Lighthouse Investment Management

Lighthouse Investment Management
Special Report
China
and the IMF
Special Report - China & IMF - November 2015
Page 1
Contents
Executive Summary....................................................................................................................................... 3
Chinese Yuan Into SDR Basket? .................................................................................................................... 4
IMF Quota and Votes .................................................................................................................................... 5
The Dollar Peg ............................................................................................................................................. 11
Implications of Yuan Devaluation ............................................................................................................... 18
Page 2

Executive Summary
Here are the key take-always from this report:
1. In a political decision, the IMF (International Monetary Fund) will include

the Chinese Yuan in the SDR (Special Drawing Right) basket
2. The US will, for now, keep its veto on IMF decisions
3. Due to the Dollar peg, and the Dollar's strength, the Chinese Yuan has
appreciated against most currencies, hurting China's competitiveness
4. Rising Chinese wages led to soaring unit labor costs
5. The PBoC (People's Bank of China) is now forced to support the Yuan by
selling Dollar reserves
6. To regain competitiveness, China will be forced to devalue its currency by a
large amount, possibly up to 50%. This devaluation will spread towards
other Asian countries, possibly triggering another Asian financial crisis
7. China has become the dominant buyer in many commodities as well as
luxury goods. Profits from China make up significant part of earnings for
many European and US companies
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Chinese Yuan Into SDR Basket?
Monday, November 30, the IMF will announce if China's currency will be included in the SDR (Special
Drawing Right). The SDR is the IMF's currency unit. It is not a currency (yet); it has no value of its own.
Instead, the SDR is simply calculated from a basket of currencies. As of today, these are the US Dollar,
the Euro, the British Pound and the Yen:
The IMF determines the initial weight (column "currency amount"); the market determines the
exchange rate ("rate in USD"). You multiply the two and you get the "USD equivalent". The sum of those
numbers equal the value of one SDR, expressed in US Dollars.
The value of an SDR in other currencies can be calculated by applying respective USD exchange rates.
For example, one SDR is currently worth 1.3748 / 1.0607 = 1.2961.
There are no SDR coins or bills; it merely exists as a digital currency.
The weight of each currency changes as exchange rates fluctuate. For example: The IMF reviews those
weightings every five years. At the last review at the end of 2010, the weight of the Euro was set at
37.4%. Due to Euro weakness, it has now declined to 32.6%.
But how does the IMF determine the initial weight?
The IMF takes into account "the share of each currency in world exports of goods and services and in
international reserves."1
While weight in the SDR basket is important, there are other things to look at: quota and votes. Let's
take a look. It's a bit technical, but helps understand how the IMF works:
"Currency Amounts in New Special Drawing Rights (SDR) Basket, IMF, December 30, 2010
Page 4

IMF Quota and Votes
IMF Quota, Votes, Share of World GDP and Foreign Exchange Reserves:
The IMF has 188 member countries. Members have voting rights. Each member gets 737 "basic" votes.
The total number of basic votes is calculated as a percentage of total votes (5.502%).
Basic votes are add an element of democracy into the IMF, but they are nothing more than a fig leaf.
The real voting power comes from the "quota".
Each member is assigned a quota. Think of it as a paid-in subscription. The amount of a member's quota
is "based broadly on its relative size in the world economy"2.
"Where the IMF Gets Its Money", IMF, September 29, 2015
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For the IMF, quotas represent a liability. We find them, as to be expected, on the right side of its balance
sheet3:
Back to the votes.

Each 100,000 SDR give you one vote. China, for example, has a quota of SDR 9,525,900,000, translating
into 95,259 votes, corresponding to 4% of total votes. To get to the total amount of votes for China, you
just add their 737 "basic" votes, resulting in 95,966 (3.81% of total).
The votes are important. A majority of 85% is needed for important decisions (like change in quotas etc).
Look at the large table of quotas and votes; the US is the only country with enough votes (16.75%) to
block any decision requiring 85% approval.
You can see where this might lead to. China, the second-largest economy by GDP, could demand a larger
quota and hence dilute the US's vote enough to lose its veto power.
For now, it's all about the question of the Yuan's weight in the SDR.
China's share of world GDP is around 14-15% (see column "% World GDP). On the other hand, the Yuan's
share among reserve currencies is a meager 1.1% (see columns "FX Reserves").
A recent Reuters article4 suggested the Yuan may enter the SDR basket with a lower weighting than
widely expected. In July, IMF staff calculated the Yuan could have a weighting of 14-16%. However,
recent rumors suggest a number around 10%.
3
4
IMF Financial Statement, April 30, 2015

"China's Yuan may enter IMF basket with lower share", Reuters, November 19, 2015
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The new SDR basket composition would then look like this:
But what are the criteria for inclusion in the basket anyway? The Australian and Canadian Dollar have a
share of global reserve currencies twice as high as the Yuan, yet are not to be included in the SDR.
Relative to its share of world GDP, China is the most under-represented country in the SDR (and the US
the most over-represented, see column " SDR - GDP"). Euro-zone countries and the UK are also overrepresented. This is a consequence of the fact that growth in developed countries has flattened out
while emerging economies keep surging ahead.
Based on SWIFT5 the Chinese currency has advanced to 5th-most used currency:
Society for Worldwide Interbank Financial Telecommunication
Page 7

