All was well in China until stocks began to plunge, and they would have continued to plunge if it hadn’t been for government intervention, which included the temporary banning of short-selling with the potential for arrests, a hiatus for IPOs, throwing good money after bad to prop up equities, encouraging investors to buy equities despite excessive debts and slowing growth, and pressuring state-owned banks to lend to failing businesses.
While all of this was taking place, China also had high hopes for special drawing rights and becoming a reserve currency, but the IMF has stated that no change is likely prior to September 2016.
The two above situations led to the Chinese government devaluing its currency by almost 2% against the U.S. Dollar. This might not sound like a big move, but the biggest daily move prior to Aug. 11, 2015 was 0.16%. Since 2005, the Renminbi has appreciated 25% against the U.S. Dollar, which gave the Chinese government room to move. But will it matter? (For related reading, see: How Does China Manage Its Money Supply?)
Red Dominoes
China is the second-largest economy in the world, and many people felt that it would surpass the United States as the largest economy in the world at some point this century. If you were to look at long-term trends, excessive leverage, and overbuilding to show GDP growth, you could have concluded that this wouldn’t take place. (For more, see: Is Now the Time for Chinese Stocks?)
The United States is in a shaky economic situation right now, but the United States also has a way of finding its way back to prosperity. When you combine American ingenuity with its vast natural resources, the United States is still the favorite to be the largest economy in the world throughout the 21st Century. However, there will be some very difficult times ahead due to deflationary forces.
While China might not reach deflationary levels, it’s not an impossible scenario. Currently, estimates are for China to grow at 7% in 2015, but this seems highly unlikely. The only way China grows at 7% is if the Chinese government finds a way to skew the number. The only reason China grew at 7% in the first half is because of financial services performing exceptionally well as equities soared higher. Equities are no longer soaring. (For more, see: Should Investors Be Bearish on China?)
Look at July as a small sampling for the Chinese economy. Exports declines 8.3% and auto sales slid 7%. One of the reasons the Chinese government devalued its currency was to make its goods for affordable for international buyers. (For related reading, see: How to Invest in China's Auto Industry.)
Also in July, state-run banks loaned a total of $240 billion. The last time state-run banks loaned that amount was 2008. What does that tell you? Also consider that all those Chinese companies that own debt in U.S. Dollars are going to get slammed. (For more, see: China Owns U.S. Debt, But How Much?)
How to Play It
It’s possible that this crafty move by the Chinese government leads to a temporary bounce in Chinese equities, which will then lead to the false belief that the Chinese economy is capable of a sustainable v-shaped recovery in a global economy where central banks are desperately fighting against deflation.
Over the long haul, there is little doubt that Chinese equities will head south once again. And again, the Chinese government will probably move in to prop up the market. This can lead to a fitful trading experience. Eventually, the Chinese government will run out of ammunition and natural forces will take over, bringing Chinese equities much lower than where they currently stand. (For more, see: Why China's Currency Tangos With the USD.)
Ironically, the Chinese are known for patience, but despite the high likelihood of the Chinese economy bouncing back in the future thanks to demographic trends (Tier 2 and Tier 3 cities being modernized + massive consumer population), the Chinese government wants to extend the current economic bubble as long as possible. From an investment perspective, a much better option exists. (For more, see: Top 3 ETFs for Investing in China.)
Trading currencies might not lead to the same kind of upside potential you would see with shorting Chinese stocks, but it will lead to a lot fewer headaches. That may sound strange considering currencies are seen as high risk and unpredictable, but almost everything in the world is working in favor of the U.S. Dollar right now. (For more, see: China’s Economic Indicators, Impact on Markets.)
Prior to this event, we had the ECB and BOJ printing money as if there was no tomorrow, which coincided with the anticipated event of deleveraging in the United States – this would lead to a strengthening Dollar. Now we have the Chinese government devaluing its currency, which strengthens the U.S. Dollar even more.
This is not a recommendation. If you want to invest in the U.S. Dollar, then please do your own research prior to doing so. My opinion is that the U.S. Dollar will move higher in the near future. I also believe that Chinese equities can only be propped up the government for a limited amount of time. The problem here is that the timing is difficult, which makes for a high-risk trade.
The Bottom Line
The Chinese government is doing everything in its power to buy time. Prior to the first wave of the crash in the Shanghai Composite Index, the Chinese government fooled everyone into believing it held a full house, but investors are beginning to see that it was nothing but a stone-cold bluff.
