Ian Lapey (Third Avenue): Where is Global Value?

Thursday, March 25th, 2010

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Over the past twenty years, New York based Third Avenue Management has outperformed the US market by six percent annually. Third Avenue manages Manulife Investment’s newly acquired AIC Global Focused Fund.

Watch this manager discuss where he’s finding value today.

Ian Lapey discusses his firms “deep value” investment style pointing out that they like “safe” and “cheap.”

Safe – 1) Strong financial position, high quality assets, relative absence of liabilities. 2) Competent management team – impressive long-term track record, whose interests are aligned with outside passive minority shareholders, like ourselves. 3) Understandable business – our investment process is very document driven, we need to have very good disclosure, and we need to be able to understand after a review of the financials in order to invest.

Cheap – “A significant discount from the intrinsic value or private market value. What we try to do in valuing the company, we put on the business person’s hat, figure out a conservative valuation of the company as either a private entity or a takeover candidate, and then pay a significant discount to this private market value. We also want the business not only to be trading at a significant discount, but we want the business to have very attractive long term growth potential. So say, double digit long-term potential to compound net asset value.”

Where in the world is Third Avenue finding value?

Highest concentration in Hong Kong – investing in several Hong Kong Real Estate operating and investing companies, accounting for about 24% of the portfolio. About 20% of the portfolio is in the U.S. – a mix of high-tech companies with huge cash rich balance sheets, and a large investment in BNY Mellon a huge asset management custodian. 11% in Canada – Forest products company and a couple of energy names.

Hong Kong real estate companies represent the biggest bet in the portfolio – these companies all have extremely strong financial positions, net debt to capital ratios no higher than 15%, the management teams have impressive long term track records, and own between 30-50% of the outstanding shares of the companies, so their interests are very much aligned with ours – and the stocks trade at a significant discount to our estimate of NAV. So currently today, the best examples for us; the most fertile ground for safe and cheap, is in these Hong Kong real estate and investment companies.

Henderson Land
Our biggest position is Henderson Land, a Hong Kong based company with very high quality assets primarily in the form of income producing real estate in Hong Kong, and a small but growing presence in mainland China. They also have a huge agricultural land “bank” in Hong Kong which should be a huge driver of growth for the company, and they own 39% of Hong Kong and China Gas, the sole provider of piped gas to Hong Kong, also with a presence in mainland China. The Chairman and CEO, Li Shau-Kee owns 54% of the common stock, so his interests are very much aligned with ours, and he has a great long term track record.

BNY Mellon
BNY Mellon is extremely well financed, and though they were battered a bit by the financial crisis, they weathered the storm quite well because they have very significant cash generative core businesses, i.e. asset custody, where they’re the leading global custodian, with $22-trillion under custody, and asset management, where they have over $1-trillion in AUM. These businesses have performed very well, in the bear market and financial crisis, and in fact, their assets under management were up over 20% in the first quarter of the year, and assets in custody were up over 10%.

Source: Clientinsights.ca

Tags: Asset Value, Balance Sheets, Bet, Bny Mellon, Business Person, Canada, China, Competent Management Team, Custodian, Financial Position, Financial Positions, Forest Products Company, Global Value, Henderson Land, Intrinsic Value, Manulife, Minority Shareholders, Net Asset Value, Private Entity, Private Market, Quality Assets, Relative Absence, Takeover Candidate, Third Avenue, Value Investment Style
Posted in Bonds, Canada, Canadian Stocks, China, Markets | No Comments »

Postcard from China – Labour Shortfall

Tuesday, March 23rd, 2010

by Richard Gao, Portfolio Manager, Matthews International Capital Management, LLC.

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I recently spent two weeks visiting companies in various cities in China, including Shanghai, Chongqing, Xiamen, Beijing, Xi’an as well as in Hong Kong and Macau. In general, most companies have seen a substantial increase in momentum to their business growth so far this year. Companies in a wide range of industries—tourism, machinery, infrastructure, retail, health care, telecommunications and software—all indicated strong growth, not only compared to the same period last year (which was at a low level), but also compared to the high levels of the fourth quarter of 2009. Meanwhile, banks are more cautious about lending this year, especially with regard to property developers. Contrary to last year when the central government initiated a massive stimulus program to boost the economy, the challenge for China this year is to maintain economic growth yet avoid overheating.

During my visit to the western city of Chongqing, I was amazed to find an article in a local newspaper about a factory owner who had just hired three new employees from an employment center. In the accompanying photo, the owner was happy and smiling, having driven his luxury car to recruit workers. Managers themselves need to go out and find labor in China these days! Indeed that was news.

