Chinese Yuan Devaluation - What you Need to Know

Summary

In this episode of Milkshakes, Markets, and Madness, Brent Johnson discusses the potential devaluation of the Chinese yuan, emphasizing the significance of understanding both sides of the trade war story. He explores why many people believe the US might lose the trade war but presents reasons why China's position is also precarious. Understanding currency dynamics and the historical context of the yuan is crucial, as past patterns might repeat, affecting global markets. Johnson underscores the interconnectedness of economies and the complexities of maintaining a currency peg.

Highlights

• The potential devaluation of the Chinese yuan could impact global markets! 🌍
• Understanding the intricate balance of currency pegs is key in global finance! 🔑
• Both the US and China face significant risks in the ongoing trade war. 🏴‍☠️
• History of the Chinese yuan's valuation offers insights for today's traders! 📈
• A 5% devaluation caused havoc in 2015; imagine a larger scale today! 🚨

Key Takeaways

• Understanding currency dynamics in global finance is crucial! 💸
• The trade war between the US and China is a double-edged sword—both sides face risks! ⚔️
• Currency pegs are complex; maintaining one can strain a country's reserves. 🤯
• China's historical experience with its currency might repeat itself in today's trade dynamics! 📚
• Global investors should keep an eye on how currency devaluation impacts their portfolios! 📉

Overview

Brent Johnson dives deep into the complexities of the Chinese yuan's potential devaluation, exploring how such a change could ripple through global markets. He explains why understanding the dual perspective of the US-China trade war is fundamental, suggesting that, while many expect the US to be on the losing end, China's situation is not as strong as it might seem.

Through an insightful historical lens, Johnson reviews the Chinese yuan's valuations since the 1980s, highlighting the multiple instances of devaluation and how they shaped China's economic landscape. He elucidates the relationship between the yuan and US dollar, and points out why maintaining a currency peg is increasingly difficult given today's economic pressures.

Johnson emphasizes that with the intertwined nature of global economies, investors must be prepared for potential currency shifts. Highlighting the risks both the US and China face, he warns against the oversimplification of complex trade dynamics. A keen awareness of these elements could be pivotal for anyone looking to safeguard their investment strategies.

Chapters

• 00:00 - 00:30: Introduction The chapter explores the significance of the Chinese yuan in the global economy and discusses potential reasons why China might need to devalue its currency. It also considers the implications of such a devaluation for the rest of the world. The discussion is part of an episode of 'Milkshakes, Markets, and Madness' and clarifies that there are no certainties or guarantees regarding these events happening.
• 00:30 - 03:00: The Importance of the Chinese Yuan This chapter discusses the significance of understanding the Chinese Yuan and its potential impact on financial portfolios. The narrator emphasizes that being unprepared for changes related to the Yuan could be detrimental, highlighting a personal observation that many believe the US is... (transcript cuts off).
• 03:00 - 11:00: Historical Context of the Chinese Yuan This chapter delves into the historical context of the Chinese Yuan within the framework of global trade politics, specifically a looming trade war with the United States. The narrative challenges the prevalent viewpoint that the US is ill-prepared for this economic confrontation. While acknowledging the US's shortcomings, the chapter highlights the necessity of considering both perspectives to gain a more balanced understanding of the situation.
• 11:00 - 19:00: The 2015 Mini Devaluation and Its Effects The chapter titled 'The 2015 Mini Devaluation and Its Effects' discusses the differing perspectives on the impact of China's economic strategies, particularly focusing on the 2015 devaluation of the Chinese yuan. The narrator believes there is a lack of understanding regarding both sides of the situation, emphasizing the uncertainty surrounding China's position in the global trade landscape. They argue that China's ability to 'win' in the context of international economic tensions, such as the trade war, is not as robust as perceived. The chapter also promises to delve into the history of the Chinese yuan, exploring past events that might parallel current dynamics.
