Re: USD/China - The Donkey Kong Dollar Peg.

Why CNH/CNY will continue to weaken and why HKD is also vulnerable.

Like many kids who grew up in the 70’s and 80’s, I was an arcade game junkie. One of the games I invested countless quarters in was the endearing Donkey Kong, in which a lovestruck Mario braves numerous challenges to rescue the Princess from Donkey Kong, who has taken her captive.

If Mario is nimble enough and is able to dodge all the obstacles thrown his way, he can finally knock out the pegs of support for Donkey Kong, causing him to crash on his head.

The Donkey Kong Dollar Peg

Today, I extend this analogy to another Kong — the Hong Kong Dollar (HKD) specifically and its bigger cousin CNY. I’ll address this amalgam as the Donkey Kong Dollar Peg.

The gorilla Donkey Kong in this case symbolizes the CNY Soft Peg and HKD Hard Peg and the monetary authorities behind defending it — the PBOC (People’s Bank of China) and the HKMA (Hong Kong Monetary Authority). Mario represents the Free Market, willing to brave the obstacles thrown his way to thwart him from helping his Princess escape an opaque, overleveraged prison.

Although CNY and HKD are technically two different currencies with different monetary authorities and policies, the two are joined at the hip ultimately, and pressure on one exerts pressure on the other.

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In March, I wrote a piece expressing my bearishness on CNY and why a CNY Devaluation would prove to be a strong Disinflationary force in the near-term for the world.

Even if you don’t trade Currencies or Commodities, the strong Disinflationary pulse coming from this is something everyone should be concerned about:

The following two charts show you the difference in price action between CNH (offshore CNY, which is soft-pegged to the USD) and the HKD (which is hard-pegged to the USD — for now).

For full disclosure, I personally went long USD/short CNH in March after writing my post at 6.88, took profit at 7.27 and 7.16, and then recently re-shorted at 7.15. I am also long USD/short HKD just below 7.85.

As you can see, the Devaluation Thesis has panned out thus far in CNH/CNY (despite overall weakness in DXY), and I think we are likely to see new lows in CNH/CNY before this is over, despite recent PBOC interventions to stymie the weakening — the barrels that Donkey Kong is hurling towards Mario.

HKD has been hard-pegged to a tight band of 7.75 to 7.85 to the USD since 1983, so the price gyrations you see are overexaggerated, but the recent moves off the upper band also suggest HKMA interventions to stymie the Mario speculators from crashing the Donkey Kong HKD peg.

Source: TradingView

Why China Needs To Devalue

Brad Setser recently opined that China may have $3T more in Shadow Reserves over and above its publicly disclosed $3T of FX Reserves. There is healthy debate over what kind of assets constitute these Shadow Reserves and how liquid they are, but to me the matter is moot.

Two observations come to mind:

1. The fact that they have a closed capital account and the fact that they have such opacity that makes us guess at this number in the first place is a problem of trust in and of itself.

2. It doesn’t matter how much firepower PBOC/HKMA have to defend CNY or HKD when the real question is: Do they want to?

In short, I think China has a big economic problem and its monetary authorities, the PBOC and the HKMA, are grappling with impossible dilemmas. The unwinnable Kobayash Maru simulation that Captain Kirk had to play in “Star Trek II: The Wrath of Khan” comes to mind.

I won’t rehash what I wrote in March, but I explained the PBOC’s policy dilemma with the classic Homer myth about Odysseus needing to steer a precarious course between the Scylla of Weak CNY and the Charybdis of Strong CNY. I followed up with my reasoning for why the PBOC would likely steer towards the Scylla of Weak CNY, given the collapse in Oil prices (not to mention China’s significant SPR stocking at our expense):

Indeed, the parade of deplorable economic data has been relentless out of China, and I think the tepid attempts at stimulus thus far have done little to nothing to shore up consumer confidence.

As a Geopolitical aside, the chart above from this FT article should make you wonder what the CCP will do with a restive young (and mostly male) population that is unable to find work.

The reason why many got the Chinese Re-Opening wrong was because they extrapolated the US Re-Opening when in fact the Chinese response was almost diametrically opposite to the US response. Think about what would have happened in the US if we:

1. Locked down for another 18 months

2. Did not flood the system with both Monetary AND Fiscal Stimulus

That’s where China is today:

China’s centrally-directed, government investment-led, debt-fueled growth boom appears to be coming to a screeching halt given the distortions and wasteful capital misallocations created in the economy, now exacerbated by an aggressive Fed that is hell-bent on fighting Inflation.

As for the consumer, instead of funneling Fiscal support to a shell-shocked, locked-down consumer that is already culturally more financially conservative than the Western consumer, the Chinese government has done the opposite. If anything, the CCP’s Three Red Lines restrictions to curb property speculation have worked too well and have gutted household balance sheets which store as much as 70% of its wealth in real estate.

Absent a healthy consumer, absent more Bridges To Nowhere, China’s only game is to Export its way out, but how will it do that without a significantly weaker CNY — especially when the the rest of the world has significantly devalued against USD?

I could easily extend my Scylla/Charybdis Analogy to the HKMA, which also faces an impossible policy choice:

1. Defend the HKD Peg and further pressure Real Estate, given that 97% of Hong Kong mortgages are HIBOR Floaters (see chart of HIBOR in my Tweet below), according to this article:

   https://www.bloomberg.com/news/articles/2022-09-22/hong-kong-mortgage-costs-are-jumping-with-97-on-floating-rates#xj4y7vzkg

2. Let the Peg go the way of Donkey Kong and end a 40-year old, anachronistic HKD Hard-Peg regime.

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And this is just the Cyclical part of the equation that China is grappling with.

