Crispin Odey, founder of $11 billion hedge fund Odey Asset Management, predicts China is going to devalue the renminbi in the near future by more than its 3% devaluation in August.
He is therefore shorting equities in developed and emerging markets because he believes China is exporting deflation and recession. “Be short,” he told AsianInvestor by telephone from London. “Don’t be long.”
Odey’s argument is twofold. First, China’s transition from an economy based on government-led fixed investment and manufacturing exportable goods to one based on domestic consumption is fraught. Second, the country's problems are overwhelming whatever positive momentum may be taking place in other major economies.
Odey’s analysis of China’s economy leads him to conclude that Beijing will devalue the renminbi. The government’s fear of rising unemployment prompts it to keep having banks lend to state-owned heavy industries, which in turn means capacity goes on expanding, thereby pushing down the price of goods and services. But export volumes are not keeping pace with the rising cost of inputs, particularly as domestic wages continue to rise.
The decline in China’s terms of trade highlights four domestic trends that Odey labels ‘bubbles’.
First is an overcapacity in housing. Odey argues that the only way to fill the empty tower blocks is if more people can afford to live in them, which therefore leads him to assume the government will continue to encourage wage increases. But wages are not rising in export destinations such as the US, so the only way to maintain Chinese competitiveness will be to devalue the renminbi.
The second ‘bubble’ is bank lending and over-leverage among state-owned enterprises; SOE leverage is rising because the government is reluctant to engage in meaningful restructuring, which would lead to mass layoffs.
The other two bubbles are stock-market valuations and the overvaluation of the renminbi.
The dislocations in real estate, wages, credit, equities and the currency are mutually incompatible. They persist because they all meet various government objectives, but they can no longer all be met. The easiest one to tackle, with the fewest domestic ramifications, is the exchange rate, Odey argued.
Devaluation, part 2
“China has been a dutiful citizen with regard to its currency,” Odey said, referencing China’s decisions since the Asian financial crisis not to engage in competitive devaluations. “But that’s over.”
He is critical of the consensus among sell-side firms that China has the internal levers to manage the situation. “The investment banks all assume China has an infinite amount of time” to deal with its contradictions.
“But I think the August devaluation was a little warning to anyone with dollar overdrafts," he noted. "The next [devaluation] will be bigger.”
The People’s Bank of China devalued the renminbi against its dollar peg by 3% over August 11 and 12, the biggest single move in dollar/RMB since 1994.
Another factor that is likely to force a devaluation is capital outflows. Odey argues that, although China’s increasing debt levels are domestic in nature, individuals do not have confidence in the country’s monetary policy; they may also be stepping up illicit outflows in response to President Xi Jinping’s anti-corruption campaign. Capital outflows have increased over the past year, spiking in August. Since June 2014, when China’s foreign exchange reserves hit a high of almost $4 trillion, they have declined by $300 billion.
Odey said he believed this exodus of capital was led by individuals and had surprised the central bank.
He called the gigantic domestic credit leverage “quantitative easing without a devaluation”, and said therefore a devaluation had to follow.
A series of interest rate cuts, mandatory reserve-ratio cuts and debt-swap refinancings for local governments (exchanging their opaque structured credits for lower-yielding municipal bonds) have all encouraged banks to lend more. Debt levels in the private sector have also leaped, and total domestic debt is now twice the size of China’s GDP, according to Bloomberg.
As a result, China is in recession, in reality if not statistically, Odey said. He argued it was exporting recession to other Asian countries. This is also why China is not taking advantage of low prices in energy: it has no need for more oil because its own level of economic activity is declining.
The alternative could be painful restructuring of SOEs, but the government fears the mass layoffs that occurred the last time the government reformed industry, in the mid-1990s.
“The anti-corruption campaign is bad news for China bulls,” Odey said. That suggests the credit boom will continue, overexpanding bank balance sheets, putting pressure on the renminbi and encouraging capital flight.
If China is already exporting deflation to its trading partners, a currency devaluation would accelerate this, to the detriment of growth elsewhere. Companies are more likely to fail to meet the earnings growth expectations implied in current equity market valuations. The US Federal Reserve has already delayed its raising of interest rates once, in September, with its board citing worries about the Chinese slowdown.
“China is the key driver,” Odey said. “The Fed is reacting to that. They are a pawn in the hands of China.”