• 19:00 - 27:00: The Credit Boom in China The chapter discusses the credit boom in China. It seems to be part of a presentation intended to explore this economic phenomenon. However, the provided transcript only includes a small portion of the presentation, centering on the idea that predicting a 'winner' in this economic scenario is not the goal, emphasizing that no country necessarily 'wins' in such global financial contexts. The speaker appears to be cautious about making definitive predictions regarding economic outcomes. There is also a mention that the presentation was mistakenly moved halfway through, and the speaker is organizing the slides to properly proceed with the presentation.
• 27:00 - 38:00: Capital Flow Reversal and Its Implications The chapter discusses the potential negative impacts of capital flow reversals on different stakeholders. It highlights the importance of considering multiple perspectives or 'two sides to every coin' in economic discussions. The conversation focuses on China's economic challenges amidst global trade dynamics.
• 38:00 - 51:00: The Current State of China's Financial System The chapter discusses the current state of China's financial system, highlighting the existing challenges due to global trading dynamics. The narrative points to hyperbolic statements about the lack of ships arriving in the United States and the ensuing empty port scenarios. While there's a focus on potential shortages in the U.S., the other side of the narrative is that China faces waste issues, with inventory rotting on their docks due to the halted or reduced shipping activities. This illustrates a broader economic imbalance affecting both importing and exporting nations.
• 51:00 - 59:00: External Debt and Currency Reserves This chapter explores the complexities of external debt and currency reserves. It starts with the issue of unused resources leading to lost revenue, which in turn causes a profit squeeze and potential layoffs. The discussion emphasizes that this is an intricate issue affecting multiple countries, implying that if it were simple, there would be clear winners and losers. The text suggests maintaining awareness of these dynamics in global discussions about economic performance and stability.
• 59:00 - 61:00: Future Scenarios and Conclusion The chapter titled 'Future Scenarios and Conclusion' discusses the uncertain outcomes of conflicts, particularly focusing on America and the US, drawing an analogy with a historic fight between Haggler and Hearns in the 1980s. The main point emphasized is that in any fight or conflict, all parties will experience hits, and the critical factor is not who gets hit but who remains standing at the end of the conflict.

Chinese Yuan Devaluation - What you Need to Know Transcription

• 00:00 - 00:30 The Chinese yuan, why is it so important? And why might China have to devalue its currency? And what would that mean for the rest of the world? Well, that's what we're going to talk about today on this episode of Milkshakes, Markets, and Madness. And the reason we're going to talk about it is not because I know for sure this is going to happen. Not because there's any guarantees that this could happen, but
• 00:30 - 01:00 it is so important that you have to understand how and why it could happen because if it does happen and you're not ready for it, it could mean death for your portfolio. So part of the reason I want to talk about it today is I have felt like over the last month, everyone I speak to, and not everyone, most everyone I speak to is just absolutely sure that the US is
• 01:00 - 01:30 going to quote unquote lose this trade war. And every article I read and every interview I listen to talks about all the ways the United States is not prepared for this. And listen, very good points are made. The US is not in fantastic position. However, there is always two sides to every story. And I think it's important to understand at least understand the other side of the story
• 01:30 - 02:00 and then you can come to your own conclusion whether or not. But I feel like nobody understands both sides of the story and all the focus is on one side. So, I'm going to give you my side of why I think it's much more uncertain than many other people and why I think China is perhaps not in such a great shape to win this quote unquote trade war. And then I'll tell you a little bit of history of the Chinese yuan and why I think the same things could potentially
• 02:00 - 02:30 happen again. So, I put some slides together and we're just going to walk through them uh one by one. And so, hold on. somehow was all all the way halfway through the presentation. Okay. So, again, part of part of the reason that I want to do this is not because I want to prove that the United States absolutely is going to win. I don't know who's going to win this. And the other thing I'd say is nobody quote unquote is really going to win. Nobody wins.
