China’s leaders appear to be trying to do the impossible with some of its policy manoeuvres in the past year.

They are doomed to fail.

Regular readers will know I don’t say that lightly.

For more than 35 years now I have watched China achieve things that I thought would never happen.

In my early days I dismissed many of China’s grand and ambitious plans. There was no way I thought they could be executed. I have had to eat humble pie on numerous occasions.

Examples include: The Special Economic Zone program; the inflow of foreign capital; the build-out of massive infrastructure – roads, railways, ports, airports, electricity; successfully reining in rampant inflation back in the late 1980’s; the unprecedented urbanisation program to house and find jobs for hundreds of millions of migrants from the countryside; dealing with massive excess supply of buildings in the late 1990’s; Entry into the World Trade Organisation (WTO)…

These achievements have been impressive. Over the past couple of years I have had to reflect that China’s achievements of the “impossible” have focused on the real economy. Building stuff, making stuff, moving people and goods around and organising production. Bricks and mortar, steel, aluminium, coal, electricity, and jobs.

But China’s authorities have been less accomplished in dealing with financial and capital markets.

The handling of the local stock market on the way up and on the way down in the past couple of years has been ham-fisted.

Management of the currency related issues over the past year have been poorly administered.

These things matter. Never more so that right now as China emerges as the second largest economy in the world and has pretensions of taking a seat at the “Big Boys’ Table” of global finance.

The jury is still very much out on their ability to deal with these matters to achieve the same sorts of impressive results that it has managed in the “real” economy.

The sceptics are many, and are venting their views ad nauseam.

China recently has been flirting with one economic reality that I am convinced will fail.

I have watched countries try to achieve this impossible feat over many years only to get knocked viciously backwards. Mostly with devastating results on their economies, their people, their companies, and their economic prospects.

In fact sometimes I suspect that their leaders don’t even realise that they are attempting the impossible.

The “impossible” that I refer to here is the Impossible Trinity, or the Trilemma.

This trilemma states that a country (or central bank) cannot have all three of the following conditions at the same time:

  1. Free movement of capital (i.e. no capital controls).
  2. Independent monetary policy (i.e. ability to set interest rates)
  3. A fixed, or managed currency

You can have two of the three conditions but not all three.

The Impossible Trinity is the fact that a country (or central bank) cannot have free capital flows, independent monetary policy and a fixed or managed currency AT THE SAME TIME.

Policy moves in the past year suggest that China is trying to achieve all three conditions simultaneously.

It won’t work. Something will have to give. The implications are significant so let me explain why.

Just to use a simple example of how the trilemma works…

Let’s say a country wants to set and lower its own interest rates. It has independent monetary policy (Condition #2 is satisfied).

With lower rates people withdraw their money to invest elsewhere to earn a higher return of capital i.e. Condition #1 is satisfied, they are free to move their capital offshore.

Now, when they do so they sell the currency. If the government attempts to satisfy Condition #3 by fixing the currency, the central bank will need to sell their foreign exchange reserves (say U.S. dollars) to ‘defend’ (i.e. buy) their own currency.

But foreign exchange reserves are finite. And when they run out, the currency fix can no longer be defended. There’s no ammunition left.

Hong Kong is a good example. The Hong Kong dollar is pegged to the U.S. dollar (Condition #3) and we have total free movement of capital (Condition #1).

However, Hong Kong does not have independent monetary policy. We cannot set interest rates. We are governed by what the Fed does.

If Hong Kong tried to increase interest rates, what would happen?

Well, investors borrow U.S. dollars at the lower interest rate, invest in Hong Kong dollars at a higher rate, and the peg would mean no currency risk… a 100% risk-free carry trade!

Hong Kong’s de-facto central bank would turn into a giant cash machine!

Clearly, this isn’t sustainable.

Hong Kong like most developed countries conforms to the trilemma. The exception being that Hong Kong fixes the currency rather than sets interest rates.

A good many Asian countries tried to do the impossible back in the 1990’s with open capital accounts, independent monetary policies AND fixed exchange rates.

They ultimately found that they could not have all three conditions, with the result that fixed currency regimes crashed and burned and countries suffered devaluations of 20% to more than 70%.

It didn’t work and played a huge role in exacerbating the severity of the Asian Financial Crisis.

Thailand was the first country to finally crack and admit that the impossible trinity cannot be violated.

The cascade of currency devaluations, economic and financial mayhem that ensued in the following two or three years is the stuff of financial history.

Now we come to China.

Until recently China conformed to the rule.

It did have a fixed, stable currency (condition #3 was met). The exchange rate was “managed”.

It did have independent monetary policy in that its central bank can set interest rates independently (condition #2 was met).

But it did NOT have an open capital account. It had strict controls on inflows and outflows of capital. Thus condition #1 was NOT met.

Conditions of the trilemma were satisfied.

But over the past 18 months, policies have changed which are testing the trilemma. They are flirting with the impossible.

First, China has moved to make its capital account more open.

This is allowing Chinese companies and individuals to take money out of China more easily. We see these flows into asset purchases in many parts of the world – real estate, land, farms, companies, commodities, art – you name it.

And it is becoming easier for foreigners to buy assets in China, particularly stocks in the local markets.

The capital account is not totally open for sure, but more open than it was.

Second, it is also trying to move away from a narrowly fixed currency regime. It is trying to make its currency more “market” driven, though it is still very largely controlled.

In essence China is flirting with policies that go against the golden rule of the trilemma.

It will not succeed.

It has to give up on something.

I don’t believe for a moment that it will give up on monetary policy independence. It wants to have control over interest rates, particularly given the current slowdown in economic growth.