Imagine what happens if China’s Cyclical downturn actually coincides with a much longer-term Structural/Demographic downturn?

China’s Smoldering Crater Scenario comes about if there is Constructive Interference between Short-Term and Long-Term Cycles, to borrow a Mental Model from physics/engineering that I wrote about last year:

As it turns out, Richard Koo, who has studied Japan’s Lost Decades extensively, recently made some points that make me believe that Constructive Interference between short-term and long-term cyclical downturns could be a real possibility for China:

Richard’s recent interview on Odd Lots is a must-listen, in my opinion.

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What Is The PBOC/HKMA Afraid Of?

Despite all of these reasons for why China would want a weaker CNY/HKD, why has both the PBOC and HKMA been defending CNY and HKD, respectively?

The PBOC, on the evening of 7/19/23 intervened particularly aggressively, by fixing CNY at ~7.15 when CNH was trading ~7.22, directing state banks to sell USD/buy CNY, and adjusting some “macro-prudential” parameters to encourage more foreign inflows. To put this into perspective, the PBOC has not been this aggressive in its interventions in about a year since CNY nearly hit 7.40.

Weston Nakamura gives an excellent overview and puts this recent bout of intervention into context:

Weston believes these actions were meant to stymie default risks in USD-denominated bonds of Chinese property developers. Maybe, but as Kyle Bass points out in his recent address at the Hudson Institute, there might actually be Geopolitical reasons behind the much higher 65% default rate of USD-denominated bonds vs. the 21% default rate of onshore bonds of the same Property Developer credits:

Regardless of underlying motivations, these actions don’t appear to be coming from a position of strength and smack of desperation to me.

What is the PBOC afraid of?

I believe that China needs a weaker CNY but fears losing control of the situation and is desperately trying to manage the optics against a Disorderly Devaluation; similarly, the raison d’etre for the HKD Hard Peg no longer exists, but the PBOC/HKMA fear the repercussions of breaking the peg.

In other words, The Donkey Kong Dollar Peg looks wobbly.

On the HKD side of things, one of my eagle-eyed Substack subscribers found this excerpt from a recent BofA report, italics mine:

The use of the HKMA's discount window is rising since April 2023. Exhibit 9 shows the days when the HKMA increased aggregate balance via the discount window since the first weak-side CU event for this cycle, starting May 2022. For this analysis, we only include the injections which were larger than HK$100m to see more clearly the relationship between the use of discount window, aggregate balance and the spread between the overnight HIBOR and the Base Rate. We can see, in nominal terms, that the use of discount window is approaching levels similar to late-2019. Rising use of the discount window shows increasing payment failure among Hong Kong banks. However, there is a distinctive difference between the uses (then versus now). In late-2019, due to the year-end funding squeeze, market rates (i.e. overnight HIBOR) were higher than the HKMA base rate, which provided the Hong Kong banks an incentive to trigger the discount window versus borrowing overnight from other banks. However, in April and May 2023, overnight HIBOR fixings remained far below the Base Rate but still resulted in a relatively large tapping of the discount window. This may be a sign of friction in the interbank clearing system as Hong Kong banks are unable to settle payments before day's end resulting in the triggering of the discount window. Moreover, relative to 2019, the absolute level of aggregate balance is now smaller (HK$45b now versus HK$54b in 2019) and the nominal value of payments is also larger given monetary inflation after the COVID period. The Hong Kong banking system will increasingly rely on the HKMA funding to bridge payments. These combined observations suggest that the Hong Kong banking system will increasingly be dependent on the HKMA's discount window to bridge payment as funding conditions remains tight and deficit banks scramble for funding. The scramble for funding will be particularly acute during quarter ends when overnight funding cost is seasonally increased.

The HKMA’s ceding of monetary authority to the Fed by dint of its HKD Peg is creating fractures in its banking system, as this article explains.

Here are some quotes from my aforementioned “Ball In A China Shop” piece from March, specifically about the HKD peg:

If push came to shove for the HKMA, I would guess that the PBOC would have to make a choice on whether or not it steps in. And that leads us back to the question of not whether it can (potentially bolstered by Setser’s Shadow Reserves thesis) but whether it truly wants to, given the strong simultaneous short-term Cyclical headwinds superimposed upon long-term Structural/Demographic headwinds.

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Conclusion

In addition to the Macro data I have been tracking, the anecdotal gut-checks from friends on the ground in China indicate that things are bad.

Another friend in the Real Estate business corroborated this and said that even folks who are very “pro-CCP” are not making money, implying that even the well-connected are not exempt. The same friend said that he is once again seeing scared Chinese money (that has somehow circumvented China’s official $50k/household outflow caps) bidding for Single Family Homes in SoCal. What a strange, distorted Macro environment, where mostly Deflationary forces emanating out China are somehow exerting some Inflationary forces in certain pockets of the US economy!

Alas, I am not so sanguine on the impact on global Oil/Commodities demand.

This is the reason why I continue to hold short positions in both CNH and HKD as “Chicken Hedges” against my Long-Term Oil PE exposure, which I explained in this interview:

Bottom Line

The outlook for the Donkey Kong Dollar Peg (CNY, CNH, HKD) looks asymmetrically bad, and I don’t mind jumping over a couple barrels to reach the Princess. If Donkey Kong crashes, the reverberations will be felt in every Asset Class in every corner of the world.