China: devaluation seems to be off the table

Outlook:

Today is a national holiday in the US (Martin Luther King Day) and most mar-kets are closed. A quick tidbit: something that never gets enough attention about Martin Luther King—he embraced and promoted the non-violent approach of Gandhi. King believed Gandhi’s philosophy and methods were the best way to overcome injustice and racism. Imagine if he had preached violent methods.

This week we get inflation data from the UK, US and New Zealand, plus ECB and BoC policy meetings. But the important data is from China tonight/tomorrow—see the tradingeconomics.com calendar below.

First thing Sunday morning, we rushed to the newswires and newspapers to see what actions China was taking to mitigate the crisis that grew like Topsy last week. All we got was the Chinese Infrastructure Investment Bank AIIB deciding to make loans in dollars. Late Sunday we got the rise in offshore bank reserve requirements. This seemed too little, too late and the Shanghai opened lower--but then turned around to close up, if only a little. Usually the absence of news is bad news, but it seems as though Chi-na is taking a slowly, slowly path toward regulatory change, whatever it turns out to be.

We continue to think the biggest threat is capital outflow and therefore the most logical safeguard is cap-ital controls. The Economist writes that China saw an annualized pace of $1 trillion capital outflow in the second half, with reserves down $100 billion in December alone. But it would be embarrassing to backtrack on liberalization reforms. Tough. Better to be embarrassed than to be broke.

Devaluation seems to be off the table. One reason could be that about 1% or $1 trillion of the massive debt pile is dollar-denominated, and plenty of it in state-owned enterprises. The hardest thing to swallow is the Chinese stance on communication with market players. The command-economy mentality means the Chinese government assumes the right to intervene or regulate however it likes without explanation to anyone. “Transparency” is not a goal, or even a factor. After all, the citizens are accustomed to dicta-torial ways and as for foreigners, to hell with them. This is probably a mistake that will come back to bite the Chinese government. We should probably assume the US Treasury Secretary spent some time on the phone over the weekend saying exactly this. Raising reserve requirements on offshore banks has the virtue of being a clear message, and one that worked, too—the divergence between the on-shore and offshore yuan fell from 1% on Friday to 0.1% today.

It’s more than a matter of style—it’s a matter of mindset. As long as the Chinese government thinks it has the right to control markets, the crisis will never really be over.

The other influential story is oil. Brent going to a handle of $26 reminds everyone of the crash after 9/11 to near $26, even if that was the WTI measure. That the oil price has recovered off the overnight lows reminds us to take heed of “sell on the rumor, buy on the news.” This is not to say the bottom is in. We will continue to see a supply glut for a very long time, all this year and into next year. Barring a supply surprise—Iran’s failure to invest in oil capacity results in lower exports, something disruptive in Saudi Arabia—oversupply should continue to drive oil prices even lower. But some traders may be seeing a light at the end of the tunnel.

The Iranian story could end up being bigger than we now think. Iran suffered a self-imposed isolation that was very expensive. The end of sanctions—even with very little wiggle room in the US—means European and Asian investors can go flooding into Iran. For one thing, Iran is technically back in the international banking system as of today, including SWIFT. For another, opportunities must be abundant to modernize and upgrade outdated facilities of all sorts that have been limping along, not to mention consumer goods, living on pirated stuff for years. Iran could be the big growth and investment story of the year. It won’t match China, of course, because of China’s size, but in a sea of drowning emerging market states, the one paddling along with its head above water will get the notice.

It’s not a big data week but it’s not empty, either. In the US, probably the big news will be housing starts and CPI on Wednesday, with existing home sales on Friday. Also Wednesday is the Bank of Canada, complete with a report on the economy. Some analysts see a rate cut ahead, but with the CAD down for nearly two weeks to multi-year lows, we are having a hard time imagining a cut. The CAD fell 350 points last week alone to a low not seen since 2003.

Before US CPI on Wednesday, we get CPI from the UK tomorrow and a speech from BoE Gov Carney. Then on Thursday, the ECB meets. The mood is changing about the ECB. Earlier surveys indicated the ECB will not expand or extend QE. In fact, the euro started its rise on the day Reuters cited five ECB insiders, unnamed, asserting no change in the program. But now Bloomberg reports some 60% of econo-mists surveyed expect a change this year, if not this week. This is because the governing council is bound by its own rules to heed specific surveys dealing with key economic data, especially inflation. And there is no way anyone is getting any inflation these days.

And finally, the Davos conference begins on Thursday. This is a self-serving display by people who im-agine they are important and thus easy to dismiss, but we do sometimes get some interesting perspec-tives. This time it’s likely Draghi, speaking Friday “The Year Ahead: The Economic Outlook for the Eurozone.” We have complained before about “all central banks, all the time,” but we are back there again. We have no idea what Draghi will say at Davos, of course. But the market is willing to bet on optimism (no change in QE and a rise to resistance at 1.1128—see the daily chart below) or pessi-mism—breaking support at 1.0864. Either is plausible. Watch out.