• 02:30 - 03:00 Everybody's going to get hurt. And I had this co I had this conversation on on on Twitter the other day is listen I'm just I just want I I feel like I'm always pointing out the other side of the story. And so uh I'm going to take today as an opportunity to kind of go through it in a little bit more detail of why I think China uh you know has some trouble. Uh but you know there is always two sides to every coin. There's two sides to every trade and there's two
• 03:00 - 03:30 sides to every door. And so when you read articles or when you see hyperbolic statements about the ships are no longer arriving in the United States and the ports are empty and it's only a matter of time before the shelves are empty. Listen, that's true. That's probably going to happen. It's almost baked into the cake at this point. But that's only half of the story. The other side means that on the other side of the ocean there's wasted inventory rotting on those docks and just sitting there and
• 03:30 - 04:00 going unused. And that means lost revenue. And lost revenue means a a profit squeeze. And a profit squeeze means people get laid off. So this is not a one-sided coin. This is not a one-sided issue. And it's not a one-sided war. If it was one-sided, the other countries wouldn't be upset about it. They would have already won and they'd be they'd be dancing. So, we just have to kind of keep all of this in mind when you hear all of the death of
• 04:00 - 04:30 America and the US cannot possibly come out ahead in this thing. Um, and I've used this analogy many, many times. Listen, I don't know who's going to win this. All I know is that in a fight, everybody gets hit. It it's not a matter of who gets hit. What matters is who ends up standing at the end. Now, this this is a fight I've referenced many times. This is Haggler versus Hearns in in the 1980s. And this is the first round. And you can see the guy on the
• 04:30 - 05:00 right has blood all over his face because the guy on the left was hitting him pretty hard. And you know, at the end of the first round, somehow his corner got the blood stopped from bleeding and he came back out and he won the fight in the third round. But the point is is I don't expect the US to come out of this unscathed. I expect the US to get hit. I expect the US to bleed and I don't expect this to be an easy victory. But I also don't think it's
• 05:00 - 05:30 necessarily going to be an automatic loss. And I'm going to walk through why that is now. So, let's look at China because in my opinion, and some people disagree with me on this, but in my opinion, the whole tariffs thing, even the tariffs on other countries, the tariffs on Mexico, the tariffs on China, the tariffs on the EU, it's really all about China. And so that's why this presentation and this episode is going to focus on China and what could go wrong in China and what could
• 05:30 - 06:00 potentially keep China from quote unquote winning this trade war. So but what we're going to focus on is the yuong because I think often one of the most underappreciated aspects of global finance is currencies. you know, people will focus on trade and budget deficits, you know, and uh profits and GDP growth, but I feel like currencies aren't as
• 06:00 - 06:30 appreciated as well as they should be. And the US dollar yuan cross is probably well, it's definitely in the top five and it might be the most important ratio in all of global markets and it's because it's the two biggest trading partners in the world. you know, it's it's it's the reflection of of of of in many ways their dealings with each other. It's more than that, but that's a big part of it. And so, this is a chart going back to the 1980s of the Yuan.
• 06:30 - 07:00 Now, the reason this is important is because of the trilmma or as some people call it the impossible trinity. And the impossible trinity says you can only have two of three things. You can have free capital flow, you can have sovereign monetary policy, and you can have a fixed exchange rate. You can have any two of those three, but you can't have all three of them. Um, and so as an example, if China has a
• 07:00 - 07:30 fixed FX rate and it allows free capital to flow in and out, then it has to use monetary policy to maintain that fixed rate. And so as a result, it's sovereign, its monetary policy is no sovereign. It's no longer really, you know, up to them. They have to do certain things to keep that fixed exchange rate. Now, if they wanted to have sovereign monetary policy and they wanted to have free cash flow, that's no
• 07:30 - 08:00 problem. But then they can't have a fixed exchange rate anymore. And they have had a fixed exchange rate for a very long time. And there's a reason why. Because floating in a in a in a in an in a regime of floating exchange rates, it's a zero- sum game. If one country pursues an inflationary policy, that means the deflation they're trying to combat gets exported somewhere else and vice versa. So monetary policy and
• 08:00 - 08:30 currency levels and exchange rates often determine exports, imports, profits, losses, and it's a really, really important thing, especially if you're an exporting economy. And so it's a very, very important thing for China. Now let's just in order to really understand why this is important. It's important to understand a little bit of history of the yuan. So if we go back to the 1980s and now just just as some
• 08:30 - 09:00 reference as the pink line the pink line is the yuan as it rises that is the yuan losing value. Okay it's just the way the chart is. So, as you can see, from the 1980s to the early 1990s, it devalued a lot. And from, let's call it 1981 to 1993 or four, it devalued quite a bit, but kind of at a steady rate. And then China did a huge one-time 25%
• 09:00 - 09:30 devaluation all at once. And they pegged the yuan or the dollar at 8.5. And the reason they did that is they wanted to attract capital flows into China. And the reason they pegged the currency is if you peg the currency, in other words, you you make it so that it does not fluctuate that removes quote unquote currency risk from other entities around the world looking to invest in China.