This apparent phenomenon of a labor shortage in China is becoming severe. Not only is this shortfall in traditionally labor-intensive export areas such as the Pearl River delta in the south and the Yangtze River delta in the east, but also in the country’s western and northern regions. Managers from several export-oriented industrial companies with factories in Guangdong told me that despite 15% to 20% wage hikes for factory workers, firms are still experiencing difficulty recruiting workers.

One of the main reasons behind the labor shortage is that there are increasingly more job opportunities inland. Factories in the coastal regions rely heavily on migrant workers coming from the country’s mostly rural inland areas. As these areas become more prosperous, migrant workers who might have previously relocated in search of work are staying closer to home. In addition, it is also becoming harder to find young Chinese who want to work in factories as China’s younger generation is generally more optimistic about their career options.

After years of being the world’s low-cost producer, China no longer seems to have a cheap labor pool as its heartland catches up with its more modern coastal regions. Better living standards throughout the country will surely lift China’s domestic consumption over the long term. However, for the time being, factories that rely on cheap labor should likely see their already thinning profit margins come under further pressure. This will likely force them to either exit the industry or try to move up the value chain and increase productivity.

Richard Gao
Portfolio Manager
Matthews International Capital Management, LLC

Tags: Business Growth, Capital Management, Capital Management Llc, China, Chongqing, Cities In China, Emerging Markets, Employment Center, Export Areas, Guangdong, Labor Shortage, Luxury Car, Matthews International, Northern Regions, Pearl River, Pearl River Delta, Portfolio Manager, Property Developers, Richard Gao, Substantial Increase, Xiamen, Yangtze River, Yangtze River Delta
Posted in Canadian Stocks, China, Markets | No Comments »

Jim Rogers on China, Trade War, and the Loonie

Saturday, March 20th, 2010

By Dian L. Chu, Economic Forecasts & Opinions

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In a Business News Network interview on Mar. 18, Jim Rogers, famous investor and creator of the Rogers International Commodities Index (RICI) speaks about the recent currency and trade confrontation between the US and China:

“If [you] slap somebody in the face, they are going to take a defensive attitude to save the face…I do not know why the United States is doing this in public, ..that never worked, especially with Asians.”

Rogers – Float to Grow

Rogers thinks the U.S. should try to explain to the Chinese that it is to their benefits to allow some flexibility in their currency. For instance, yuan’s appreciation will in turn lower the cost of China’s imports and its supply chain.

He acknowledges that the Chinese understand that their currency policy will need to change eventually in order to become a major player on the world stage.  Although the yuan has appreciated some in the past few years, but it is just not up to the expectation of the U.S.

Rogers estimates Chinese renminbi (yuan) could replace the dollar as the next reserve currency of the world in the next 10 to 20 years.

My Take – Yuan Appreciation Could Increase U.S. Deficit

It is consensus that the United States has strong economic fundamentals attracting high rates of capital investment. On the other hand, the U.S. has a chronically low household saving rate, and recently a negative government saving rate as a result of the budget deficit.

As long as Americans save relatively little, foreigners will use their savings to finance profitable investment opportunities in the United States; the trade deficit is the inevitable end result.

As pointed out in my previous article, renminbi appreciation will unlikely achieve the intended effect of reducing the bilateral trade deficit, and could instead have a negative impact.  Unless there is a significant shift in the domestic consumption/demand levels, the U.S. will need to procure either still from China, or from some other sources, but now at higher prices due to the yuan revaluation.

Rogers – A Non-American Style China Real Estate Bubble

Currently, the excessive liquidity trapped in the reserves is essentially causing various bubbles developing in many Chinese coastal and urban real estate sectors. Rogers sees the real restate bubble in China is one of price instead of credit. As such, a bubble burst will likely have a much more muted effect in China than the housing crisis in the U.S.

Rogers – Long Loonie, Short U.S. Bond

Rogers believes the Canadian dollar (loonie) is “one of the soundest currencies in the world on a fundamental basis.” He has owned the Canadian loonie “for years” as a long-term play, with his recent dollar positions as a short-term momentum play.

He also says the only other bubble in the world he sees right now is in the U.S. long bond market, and he expects to short that market in the “foreseeable future.”

“The concept of how anybody would lend money to the United States government for 30 years, in U.S dollars, is just incomprehensible to me…even at 6%, it’s just staggering.”

My Take – Many Bubble Candidates Ahead of China

I’ve dismissed the so-called “Chinese real estate bubble crash” catastrophic scenario in several of my articles.  Admittedly, China’s real estate sector is currently in the overheating zone; however, a U.S.-style bubble is less likely primarily due to a much lower buyer leverage as compared with the U.S. and a market structure null of debt securitization.

