## Friday, August 14, 2015 ... /////

### A huge overreaction to Chinese currency adjustments

For three days of this week, the Chinese authorities did some work to weaken their currency, one yuan renminbi (the last word means people's currency). The world markets reacted hysterically again. I think that those things show that way too many emotionally unstable, immature, and irrational people have too much money – and use them to invest into tools they are not ready for.

Every good communist currency boasts pictures of mass killers. This one, Mr Mao, has arguably killed 78 million people. One murdered human could actually become a pretty good currency – worth some 2 million yuans (if you count the yuan M2 money supply).

Let me add a few details. First, let's begin with another story in the Chinese market.

In the recent year, up to a peak in June 2015, the Chinese stock market experienced an unbelievable growth. At some moment, a generic Chinese USD-denominated stock fund added 150% – strengthening by the factor of 2.5 – within the most recent 12 months. If you add the strengthening of the dollar relatively to other currencies, e.g. European ones, you will see that the Chinese fund tripled the initial value for a European investor.

It had to be a bubble. Now, it's easier to say that it was almost certainly a bubble, at least partly, because it seems that a portion of the bubble has already burst. The Chinese stocks were very volatile but in recent weeks, they were losing some 30% relatively to the peak (although the collapse has been largely stopped, if not reverted, by some interventions by the Chinese government). When you read about the emotions in China, you can't avoid the conclusion that these dramatic swings are mostly due to the low sophistication of the Chinese investors.

Most of the members of the "active new capitalist communist China" – some 100 million people – have some funds in the Chinese stocks. But they are no real gurus. I think that we, in the post-socialist Europe, don't share much of the consternation by the ingenious China that owns the future. If the post-socialist Europe has some features – less polished, more dirty, less ready to embrace luxury, whatever – that distinguish it from the Western Europe, China has even more of those. In some sense, China is just an even dirtier, overgrown sibling of post-socialist Europe.

They're very different from us but many of their competitive advantages as well as disadvantages are qualitatively similar to those of Eastern Europe – and the large growth has been taking place largely because most of the Chinese population is still vastly poorer than what their potential allows. There are some differences in both directions – for example, the Chinese are more likely to steal your ideas and know-how than the Eastern Europeans (even from us). And even though I could name things in which China is ahead of us, I still have to ask: Why do the Westerners love to worship China and its future so much?

Some of the ordinary Chinese investors tell you that the government has promised them it was a safe investment and they were disappointed when the stocks also went down. What? Do you really believe that an investment may be guaranteed to double or triple every year without any risk? It would be better than a perpetual motion machine. You can't be serious. If you love and trust your communist government this much, something is wrong with you and you should better avoid things like the Chinese stock market – something that is labeled as "very risky" in almost all European banks' booklets.

The Chinese mixture of communism and capitalism has many bizarre features. The system isn't democratic in any terribly useful sense. But almost no one (in China) seems to care much. But much of the economy is already capitalist – in many cases, more unregulated than in the "capitalist" Western countries.

I think that the Chinese government should work hard to transform the Chinese population into competent investors who understand capitalism. It should order some of the citizens to calculate the correct price of each company according to some algorithm, sell when the company seems overpriced, buy when it seems undervalued, and so on. Others should be taught another, complementary algorithm, and so on. Intrinsically, the Chinese are smart enough so that many of them could learn much of it.

At this point, however, almost all the Chinese investors are a stupid herd that just coherently "buys" when other sheep are doing so (lots of the ordinary Chinese folks have borrowed lots of money to buy when the bubble was growing), and "sells" when the sheep decide to run down the hill. This is too bad. But it may get fixed in the future.

Back to the currency pegs

China and America effectively belong to the Sino-American currency union. Well, for many years, the Chinese currency has been more or less pegged to the U.S. dollar. The changes of the exchange rate were limited by the law and interventions.

You may check that during most of the year 2015, one U.S. dollar was worth 6.21 yuans. During the three days, mostly the first one, the Chinese powerful decided to weaken the yuan to 6.40 yuans per dollar. It's a change by 3 percent, almost exactly. Is it a reason for the hysteria we have seen?

I don't think so.

First, China used to manipulate its currency much more intensely than by weakening it by some 3 percent. Those days belong to the history books. I actually think – because of the trade balance and other things – that the Chinese currency is about as strong as it should be right now.

In recent days, China decided to weaken the yuan because they recorded "just" some 6% growth rate and they were used to numbers above 7% and close to 10%, for many years. An artificially weakened currency surely encourages exports. The Czech National Bank did the same – but by 6 percent (relatively to the euro, not just 3 percent) – at the end of 2013 and almost no one outside Czechia cared. The principle and justification seems almost exactly the same, despite our central bankers' suggestions that they are more sophisticated than the officials in some emerging markets. It's always some sort of artificial unbalanced act of mercantilist interventionism. I think that the currency exchange rates should simply be "roughly" to guarantee vanishing trade balances of all countries.

(The latest Czech GDP year-on-year growth is 4.4%, best in Europe, and I am sure that a percentage point is due to the artificial weakening of the crown. But I don't think that given the distortions, the increased number should be interpreted as an objective improvement. People are able to do less, at least globally, for their money. Without interventions, we could have a 3% growth which would still be very good and "not suspicious". This 4.4% growth feels like the pride of 4 women who were partly appointed due to affirmative action. Wouldn't 3 without AA be better?)