• 09:30 - 10:00 One of the biggest things international investors look at when investing in another country is the currency risk. So if a country can remove that currency risk, then they can remove some of the objections to being investing in that country and then they can attract capital flow. So that's why they did it. So then we fast forward from you know 1994 to 2005. Um, and at that point they start to loosen the peg. And so what does that
• 10:00 - 10:30 mean is that they let it start getting stronger. And they didn't completely abandon it, but they loosen it. And and and over the next I don't know what is it 10 years. 10 years uh they moved to kind of this managed float and the yuan appreciates. So it gets stronger. It goes from like 8 and a half all the way down to six. So, it's a pretty big strengthening, right? And kind of in the
• 10:30 - 11:00 2010 to 2014 time frame, they they they it's it's no longer pegged and it's no longer free floating, but it's kind of a managed float. Okay. Then that went on for a couple years and then kind of out of the blue to many people's surprise and to market surprise in August of 2015, China kind of let the peg go kind they did a mini devalue and over the next four or five months the the yuan
• 11:00 - 11:30 fell by 5%. And since that time, you know, it's kind of now and then they they move to a band where they they they it's pegged to a quasi band of a basket of currencies, not so much just the United States dollar. Okay. So, but and and since that time, the yuan has fallen from, let's call it six to a little over seven, seven and a quarter, right? And so, the yuan has been
• 11:30 - 12:00 weakening over the last 10 years. Okay, it's important to have that com that that'll help understand going forward. Okay, so this is a z if we zoom in this is August of 2015. This is the mini devout. So when you can see when it when it when it jumps from six to six almost 6.4 in a couple weeks, that's that was a pretty big deal. That was a pretty big surprise to everybody. um and to show you that that was a big
• 12:00 - 12:30 surprise to everybody and it royd capital markets. So this is a number of different risk assets and equity indices around the world. So this is 2015. You can see everything was kind of trending up and to the right into the summer and then it started to roll over a little bit in July and then in August boom hard leg down all at once. That's the Yuan mini deval. So, here's we zoom
• 12:30 - 13:00 in even more. So, this is just July to September. Again, you can kind of see everything's kind of going sideways to down a little bit uh from the middle of July to the middle of August and then a hard downturn. So, you know, this is equity indices down anywhere from 5 to 20% over a couple weeks. Pretty similar to what we just had in early April. five to 20% on a number of different risk assets over just a couple week periods.
• 13:00 - 13:30 So, it was pretty pretty dramatic. Okay, let's keep going. Now let's talk about the why they would want to to peg the currency in the first place and how China had such fantastic growth um in the early in the late 90s early 2000s um because again that is part of the reason they pegged the currency in the first place and then they had this
• 13:30 - 14:00 amazing growth and it was fueled by the inflow of foreign capital and credit expansion. So let's talk about how that works. So the 1994 devalue set this all in motion. Okay, so capital flows into China and into Chinese banks. So entities, people, investors from around the world decide they want to get involved in China. They wire their money to Chinese banks. But you can't use euros and yen
• 14:00 - 14:30 and dollars in China. You need yuan. So this capital gets converted into yuan so it can be invested and spent. But this is the functional equivalent of buying yuan and selling dollars. Okay, that puts downward pressure on dollars and upwards pressure on the yuan. But that defeats the purpose of the devout. They wanted a weak currency.