But who says China's GDP numbers are not made up? There is a lot of doubt regarding the accuracy of
its GDP. Also, the impact of exchange rates is huge.
Take Brazil, for example. From 2011 to 2014, GDP in local currency (Real) grew by 26% while shrinking
by 10% in US Dollar:
Since its peak in July 2011 (1.53) to its low
in September of 2015 (4.24), the Real has
lost 64% of its value expressed in US Dollar.
As international comparisons are usually
computed in US Dollars, this is the number
that counts.
Take Venezuela; at the official exchange rate of 6.35 Bolivar, 2014 GDP increased by 37% from $371bn
to $510bn. At the black-market rate of 281.05, however, GDP shrinks by 97% to mere $12bn. There is no
limit in how much a currency can fall, since it's all fiat currencies, backed by nothing.
Brazil could have tried to stop its currency from falling by intervening in the foreign exchange markets.
Its central bank could have bought its own currency (thereby reducing the monetary base) and sell US
Dollars (thereby reducing its currency reserves). It chose not to do so in order to protect its currency
reserves:
Page 8

The price to pay, however, was the exchange rate:
China, on the other hand, has been bleeding Dollar reserves in order to defend its currency:
Page 9

The strength of the US Dollar has taken the Yuan on an unwanted upwards ride against most major (and
other) currencies:
China can afford to do so for a while, since it had accumulated the world's largest amount of foreign
currency reserves (over $4 trillion at one point). However, $500 billion have left within 15 months.
The People's Bank of China (PBoC) is trying to hold the Yuan as stable as possible towards the US Dollar.
This is done to minimize (or eliminate) currency hedging costs for importers and exporters, giving them
confidence they would not suffer from sudden currency movements. This makes planning future costs
and revenues easier. Small companies can afford to take larger risks if currency fluctuations are
contained.
Page 10

The Dollar Peg
The PBoC keeps the Yuan on a quasi-peg with the US Dollar:
Almost all other currencies have depreciated against the US Dollar, some dramatically, the Yuan has
effectively appreciated strongly against most currencies. Among them currencies from Asian countries
competing with Chinese exports. This makes Chinese exports less competitive.
Page 11

Due to this peg to the US Dollar, the Chinese Yuan, seen from other countries' perspective, has
appreciated significantly over the past three years.:
Note the appreciation against the Brazil Real (100%), Japanese Yen, Indonesian Rupiah and the
Australian Dollar (each around 50%).
Add to that an average
annual wage increase of
12% and China suddenly
loses its traditional
manufacturing cost
advantage. According to
industry sources,
comparable positions in
middle management
have to be paid higher
wages in China than in
Germany.
Page 12

So why would China not let its currency depreciate? The drain on currency reserves indicates the PBoC is
forced to intervene to prevent its currency from weakening (as opposed to prevent it from getting too
strong, as was the case before summer 2014). The PBoC would make a handsome profit from letting the
Yuan weaken; it is long the US Dollar (3.5 trillion) and short its own currency. A depreciation of the Yuan
of 10% would result in a profit of USD 350 billion (or 2.25 billion Yuan).
Being long 3.5 trillion USD is actually a bad deal for the PBoC as interest earned in short-dated US
Treasuries is close to zero (0.5% for 1-year maturity). Yields in Chinese Yuan are much higher, with the
PBoC's one-year lending rate at 4.35%.
The interest rate differential used to attract hedge funds in what is called a "carry trade". You borrow
funds cheaply in US Dollars and invest the proceeds in higher-yielding Chinese paper. As long as the
currency fluctuations do not eat up the interest rate differential you a pocketing an easy profit. Carry
traders usually employ significant leverage. While carry traders pocket a positive interest rate
differential, the PBoC sits at
the other end of the deal,
suffering from negative
interest rate differential.
The size of those carry
trades has been estimated
to have reached more than
USD 1 trillion6. Currency
traders often employ
leverage that can reach 50,
100 or even 500 times their
own funds. At 100 times
leverage, a 1% move in the
underlying currency can
wipe out your entire funds.
So you can imagine what
would happen in currency markets if carry traders fear a looming devaluation of the Chinese Yuan.
Everybody would try to get out (sell Yuan, buy back US Dollars) before a drop.
There was a whiff of panic when the Yuan dropped 2.5% between August 11th and August 13th. The
PBoC had just experienced the largest ever drain in foreign exchange reserves ($93bn in July). Onemonth swap rates surged to 18%.
So why would China not let its currency depreciate - especially now that the pressure to appreciate has
faded away? Why not let the market do its work for the PBoC?
"One of China's Most Popular Trades May Be Coming to an End", Bloomberg, August 11, 2015
Page 13

