In recent commentary, Stephen Jen, the CEO of the British hedge fund Eurizon SLJ Capital and a reputable theorist known for his "Dollar Smile Theory," has made a noteworthy prediction regarding the financial dynamics between the United States and ChinaJen positions that, as the United States approaches a cycle of interest rate cuts, Chinese companies could potentially liquidate up to one trillion dollars in dollar-denominated assetsSuch a move, he argues, could facilitate a corresponding appreciation of the Chinese yuan by as much as 10%.

His insights came into focus after Federal Reserve Chair Jerome Powell announced, during the recent Jackson Hole Symposium, the readiness to lower policy interest rates in the United States, signaling a probable rate cut in SeptemberJen interprets this monetary policy shift as an opportunity for a substantial rise in the value of the yuan against the dollar.

The logic that underpins this prediction is rooted in a well-understood economic principle

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One can argue that a decrease in interest rates typically stimulates the domestic equity markets, particularly in A-shares in China, as capital commonly flows back into these markets in anticipation of better returns when the dollar weakens.

However, Jen also highlights several potential systemic risks within the U.Sstock market that might accompany these interest rate adjustmentsThe first risk is that of liquidity draining from equities to bondsAn interest rate cut would enhance the attractiveness of U.STreasury bonds, which could siphon off capital from stocks as investors look to secure their portfolios in what they perceive to be safer investmentsThe renowned investor Warren Buffett, for instance, holds significant cash reserves, which raises speculation about whether that cash may soon be deployed into the Treasuries market.

The second risk is centered around the potential depreciation of the dollar

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When interest rates are lowered, the spread between U.Sand foreign interest rates tightens, increasing the likelihood that international investors will retreat from U.Sassets in dollar terms to mitigate potential currency losses due to a declining dollar.

Lastly, there exists a self-weighting mechanism in the stock market, particularly evident in the current bullish trends observed in U.SequitiesMuch of this growth is driven by speculative valuations rather than tangible earnings growth, particularly in sectors like artificial intelligence, where profitability remains largely theoretical at this stage.

Jen asserts that, with the onset of rate cuts, capital will likely begin to exit from the dollar-driven marketsThis leads to a compelling question: with current global economic conditions, where else can such capital flow positively? It seems implausible to argue against a rebound in China’s A-shares even amidst a broader market correction, purely from the basic principles of capital movement.

Still, one cannot help but be curious about the foundation upon which Jen's estimation of one trillion dollars is built

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Peering into the global narrative, we discern that since the onset of the pandemic, Chinese enterprises might have amassed over two trillion dollars in offshore investments, with the yield rates on these investments being potentially more favorable compared to those denominated in yuanAs the Federal Reserve's rate cuts take effect, this could diminish the dollar's appeal, paradoxically entailing a reinvestment of approximately one trillion dollars back into the Chinese market.

Jen also suggests that if crude oil prices continue to plummet alongside an overvalued dollar, coupled with concerns regarding U.Sfiscal deficits and a potential soft landing for the economy, the Fed might resort to more aggressive rate cuts than many analysts currently anticipateIn such conditions, the yuan could experience a significant appreciation of up to 10%.

However, if the People's Bank of China opts not to intervene in the dollar’s liquidity flow, the yuan's appreciation may indeed exceed this projection

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Furthermore, Jen highlights that the timing of such an event does not strictly hinge upon the rates being cut but instead may occur during accelerated depreciations of the dollar in a potentially stabilizing U.Seconomic environment, where inflation abates without triggering a recession.

Nevertheless, policymakers in Beijing remain cautious regarding excessive yuan appreciation, which could jeopardize China's export competitiveness and hinder the already sluggish economic recovery.

In absorbing Jen's rationale, while I find substantial merit in his logic concerning capital flows and market dynamics, I harbor reservations regarding the quantifiable figures he providedSeveral financial institutions have conducted their evaluations, which yield less dramatic estimatesFor instance, Macquarie Group Limited posits that since 2022, Chinese exporters and multinational corporations have accumulated around five hundred billion dollars in overseas assets, while Australia and New Zealand Banking Group Limited places the figure lower at an estimated four hundred thirty billion dollars.

When examining China's trade figures over the past four years, a goods surplus of approximately 19.12 trillion yuan has been recorded alongside a services deficit of 2.38 trillion yuan, amounting to an overall gain of 16.7 trillion yuan, which roughly translates to just over two trillion dollars

However, I am compelled to inquire about the net capital outflows from ChinaFrom the first quarter of 2020 to the first quarter of the current year, net outflows totaled around nine hundred forty-six billion dollars.

During this period, China's current account expanded by a staggering one trillion three hundred thirty billion dollars, while foreign reserves remained capped at around three trillion two hundred billion dollars, indicating no notable increaseThis discrepancy suggests a substantial portion of current account and trade surplus remains unconverted, implying that several billion dollars of capital have exited the country in dollar formAn additional note is that capital accounts reveal over a trillion dollars in net outflows, showcasing an increase in outward investment.

Ultimately, while the broad strokes of allowing two trillion dollars in incremental capital does not appear overly contentious, the feasibility of one trillion dollars returning remains open to debate