China Enters The Big Leagues - December 3, 2015

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Greetings,

To the surprise of absolutely no one, the IMF decided on Monday to include Chinese Yuan in its Special Drawing Rights (SDR) basket of currencies. Inclusion in the largely ceremonial basket is a solid endorsement for China, as the world’s second largest economy crawls towards an open capital account. It’s the first change in the SDR’s composition since 1999, when EUR replaced the Deutsche mark and French franc, and Beijing worked with the IMF for years to make it happen. The only controversy is whether or not CNY actually belongs in this group, or if the IMF is just appeasing the Chinese. Eswar Prasad, a former head of the IMF’s China team, said that had the IMF review been applied to any other currency, it would not have qualified.

In August, the IMF said it expected the PBoC bring CNY “quite close to free-floating” within 2-3 years. In order for that to happen the central bank will have to increase liquidity, and it’s already made some decent headway. CNY was the 5th most-used currency in payments this September. There are now 3.1 trillion CNY in bilateral swap lines between the PBoC and 32 other central banks. These are solid steps, but opening up Chinese equity and bond markets to foreigners is a necessity for sufficient liquidity.

And that’s why this announcement is important. The potential for capital inflows into China is staggering. China’s interbank bond market is the third largest in the world, and that’s without foreign involvement. Eventually, we should expect to see CNY reach a double-digit share of global reserves — inflows on the order of $800 billion to more than $1 trillion. Even a conservative estimate of reallocating 1% of global reserves each year would mean about $80 billion inflows annually. Last month, benchmark provider MSCI said it would add 14 U.S.-listed Chinese firms for the first time to indices that hold $3.5 trillion in assets from passive investors. As a result, the firm estimates investors will buy $99 billion in shares of the soon-to-be included Chinese firms. That’s just 14 companies…

Theoretically, there should be more foreign involvement already. The launch of a stock-trading link between Hong Kong and Shanghai a year ago was meant to be a landmark in the opening up of China’s financial markets, allowing more foreign investors than ever to own Chinese shares. But the anticipated flood of money hasn’t materialized as expected. Just 120.8 billion CNY ($19 billion) has been drawn into the scheme since last November, only 40.3% of the total permitted under the program. Why? Mainly the government’s ill-advised involvement in the stock market this year, including encouragement of margin lending on the way up, heavy-handed stabilization tactics during the crash, and punishing brokers in the aftermath.

If the Chinese government can enter global capital markets smoothly without scaring-away investors, everyone stands to benefit. China could use the inflows, and investors would love the relatively high-yielding (if risky) investments. The real test will be how these reforms hold up during a crisis. It’s easy to talk about embracing free markets, but they can be unforgiving.

The Cup & Handle Fund is up around +5.0% YTD, and +6.5% Y/Y. October was our second down month since inception, but we made that back in November. We’re sticking with some relative value bets that have worked very well recently. I’m hard at work on the December letter, which should be out on Monday. If you’d like to start receiving these letters click here.


With that I give you this week's letter:

December 3, 2015


As always, if you have any questions or comments or just want to vent, please send me an email at mike@cup-handle.com.

Until next time, tread lightly out there,

Michael Lingenheld

Managing Editor – Cup & Handle Macro

Posted to Cup & Handle Macro Research on Dec 02, 2015 — 1:12 PM
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