• 14:30 - 15:00 They wanted a weak currency to pull inflation into the into the country to spur growth and um and make their exports more attractive to the rest of the world. So if they you know when money goes in and they sell the dollars and buy the yuan that almost that that begins to defeat the purpose of the devout. Okay. So what do they do? So the
• 15:00 - 15:30 bank of China takes the dollars, prints new yuan and gives the yuan to the bank and then the bank of China holds onto the dollars as foreign currency reserves. Okay? So the bank of China keeps the dollars as foreign currency reserves and the Chinese commercial banks take the new yuan that they get and they use that to make yuan loans and this boosts the economy. And this lending boom
• 15:30 - 16:00 stimulates economic growth and it and as a country starts to grow it attracts even more capital. So then more capital flows into Chinese banks and you start the whole cycle all over again. And this was very very very successful. So, so much so that from 94 to 2014, foreign currency reserves go from
• 16:00 - 16:30 basically nothing to $4 trillion by the middle of 2014. That's pretty big. Okay. Now, over that time period, they didn't just take the dollars coming in. I said they give it to the banks and the banks lent it out. That is a credit boom. And over that same time period from actually just from
• 16:30 - 17:00 2004 to 2014, China made $27 trillion, not in yuan, in dollars worth of new loans into their banking system. $27 trillion from 2004 to 2014. That is bigger than the current GDP of the United States and that is more credit that they extended in a 10-year period
• 17:00 - 17:30 than the United States did in 200 years. So just think about that. That is how China had such marvelous GDP growth. It was based on foreign inflows and leverage. Now, if you create $27 trillion worth of money and you can't throw a good party, you should be shot on general principle. So, that's where the party in China came from is this massive credit extension. Okay. So, what would ever
• 17:30 - 18:00 happen if these Chinese capital flows reversed? What if the inflows became outflows? Well, the thing is we don't have to guess. we know and that's what led to the mini defile in 2015. So this is a couple of charts that were created back during that time by both Bloomberg and McQuary. Um but it basically shows that in you know the
• 18:00 - 18:30 first part of 2014 and early 2015 capital outflows ranged anywhere from 250 billion to500 billion. It all depends on how you kind of want to calculate it. But capital flows started to reverse. Okay, it was the the inflow stopped and the outflow began. You can see that here as well. If you look at uh the the per or I'm sorry,
• 18:30 - 19:00 the orange line, the foreign direct investment capital flows are negative. And you can see they they they got negative quite a bit after the global financial crisis in 2008. And then by 2014 both the valuation of the reserves and the outflow were picking up. Okay. What else started happening in 2014? Why did outflows begin in 2014
• 19:00 - 19:30 2015? Well, foreign de foreign direct investment peaked into around that time. Shanghai stock market peaked around that time and it fell for about five years. It rallied again after COVID due to all the global stimulus and it has since subsequently fallen back down um and it's down like 30 40% from its 2015 peak.