As for a bubble burst, there is currently no shortage of highly qualified candidates in the Western Hemisphere, with more up-and-comers waiting in the wing.  For instance, Europe’s PIIGS countries (Portugal, Italy, Ireland, Greece, and Spain), the U.S. and the Great Britain, based on recent rating agencies’ warnings, just to name a few.

Rogers – Protectionism = End Game

“Nobody has ever wanted a trade war, as it is the end of the whole game and disastrous for everybody’s concerns.”

Rogers thinks current protectionism originated in the U.S. has a contagion effect, which will likely exacerbate global geopolitical and trade tensions. He cautions that just as the U.S. protectionism in the 30’s did not help with the Great Depression, the current protectionist measures will unlikely have that much positive effect on the economy.

My Take – Serious Trade War Brewing

A synchronized recovery in China and the U.S., as we are presently witnessing, will undoubtedly heighten the competitive currency devaluation. It appears Washington will argue in perpetuity that the renminbi is undervalued as long as U.S. imports from China exceed our exports to China.

Meanwhile, Paul Krugman’s call of labeling China as a “currency manipulator” is being increasingly speculated to be included in the Treasury Department’s semi-annual report on foreign-exchange-rate practices, due to be released in April.

Tensions and trade feuds are bound to persist since the U.S. places more emphasis on the short-term “fixes” through price and the yuan exchange rate; whereas the Chinese put more emphasis on medium and long-term structural and institutional change.

眼中有敵，天下皆敵；眼中無敵，天下無敵 (One’s attitude determines how one sees things) ~ Chinese proverb

Video Source: You Tube

Tags: Bilateral Trade Deficit, Budget Deficit, China, China Trade, Chinese Currency, Chinese Renminbi, Commodities, Consumpt, Consumption Demand, Currency Policy, Defensive Attitude, Domestic Consumption, Economic Forecasts, Economic Fundamentals, Emerging Markets, International Commodities Index, Jim Rogers, Loonie, Network Interview, Profitable Investment Opportunities, Renminbi Yuan, Reserve Currency, Rici, Rogers International Commodities Index, S Rogers, Trade War
Posted in Canadian Stocks, China, Commodities, Markets | 1 Comment »

How will an RMB revaluation affect China, the US, and the world?

Thursday, March 18th, 2010

by Michael Pettis, author of China Financial Markets blog, and professor at Peking University’s Guanghua School of Management.

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The Chinese new year has only just started, and already trade tensions are ratcheting up. This is perhaps appropriate — astrologers tell us that the year of the Tiger is often a year of instability and conflict — and I suspect things will almost certainly get worse. The timing of various domestic political events in the US, China and Europe will make it harder than ever for any of these countries to back down before 2012 (by which time, presumably, the world will have ended anyway).

Last Thursday President Obama made a fairly strong speech in which he urged China to adopt a “more market-oriented exchange rate”. The timing of the speech was important. On April 15 the US Treasury department will release its report stating whether or not China is a “currency manipulator”, and it is hard to believe that the Treasury department is not facing some pretty stiff pressure.

China’s response to Obama’s speech was pretty rapid and pretty angry. According to an article in the Saturday issue of the Financial Times
Su Ning, a deputy governor of the Chinese central bank, said the US should not “politicise” China’s currency policy…“We always refuse to politicise the yuan exchange rate issue and we never think that one country should ask another for help in solving its own problems,” Mr Su said on Friday.
What it means to “politicise” the currency policy wasn’t made clear, but on Sunday Premier Wen also jumped into the fray. He denied that the RMB was undervalued and, in the words of an article in Monday’s Wall Street Journal, added the following:
“I can understand that some countries want to increase their share of exports,” Mr. Wen said, in an apparent reference to the Obama administration’s goal. “What I don’t understand is the practice of depreciating one’s own currency and attempting to press other countries to appreciate their own currencies solely for the purpose of increasing one’s own exports,” he added. “This kind of practice I think is a kind of trade protectionism.”
Wen is absolutely right. Undervaluing or depreciating a currency certainly is a form of trade protectionism, but that, I think, is exactly the point. In a world of sluggish growth and rising unemployment, everyone’s currency policies are legitimately going to be scrutinized over whether they constitute trade protection.

An article in the People’s Daily has Wen also warning that “China opposes accusations and even forceful measures that press for yuan appreciation, which will not benefit the exchange rate reform.” The claim that external pressure will never advance reforms in China is now much debated in Europe and the US, and may be less widely believed abroad than it has been in recent years. We’ll see.

