China’s economy continues to be one of the major drivers of the global market. And its currency is the lynchpin that is driving a lot of macroeconomic factors behind it. As a result, much of the talk in the markets these days tends to revolve around one question: Just how weak will the Chinese renminbi get?

What markets are watching most closely is the level of foreign currency reserves in the People’s Bank of China. China currently holds the equivalent of $3.3 trillion in foreign currency reserves. To keep the renminbi from falling, the bank would need to spend some of those reserves to buy renminbi and prop it up. The International Monetary Fund believes that a trade-focused country like China should have $2.7 trillion in foreign currency reserves in order to have sufficient room to maneuver in the global economy.

But just last December, $108 billion of this reserve fund was eaten up, while January will probably see a $120 billion decline in reserves as well. If this pace keeps up, China could hit that $2.7 trillion minimum by mid-year, at which time they would need to think about how to manage their currency going forward.

One reason there’s so much interest in this situation is that several big-name hedge funds have been vocal about their short positions in the currency and many of them have very big bets. There are other players in this drama as well. For instance, China’s National Chemical Corp. – ChemChina –has announced a bid to buy Swiss agricultural company Syngenta for $43 billion, the largest such deal on record. There are also a lot of smaller corporates with U.S. dollar-denominated debt that are underwater with current renminbi exchange rates. And with the prospect of even lower currency levels ahead, there is talk of a rush to pay off some of that debt, which in turn puts more pressure on the currency to weaken.

In our view, here’s what needs to be considered.

  • If the PBoC is truly going to run out of reserves in a few months, then instead of wasting money to defend its value, they can let the currency freely float. However China does not have a free market principle market, and this may result in creating the kind of chaos and volatility that China hates, as their mantra has always been “stability.”
  • Alternatively, the government may impose capital controls so that the Chinese cannot invest abroad any more or make that investment very restricted. However, some feel that there will always be a grey market, so this approach will not be effective.
  • There is talk about having a one-off devaluation or combining the previous two solutions.  But the question about this approach is whether it will correctly fix the problem.

In general, we cannot see the light at the end of the tunnel yet and unfortunately we don’t have a solution. However, China’s situation is affecting the emerging markets, commodity prices and the global economy such that, for us in the U.S. it’s unlikely that the Federal Reserve will be in a hurry to raise rates this year. This situation also explains the fall in the U.S. dollar, which has been dropping every day this week. 

The information in this report was compiled by the staff at City National Bank from data and sources believed to be reliable but City National Bank makes no representation as to the accuracy or completeness of the information. The opinions expressed, together with any estimate or projection given, constitute the judgment of the author as of the date of the report. City National Bank has no obligation to update, modify or amend this report or to otherwise notify a reader in the event any information stated, opinion expressed, matter discussed, estimate or projection changes or is determined to be inaccurate. This report is intended to be a source of general information. It is not to be construed as an offer, or solicitation of an offer, to buy or sell any financial instrument. It should not be relied upon as specific investment advice directed to the reader’s specific investment objectives. Any financial instrument discussed in this report may not be suitable for the reader. Each reader must make his or her own investment decision, using an independent advisor if prudent, based on his or her own investment objective and financial situation. Prices and availability of financial instruments are subject to change without notice. Financial instruments denominated in a foreign currency are subject to exchange rate risk in addition to the risk of the investment. City National Bank (and its clients or associated persons) may, at times, engage in transactions in a manner inconsistent with this report and, with respect to particular securities and financial instruments discussed, may buy from or sell to clients or others on a principal basis. Past performance is not necessarily an indication of future results. This report may not be reproduced, distributed or further published by any person without the written consent of City National Bank. Please cite source when quoting.