• 19:30 - 20:00 GDP growth peaked right before and kind of right after the global financial crisis. And so as the GDP growth started to fall, it no China no longer looked as attractive as it had in the early 2000s when all of those loans were being created and the GDP growth was ramping
• 20:00 - 20:30 higher. So by the time 2014 comes along and the GDP growth continues to fall or continues to slow, foreigners who had invested in China start to pull their money out. Housing in China which had grown to be to 35% of Chinese GDP by 2014 starts to fall. It's still a huge number uh over
• 20:30 - 21:00 20%. But it became but their housing market which was all fueled by those loans that we showed peaked in 2014 and China's demographic collapse started to pick up speed around 2014 and it continues today. So these are all reasons why China had challenges
• 21:00 - 21:30 back in 2015 and what ultimately led to the mini devout. And all of these challenges are still affecting China today. None of these have been solved. So every slide I just went over, you could just fast forward that to today. And this is why China has their own problems to deal with. And it's why not only does the United States have challenges as this trade war heats up, but it's why China
• 21:30 - 22:00 has a number of challenges as this trade war heats up. Okay. So let's try to understand why did the outflows lead to the yuan falling. Okay. Well, now the cycle goes in reverse. rather than money coming in, money leaves. And when when when inflows reverse, you get a reversal of that vicious cycle that we saw earlier. So capital flows out of China, which means
• 22:00 - 22:30 growth slows and you get a credit crunch and then in more investors want to leave. So investors sell their yuan. They give their yuan back to the commercial bank and they buy dollars. But the commercial banks are short dollars and don't have the ability to print them. So what do they do? They go to the Bank of China and they give Bank of China yuan. The Bank of China gives them the dollars and the dollars get
• 22:30 - 23:00 wired out. But that's the functional equivalent of selling yuan and buying dollars. So again, the dollar rises and the yuan falls. Okay. And the other thing I should I I'll explain this in a minute, but part of the thing that part of the way they maintain the peg is that China, the central bank that has all those dollars in the foreign currency reserves, they use a
• 23:00 - 23:30 combination of those dollars and interest rates to buy dollars on the open market or sell dollars on the open market or buy you on or sell you on. They use it in the open market to maintain the level of the peg. That's what a manipulated currency is. That's what a currency peg is. They use a combination of their foreign currency
• 23:30 - 24:00 reserves, uh, interest rates, and then, you know, there's there's some other things that they can do as well, but they can influence the level of the FX rate, and that's what they do. But they need foreign currency reserves. They need dollars to do this. Okay, so the functional equivalent of selling yuan and buying dollars. But this puts further upward pressure on the dollar and downward pressure on the yuan. And as people see the yuan losing value, it makes them less likely to invest further
• 24:00 - 24:30 in the country because now currency risk has been reintroduced. And what does that lead to? It leads to more skepticism, more capital outflows. And so you go back slower credit growth, more of a credit crunch, more investors wanting to get out, more investors selling they want. So, this just goes around and around. The flow has reversed and that is why it and that that that this is why the Chinese yuan
• 24:30 - 25:00 is currently sitting at its weakest level in many many years. And it's why if this continues, the trade war continues and they have to continue using their reserves rather than new inflows to peg the currency, they could end up losing control of it. So let let's let's let's go back and look at this again. So in
• 25:00 - 25:30 2015 at the it that cost them $700 billion for that mini devout when the outflows started going and they were trying to maintain the peg. They had to spend $700 billion to keep it from falling even more than it fell. Okay? So remember that number 700 billion. Their reserves peaked in 2014. By the end of 2015 they
• 25:30 - 26:00 had gone from 4 trillion to 3.3 trillion. Okay. By the end of 2016 they had lost another 300 billion. So in two years or a year and a half, they lost a trillion dollars or 25% of their foreign currency reserves trying to maintain the
• 26:00 - 26:30 peg. So I'm going to jump forward here. Okay, but remember that Chinese banking system? Oh, sorry. This looks like this got formatted a little bit wrong. Remember that Chinese banking system I told you about that from 2004 to 2014 they created $28 trillion worth of debt? Well, they didn't let the they didn't let the the outflows stop their leverage. In other words, they leveraged up even though the
• 26:30 - 27:00 outflows started to started to in sorry even though the inflows into China slowed dramatically and even though the outflows started to increase, rather than stop lending, they actually levered up their system even more and they created another 30 trillion of debt on top of the 30 tr over the next 10 years. that they had lent out in the first 10
