Saturday, February 21, 2015

Opinion: Russian junk bonds and the weakness in Yuan

All three rating agencies have cut the ratings of Russian bonds to junk status with a negative outlook. A Ruble does not even fetch 2 cents of American currency now. It appears Putin underestimated the impact of economic sanctions. His tankers and missiles were battle ready but his economists failed him. Well, it is not just Russian currency and economy under attack, there are so many who are licking their wounds too including a strong contender to USD, the Euro. With crude oil prices being halved, all oil producing nations will have to re balance their budgets else they run the risk of depleting their reserves. Currencies of emerging countries are struggling to come out of the well they have fallen into, including the Indian Rupee, though the damage is not severe.


Ruble vs. USD Source: Investing.com
We know all currency valuations are relative and fluctuations are against another currency. For every loser, there has to be a winner in a zero-sum game. And there is only one gainer, USD. Was this bound to happen, or was it a conspiracy or a mystery? It cannot be mystery for sure as it cannot be explained. If it was bound to happen, how long this will continue and who will be the next victim? That is a better question to ask. It seems Chinese currency is the one next in line of fire.


Why China? It is Crimea and Oil which did the damage to Russia. But China did not attack any of its neighbors (though it has desires) and it is not an oil exporter. Right, but we need to approach it differently. When dollar was strengthening, China had to earn additional dollars to keep up its currency with it but China’s trade figures with US does not show any change. So gains in dollar would not spillover to Yuan. Unlike in yesteryear's, China cannot print its currency to buy those dollars as it would cause inflation in a low growth year. For this reason, Yuan which was pegged to dollar could not maintain its exchange rate with dollar and it lost some of its value in the last two months. You may observe the losses are not significant. But the crack can propagate for multiple reasons. Dollar is set become even stronger when Fed raises interest rates in US. That will weaken Yuan in the same proportion. When yields on US treasuries rise (probably by end of this year), it may trigger outflow of capital from China which can do serious damage to its currency. As domestic growth is slowing down in China, new investments do not come in like before. And on those trillions dollar worth US treasuries China is holding, it will suffer capital loss as bond prices will drop when yields rise. It will be like an interest free loan from China to US. China may start liquidating those treasury bills to prevent any serious damage to its currency. But it has to do it slowly in order to prevent inflation. The damage to its currency may not be severe as Ruble. But any damage is still damage. Economic theory suggests there are no long term benefits in engineering exchange rates.

Chinese Yuan vs USD Source: Investing.com
As long as US maintain its trade figures with China, there are no serious threats to valuation of Yuan despite any set-backs. But US is building its factories too and filling them with robots to achieve cost benefits, so the trade figures may not remain the same. Until there is one currency for the whole world or equality in GDP among many countries, big brother will continue to rule and enjoy at someone’s expense.