My theory: a sudden devaluation could have put SDR inclusion into jeopardy. Based on official criteria, a
currency must be "widely used and freely usable" in order to be considered.
As seen before, the Yuan is not used very widely; there are other currencies that should have been
included instead of the Yuan.
"Freely usable" is also questionable. There are even two different exchange rates for the Yuan: an
onshore (currency symbol CNY) and an offshore (CNH, traded mostly in Hong Kong) rate. The PBoC
keeps the CNY on a very short leash, while the CNH is allowed to trade away a bit from the onshore rate.
The offshore Yuan (red) currently trades at a premium (= weaker) to the onshore one (blue); this can be
a sign market participants expect the official exchange rate to weaken soon:
The PBoC is currently running a currency system called "BBC" - basket, band and creep. The basket
consists of many currencies (exact composition unknown, but the US Dollar is estimated to have a
weight of as much as 98%). The PBoC allows the onshore Yuan to trade within 2% from a central parity
(announced daily at 1:15pm GMT) on both sides during one day. The closing price of day one becomes
the central parity of day two, and so forth:
Page 14
In theory, the Yuan could thereby move 10% within a week (5 x 2%), or 40% within a month. But it is far
from traded freely.
The trading band has been increased very carefully over the past 10 years:
Page 15

It seems the IMF's decision to include the Yuan in the SDR was more of a political decision. So far, IMF
staff has sent its recommendation to the IMF board. However, Christine Lagarde (IMF managing
director) has already made clear she supports the staff's findings. She preempted the board's decision.
Could this have to do with the fact China is the largest buyer of SDR's? The PBoC has, in US Dollar terms,
the largest
balance sheet of
all central banks.
The Chinese
know their huge
holdings of
Dollars are a
problem if and
when the US
Dollar loses
value.
Exchanging some
of those Dollars
against SDR
might cushion
the impact on
China and give it
some leverage at
the negotiating table of a potential "Bretton Woods 2.0".
China's stock market and real estate bubbles have burst. The credit bubble, however, is still in full swing.
Affluent Chinese are trying to bring wealth into safety and are buying up condos / houses in Australia,
Vancouver and London, resulting in a massive flight of capital. This will continue as long as the PBoC
does not enact tougher capital controls and as long as the Yuan / US Dollar exchange rate does not
collapse.
If China wanted a weaker exchange rate, how would it proceed? If you do it slowly, you only invite
speculators onto a free ride.
Page 16

Past devaluations have been quick (up to 50% within a day):
Page 17

Implications of Yuan Devaluation
A devaluation of the Yuan would further curb China's imports (as prices of imported goods would
increase in Yuan):
Page 18

The US' trade deficit with China would widen further. At $350bn it already makes up more than half of
China's total positive trade balance ($600bn):
Page 19

China's trade balance with Germany is barely positive, as China imports much needed machinery and
engineering (and cars). Chinese imports have recently been on the decline, at least if measured in US
Dollars (the strong US Dollar leads to smaller values when calculating from Euros):
Page 20

However, a slow-down of Chinese imports is also visible when calculated in Euros:
Page 21

Brazil has an even trade balance with China. However, Chinese imports from Brazil have seen a serious
decline already:
Page 22

South Korea has benefitted massively from Chinese imports. However, the goods times might be coming
to an end as the trend seems to have peaked:
Page 23

Australia is usually running a trade deficit (here: all trade partners)
Page 24

...despite its large trade surplus with China (or deficit from a Chinese perspective):
Chinese imports from Australia are down 20% from the peak (much of decline might be due to price
decline of raw materials, not necessarily volume).
Page 25

At the peak, iron ore and coal (both needed to produce steel) exports made up more than one third of
Australian exports. It's basically dirt being shipped in huge quantities to China. Once the construction
boom (or the financing thereof) stops, overcapacities will be huge.
Page 26

Countries most vulnerable to a slow down of Ch
Chinese imports:
According to a report7, Chinese buyers account for 46% of global luxury purchases, making them the
biggest buyers on the planet (American
American buyers second place with 19%).
The Wall Street Journal quoted a study8 stating "China contributed about 59% of net profit at
Volkswagen, 45% at BMW and 37% at General Motors.
A senior employee of a German car maker told me that you could take apart and then sell all the
individual spare parts of a BMW in China for eight times the price of a new car.
The importance of China for the world economy cannot be overstated. The last time China devalued its
currency a lot, in 1995 (50%), other Asian countries subsequently suffered. Their currencies also began
to weaken in a downwards spiral that evolved into the Asi
Asian Financial Crisis (1997-99).. History doesn't
repeat, but it rhymes. Be prepared.
7
8
2015 China Luxury Report

IHS Automotive
Page 27

Any questions or feedback welcome.
Alex dot Gloy at LighthouseInvestmentManagement dot com
Twitter: @gloeschi
Alex Gloy
Disclaimer: It should be self-evident this is for informational and educational purposes only and shall not be
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