• 27:00 - 27:30 years. So from 2004 to 2024, they made $60 trillion worth of loans. That is a lot of loans. So that is the amount of leverage that is in the Chinese banking system. I'll get to why that's important here in a second. That's important because as you can imagine, all of that $60 trillion of
• 27:30 - 28:00 debt that's been lent out is not money good. In fact, the bad debts continue to rise. The NPL or the non-performing loans in the Chinese banking system, some estimates have it over 5%. Take a guess what 5% of 60 trillion dollars is. Anybody got a good math calculator? It's about $3 trillion of bad loans. That's a lot of money. That's a lot of
• 28:00 - 28:30 bad loans. Okay, but keep that keep that $3 trillion number in the back of your head. $3 trillion worth of bad loans. Okay. Now, if you look here in the middle, this shows the outflows again back around the mini deval in 2015. But then if you look over to the right side of the chart, you can see the outflows have been increasing again over the last couple years. And that is
• 28:30 - 29:00 because China's economy continues to slow. Their real estate market continues to falter. And it's a consequence of a of lack of foreign investment continuing to go in and increasing worry about the peg of the currency. It's a much riskier proposition to invest in China today
• 29:00 - 29:30 than it was 20 years ago. Okay? And let's be honest, this Chinese capital flows, it's not just because people are worried about a potential crisis. The crisis is already in China. It is not theoretical. Their real estate market has plummeted and they have more problems at the
• 29:30 - 30:00 governmental level, the intragovernmental level, the corporate level, and the individual level in the banking system than many people want to admit. But it's becoming so big that it's hard to ignore anymore. This isn't me saying this. This is Bloomberg saying this. And it's many people besides Bloomberg saying this as well. So let's take a look at the Chinese banking system a little bit more. Okay. So the total credit extended
• 30:00 - 30:30 to non-financial sector versus GDP, it's three times GDP. So even though GDP growth has slowed, credit has not. In fact, credit has accelerated. Remember when I said they loaned 30 trillion into existence from 2004 to 2014 and then they loaned another 30 trillion on top of that. That
• 30:30 - 31:00 is how the leverage has increased rather than decreased as the growth of GDP has fallen. And then many people will say, "Yeah, but Brent, they clearly aren't having any problems because Chinese sovereign rates are lower than US sovereign rates." Well, okay, that is true, but you have to understand China is not a hugely open
• 31:00 - 31:30 market. Less than five all out of all of China's sovereign debt, less than 5% is owned by external entities. In other words, like 96 or 97% of China's debt is owned by China's Chinese entities. Okay? And Chinese entities and investors are experiencing extreme deflation. None of them want to risk their own
• 31:30 - 32:00 balance sheet by investing in many more equities and any more real estate or anything of risk because they're in this deflationary spiral. Plus, they get a tax break to buy Chinese government bonds. And in some cases, they're mandated to buy Chinese government bonds. And the PBOC continues to do everything short of outright overt QE to keep the system going. In other
• 32:00 - 32:30 words, the reason rates are low in China is because they're signaling an internal deflationary depression. Okay. Now, let's focus on China's external debt because one of the arguments I always get is that China doesn't owe that much outside of China. Most of it is internal.
• 32:30 - 33:00 Okay. As of the end of last year, China had an equivalent of $2.5 trillion worth of external debt. It's because it's 2500 billion. Two and a half trillion. Okay, out of that two and a half trillion, approximately 1.1 trillion is in US dollar. These aren't my numbers. This comes from the state administration of foreign exchange, which these are
• 33:00 - 33:30 China's numbers. So by their own admission, they owe externally $1 trillion in US dollars. So here are China's foreign currency reserves fast forwarded from 2014 and you can see over the last seven or eight years it stayed pretty steady just a little bit above three and a half trillion. Okay, remember earlier when I said there was $3 trillion worth of bad
• 33:30 - 34:00 loans in the Chinese banking system? Well, that's pretty much exactly the same number as this number right here. But let's forget that for now. If we look at the composition of China's three and a half 3.3 trillion dollars of foreign currency reserves about 65% of them are in US dollars. So 65% of
• 34:00 - 34:30 3.2 trillion is approximately two trillion. So, China owes1 trillion in US dollars and has$2 trillion in US dollars in reserves, right? So again, US dollar currency reserves around two trillion, US dollar external debt around 1 trillion. That means they have an excess US dollars of around 1 trillion. Now, I'm fully aware
