When China allowed its currency to devalue around 3% in mid-August, it caught the investment world by surprise. And if legendary investor Jim Rogers is right, China’s process of freeing its currency is just beginning.
When the renminbi fell over the summer, China allowed markets to have a real say in its currency for the first time in 20 years.
Most currencies around the world float freely… that is, market forces (supply and demand) dictate the price of a currency relative to other currencies.
So if investors believe that a country’s economy is doing well and there will be a lot of demand for the currency (for example, to buy the country’s exports), investors will sell one currency and buy the one they think will strengthen. They’ll also buy a currency that offers a higher yield (the interest rate on cash) than another currency.
But this isn’t the case in China. For decades, the government, rather than markets, has dictated the value of the renminbi. China’s central bank buys and sells the country’s currency (and restricts how others can buy and sell it) in order to keep the renminbi exchange rate in a tight range.
As a result, until recently, the renminbi has steadily increased in value against the U.S. dollar. For decades, that’s been one of the few sure things in international finance. That’s meant prices in China – for goods and for labor – have risen sharply when computed in other currencies.
Jim Rogers thinks this is all going to change. Jim is one of the most successful investors in history. He co-founded the Quantum Fund, one of the world’s most successful hedge funds, with renowned investor George Soros. After the fund generated returns of 4,000% over ten years, Rogers quit full-time investing.
He went on to drive around the world, literally, and write several excellent books that blend travelogue, investment insight, and political commentary. Today, Jim is viewed as one of the founding fathers of the boots-on-the-ground approach to investing in emerging and frontier markets around the world. So when he talks about the big-picture trends that are shaping world markets, it’s worth listening.
Jim told me recently – over sparkling water on a particularly hot Singapore afternoon – that he thinks China’s August devaluation was only the beginning. He says that the renminbi will be a currency that will be as freely available to buy and sell as the Singapore dollar.
“It’s a question of time before the renminbi is freely convertible,” he told me. Governments always think they’re smarter than markets. But they never are.”
(Years after Jim left the Quantum Fund, George Soros proved that markets always win, when he “broke” the Bank of England in 1992. Soros and other investors successfully speculated against government support of the British pound, and made billions of dollars in profit.)
China is already moving in the direction of liberalizing the way it treats its currency. Late last month, the International Monetary Fund (IMF) said that the Chinese renminbi would be added to the Special Drawing Right (SDR), a basket of the world’s four most liquid and freely traded international currencies. (As we wrote, this is a big deal – but not that big a deal, yet.) That will open the door to the renminbi being held as a reserve currency by central banks around the world. For both economic and political reasons, China wants to be accepted into the IMF currency club.
But that’s only possible if the Chinese currency is freely convertible. And if it’s freely convertible, the government won’t be able to control the exchange rate. In that case, the 3% devaluation in August will have marked the start of a big change in China’s place in the international economy.
This is already happening. Late last week, the People’s Bank of China said it would change the way it measures the level of the renminbi. In the past, it’s been measured against the U.S. dollar. But now it’s going to measure it against a group of currencies (which will include the U.S. dollar) instead. “China has paved the way for a further weakening of its currency by announcing changes in how it measures the renminbi’s value,” according to the Financial Times. Last week, the renminbi lost 0.8% against the dollar, which is a big move for the renminbi.
Jim told me it’s a matter of time before the Chinese government lets the renminbi float. If he’s right, markets are going to be more volatile than usual in coming months as China continues to adjust its currency policy. The Chinese economy is big enough that small policy changes can have a big impact on the global economy. It can have an even bigger impact on global stock markets.