Officials keep assuring the world that they do not want to devalue their currency. That they do not want to engage in a damaging currency war.

We should probably be grateful for that if it is indeed true.

I think talk of 30 to 40% declines in the value of the renminbi is naïve.

The China authorities realise the impact that this would have globally and on their own economy. We’ll be covering this more in The Churchouse Letter later this week…

So that means keeping tight control on the currency, maintaining the more or less fixed regime that has operated for the past 25 years or more.

But the trilemma tells us that you cannot have independent monetary policy, a fixed or stable currency AND an open capital account.

Something has to give.

I believe policies to open the capital account will be curtailed.

Ultimately one of the conditions will break, and I believe capital controls are the easiest to implement.

There are good reasons why.

Letting the currency float freely right now would produce a big devaluation. Speculative forces are crowded at the gate.

This would bring the ire of the world down on the China policy machine. You can already hear the cries of “currency manipulator” echoing around the world out of the mouths of U.S. political nitwits already.

It would also not go down well with international bodies such as the IMF, particularly given the IMF’s already somewhat questionable acceptance of the renminbi into the Special Drawing Rights (SDR) stable of currencies that took place last year.

Devaluation would also have very little impact on boosting the domestic economy. China’s economy has surged for years under a local currency that has appreciated very substantially against the dollar and the currencies of most of its trading partners over the past decade.

Policy makers in China do not see devaluation as a cure-all for slowing growth.

It seems to me that maintaining a tight control on the currency, albeit via a wider band than has been the case hitherto, is going to be a policy priority.

So what is left? Yes, it is capital controls.

I have been banging the drum on this for many months. (See “Chinese Capital Controls: A Contrarian View“)

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The moves to open access to stock markets for domestic players and foreigners during 2015 received a lot of airtime in the financial press. The capital account is being opened – wonderful news for investors from both sides of the border. Let’s all cheer!

But all is not as it seems…

For months now the authorities have been quietly tightening the rules on capital flows out of the country again in many ways.

China’s capital controls aren’t happening in one big swing of the axe. Rather we are seeing lots of smaller surgical incisions.

There has been big pressure to take money out of China. This in turn is putting downward pressure on the currency.

China has drawn down its reserves to the tune of around US$500 billion in recent months (some say more) to buy up the renminbi that investors want to sell to buy foreign assets.

For now, the country’s reserves are huge, but this trend can’t continue indefinitely.

There is no way that the authorities are will allow this to go on and on.

They will have to give up something to maintain stability, preserve the trilemma.

I firmly believe giving up on the goal of further opening of the capital account will be the sacrificed for near term stability.

They have all the mechanisms in place to execute stringent controls on capital flows. And there is lots of evidence that they will use them. It suits the national policy psyche as well.

For example, over a casual lunch recently a senior banker told how he was summoned to face the monetary authorities and asked not to hold net short renminbi positions against the dollar.

It’s not illegal to short offshore renminbi. But no, when the authorities politely request something of you, it’s usually in your best interest to comply.

There are and will be many more examples of coercion and strong arm tactics being used to control flows and speculative positions.

We have seen the major brokers being leaned on heavily to toe the line on actions that might go against perceived policy objectives. Not to mention companies, state owned enterprises, banks, asset managers, insurance companies. The national team has been called upon.

You might have noticed that the head of Japan’s central bank, Haruhiko Kuroda, went live recently with advice to his counterparts in China. “Introduce capital controls” was his call.

Bottom line here is that anyone thinking that they are going to make a fortune out of shorting the renminbi will be disappointed.

Especially if they do so with expectations of the sorts of devaluation seen in the Asian financial crisis of 1997.

The Chinese authorities have massive control over their domestic finances, and will not be afraid to exercise those controls.

When the Chinese commit to achieving their policy objectives, “whatever it takes”, you better believe that they have powers way beyond Mario Draghi’s to execute on that promise.

This is still very much a command and control economy.

I firmly believe that there will be a little more depreciation of the renminbi this year. It’ll likely close in on 7.00 to the dollar (from 6.53 now), but nothing more.

But this growing consensus of a massive freefall devaluation ain’t gonna happen.

China’s authorities have done a dismal job of “market guidance”, explaining their policies, objectives, and intentions.

If they are going to strut on the world financial stage then they need to play by the rules.

The fact is that they have never really had to explain themselves in the past within their own economy. But this is different.

We can only hope that they realise that they cannot do the impossible with the trilemma. And just as importantly, learn that they have to communicate with the world’s capital markets more effectively.

There is little evidence that this has really sunk in yet.

My guess is that as the year goes on and it is shown that the trilemma is playing out as it should, that will prove to be a catalyst for China stocks.

A big catalyst would be a concerted effort by central bankers and other financial authorities in China to give guidance closer to the way their counterparts in the west do.

I am completely out on my own here. Just like back in 2014 when I said buy Chinese stocks and everyone told me I was crazy (we exited several trades for high double-digit gains after I called the top of the ensuing 2015 bubble).

China stocks listed in Hong Kong are cheap and spectacularly unloved. Many are pricing in financial Armageddon.

Banks trade at 4 times 2016 earnings. Air China (the national carrier, profitable) trades at 6 times earnings. China Mobile (no debt, huge free cash flow, high single digit revenue growth) trades at 12 times earnings.

When it becomes a clearer that this sudden devaluation won’t actually transpire, then these kinds of stocks stand to give us double-digit gains.

Unfortunately I think we’ll see more downside risk in the short-term first.

Good investing,

Peter Churchouse

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