• 34:30 - 35:00 that they also own some other assets outside their foreign currency reserves, and this isn't a perfect representation, but just as a back of the napkin estimate, I'm giving you what the foreign currency reserves are versus their external debt. And by the way, this does not even begin to address the fact that China needs US dollars for the most important imports, which are commodities, which is food, which is fuel, oil, energy. And
• 35:00 - 35:30 before somebody tells me that they can buy all this with printed yuan, no, they can't. Whoever is telling you that, run the other way. Maybe they can buy a tiny bit of the total using yuan and maybe it's invoiced in yuan and maybe it's settles in yuan but it is priced in US dollars and that very small amount that they are invoicing in
• 35:30 - 36:00 yuan and settling in yuan is like the some estimates are around 10%. But those are, you know, kind of these, no reputable source has put that number out there. Let let me say that. So if somebody has hard data that shows China is importing a large amount of their oil in Yuan, invoiced in Yuan, settled in Yuan, and priced in Yuan. I would
• 36:00 - 36:30 love to see it. So maybe I'm wrong. So feel free to send that to me if you haven't. But the point is if they have two trillion in US dollar currency reserves and they have one trillion of external debt that leaves 1 trillion of excess US dollar reserves. Now let's look back at 2015 again. In 2015, they spent 700
• 36:30 - 37:00 billion and they still had to deval the currency. 700 billion. They still had to deval of about 5%. And this is what happened to global markets when that happened. Pretty significant. So, let's think about where we're at today. In 2015, four or 500 billion dollars of
• 37:00 - 37:30 outflows forced China to spend 700 billion of their foreign currency reserves to keep the peg of the yuan from collapsing and they had to let it mini devout. And what's going on today is we have a trade war. And this trade war is not going to end anytime soon. And even if it does, much of the damage is already done. And the guy sitting in the White
• 37:30 - 38:00 House says any deal has to be on our terms. And how long do you think it if if if Trump doesn't get his way, how long do you think he will let Harvard and Yale and all of these other endowments continue to invest the endowments in China? What do you think happens when he mandates that they bring those back? What happens when they mandate that Chinese listings can no longer be
• 38:00 - 38:30 on the New York Stock Exchange? What happens when they tell Morgan Stanley, who has all these MSCI in indexes, that they have to to to cancel the Chinese investments for national security concerns? Or what happens when China tells their citizens, you have to repatriate your currency, all your investments abroad, you have to bring them back home because this is a national security concern.
• 38:30 - 39:00 Well, if they do that, if they if China has to if China mandates the repatriation of capital, you think Trump and his team won't mandate the repatriation of capital. The point is in 2015 when everything was going great for China and had then been up and up until then had been, you know, the poster boy for emerging markets and foreign investments. If they could have to spend
• 39:00 - 39:30 700 billion to maintain a peg in that environment, why on earth would you think they wouldn't have to potentially spend another 700 billion to defend the peg in this environment? And if they spent 700 billion of their 1 trillion reserves, that leaves them with 300 billion. How do they continue to defend the peg with only 300 billion and no more
• 39:30 - 40:00 capital coming in? Now listen, I don't know for sure this is going to happen. Maybe it won't. Maybe maybe I'll wake up tomorrow and they will have announced a a ceasefire and uh they got a beautiful beautiful huge trade deal and they can kick this can down the road for another five or 10 years. I don't know. There's no guarantees, but I'm not going to sit here and say that this can't happen. It can. I don't
• 40:00 - 40:30 know that it will, but it can. And you saw what a a mini deval of 5% did to global markets in August of 2015. Imagine what a bigger devout when they run out of foreign currency reserves or when because of national security concerns swap lines are no longer extended and dollars around the world dry up and everybody countries all over the world starts repatriating their capital
• 40:30 - 41:00 home. Are you 100% sure the Chinese will be able to maintain the yuan peg? And remember that small mini deval caused havoc in assets all over the world. What do you think a 10% or a 20% or a 30% deval will do to markets all over the world? Again, I don't know for sure what's going to happen, but I'm not 100% sure it won't. And I'm not going to sit there and
• 41:00 - 41:30 pretend like this is an impossibility. So, I'm not telling everybody you should bet on this happening. I'm just saying you shouldn't rule it out. And with that, I'll leave you guys to the weekend. I'm going to go watch the fourth quarter of the Nuggets and the Clippers. And uh you know, today's May the 4th, and I'm a big Star Wars fan, so may the fourth be with you. Bye, guys.