Well, China is not a democracy, it's governed by that nominally communist elite, and they have the right to "demand" a higher growth rate. And to "engineer" it, too. They are just trying to catch up with others, so why not? If the Chinese don't want democracy, it's their right. Externally, China is a big corporation which has the right to organize its assets and internal papers in many ways.

OK, now the yuan is 3% weaker. What does it mean? Should the stocks across the world fall by several percent because of that? I don't think so. It is an insane overreaction.

First, notice that all the other exchange rates, like the euro-dollar rate, are changing much more dramatically than by 3 percent and people don't view these swings as the end of the world. Within a year, the euro went from a high above $1.40 to a low close to$1.04 or so – this drop is much, much greater than 3% – and almost no one cared. (A quarter of this drop has been reversed.)

Why should people "depend" on a much tighter relationship of the currencies of China and the U.S., countries whose political and cultural architectures are much further than those of America and Europe, for example? Well, they shouldn't.

The qualitative logic driving the non-Chinese stocks down is simple: it will be harder for non-Chinese exporters to export to China because the Chinese consumers will have less cash (their savings have been weakened) and the Chinese competition will find it easier to win the competitive markets (because their product may be up to 3% cheaper now) – both Chinese and non-Chinese markets.

The latter observation is undoubtedly correct in principle. But how important it is? Many of the products that are being sold back and forth don't have true competitors. People know what they're buying and there are often no Chinese "true counterparts". So the change of the price doesn't change much.

For some products, the weakened yuan does bring an advantage to the Chinese producer and a disadvantage to the non-Chinese ones. How big the difference may be? I think that the 3% weaker yuan may decrease the non-Chinese exporters' sales in China by some 5 percent, and add the same absolute amount to the revenue of the domestic Chinese producers. (The absolute shift of revenues from the non-Chinese producers to the Chinese ones may be about the same at non-Chinese markets, adding an extra factor of two, but I won't pretend to be terribly accurate in the estimates below.)

Let's look at these numbers differently. The world's GDP is some $80 trillion a year. China's imports are around$2 trillion a year, about 2.5% (1/40) of the world GDP. Now, because of the currency devaluation, this 2.5% may drop to 2.4% (by 5 percent or so, see the previous paragraph) because it will be harder for the exporters to sell stuff in China.

So the difference of the non-Chinese exporters' revenue caused by the 3% devaluation of the yuan could be something like 0.1% and that's the estimate of the change of the revenues and profits of the non-Chinese exporters each year. How much should this 0.1% decrease of the revenue affect the price of the stocks?

You might multiply the revenue by the timescale – perhaps 10 years – over which the stock is effectively calculated to repay its price. In that way, you could justify a 1% decrease of the stock prices. But I think it would be a heavily overrated influence because the 3% weakening of the yuan can't be understood as a "once in a decade" event that will have a lasting impact on the markets. It's more accurate to view it as an adjustment changing the parameters for a year. Next year, the yuan will be whatever it will be, and they can drive to any value, up or down, independently of the value in September 2015. So this week's decisions are not lasting long-term decisions.

Moreover, the weakening of the yuan is very likely to have the effect they probably want – re-acceleration of the Chinese GDP growth. This is good for them but with a delay, it's good for the non-Chinese exporters, too. So if China manages to increase its GDP by 8% instead of 6% in the next year, it will mean that next year, it will also be capable of importing greater amounts of goods than it would be without the intervention. So in a year, the weakening may turn out to be a net positive even for the non-Chinese exporters to China. And this benefit will last – for the whole decade in which you expect the stock to repay its price.

At the end, I think it's a rather complicated task to even find out the sign that the devaluation of the yuan should have on the non-Chinese stocks. But I am almost entirely sure that the idea that it should be a huge, multi-percent "blow" to the non-Chinese stocks, is a result of flawed calculations, wrong thinking, and emotional overreactions. The robustly justifiable changes may be comparable to those aforementioned 0.1% for the stock price, too. The stocks outside China shouldn't have visibly reacted. The stocks in China should have added a few percent because the Chinese exporters (and others, indirectly) will benefit from the weaker yuan. But the positive effect in China should be compensated outside China, and ex-China is a 10 times greater economy than China, so all the swings outside China should be an order of magnitude smaller than the Chinese ones.

I have said that the Chinese investors are not sophisticated. They are not good at a reasonable evaluation of the price of the stocks. They don't understand the logic, why the stocks have a greater growth potential but also a greater risk than the cash. But the overreaction of the world markets to minor changes of the exchange rates suggests that the non-Chinese investors are pretty irrational, too.

The idea that the mankind's well-being depends on a tight peg linking the U.S. dollar and the yuan is preposterous. Just look at the euro-to-yuan exchange rate. One euro was 8.68 in May 2014. It dropped up to 6.57 at two bottoms in March and April 2015. It's a drop of the euro relatively to the yuan by 25%. The recent week meant that the euro strengthened back from 6.8 to 7.1, by 4.5% (because the euro also strengthened relatively to the U.S. dollar a little bit).

But the effect of this "huge devaluation event" on the euro-yuan exchange rate was still more than 5 times smaller (allow me the generalized arithmetic Lumo Czenglish that all of you understand, anyway) than the "natural" drop of the euro during the recent year. So why should the European traders get hysterical about this minor manipulation of the yuan? They shouldn't – and in fact, no one else should go ballistic, either.