These are murky political waters into which I do not want to dip, but it is hard to escape the politics of the debate. The same issue of thePeople’s Daily had another article pointing out that US debate on the currency was driven mainly by domestic considerations and that the only reason Obama brought up the subject of the RMB was to address domestic polls.
“The U.S. government wishes to eliminate trade deficit and ease its high unemployment rate by pushing yuan appreciation. That was only its wishful thinking,” said Yi Xianrong, an expert with Chinese Academy of Social Sciences (CASS).

…The saying that “undervalued yuan leads to global trade imbalance” cannot stand up to close scrutiny. Zhao Qingming, a researcher with China Construction Bank stressed that imbalance of an economy’s deposit and investment was the fundamental reason for trade surplus or deficit. Exchange rate has only minor influence. In fact, yuan appreciation brings more adverse effects to western countries than positive ones. In the past tens of years, because of the yuan devaluation and export rebate policies, western countries, to a large extent, were able to enjoy low inflation, low living cost, and current standard of living, and western governments were able to reduce financial deficit and allow their people to consume excessively.
There is, as always, a certain amount of nonsense in these articles. For example the exchange rate itself affects the ratio between savings and investment, so while the first part of Zhao’s statement is more or less right — although not as a “fundamental reason” but rather as part of an accounting identity — the second part is certainly wrong and probably meaningless. More interestingly, it seems a little weird to argue that one of the benefits that China has provided the world with its undervalued exchange rate is low consumer prices that allow countries like the US “to consume excessively”. Aside from the fact that this pretty explicitly acknowledges that the currency is undervalued, since excess consumption is exactly the problem in the US, and since Chinese per capita consumption is much less than 10% of that of the US, it seems that China should be more approving of US attempts to return the favor and allow Chinese consumers the benefit of subsidized US prices.

Everything is politicized

Still, I do think the People Daily’s article is right to say that the RMB is becoming an important domestic issue for Obama, and that it is domestic US politics that is driving much of the recent noise and the rancor. Obama’s popularity has dropped considerably, and ahead of the upcoming elections he needs to show that he is addressing fundamental economic problems. And of course it is also always easy to get votes by bashing foreigners — this is one of the many attitudes that the US and China share.

But even though the People Daily’s criticism is correct, perhaps that doesn’t change anything meaningful. The concern over the effect of the RMB on US employment may still be a perfectly valid one, and the fact that Obama is under domestic pressure to address the currency is not an especially good reason to dismiss his concerns. On the contrary. Obama has little wiggle room, and as Paul Krugman pointed out in a fiery, and probably influential, speech last Sunday, the US may hold the stronger cards in any showdown. According to the relevant article in Business Week,
Krugman said China’s currency policy has a “depressing effect” on economic growth in the U.S., Europe and Japan, as measured by gross domestic product. If China’s currency, the yuan, were not undervalued, it would have a “significant” impact on the global recovery, he said. “If we could get some change in China’s currency policy, it would help the world,” Krugman said today at an Economic Policy Institute event in Washington.

…Krugman said the world economy wouldn’t be hurt, and could benefit, if China were to sell off a large portion of its dollar-denominated assets. He said that if China were to sell all of its U.S. investments, it would help the economy by acting as a form of quantitative easing and fighting a “liquidity trap” that has recently been affecting the U.S. economy.

“We should not be afraid of what the Chinese might do if we pressure them to stop this currency manipulation,” Krugman said. At the end of 2009, China was the top foreign investor U.S. government debt, with holdings of $898.4 billion in Treasury securities. Krugman said the U.S. may need to get more aggressive in its negotiations with China, perhaps by treating the exchange- rate issue as a countervailing duty or other export subsidy. “Without a credible threat, we’re not going to get anywhere,” he said. “The chance that we would trigger a trade war is very small and it’s hard to see any alternative.”
Krugman elaborated further Monday in the New York Times in anarticle, and then in a follow up article Wednesday, both of which are likely to be much quoted and widely read. Although Premier Wen noted again in his speech Sunday that China is “worried” about the value of its US dollar reserves, perhaps as a warning that China would counteract any US trade move by selling off USG bonds, Krugman doesn’t seem especially worried about this threat.

He may be right. Aside from the fact that it is not clear how China can dump Treasury bonds, he claims that it would only help the Fed in its quantitative easing, and would probably do far more damage to Europe (since China would presumably have to buy euros) than to the US.

The latter point is almost certainly correct. China’s Selling dollars and buying something else would allow the US to get even more bang for its protectionist buck, probably at poor Europe’s expense. I would also add that the main long-term impact of dumping USG bonds might be no more than to cause a liquidation of Chinese assets at very low prices, and an equivalent transfer of wealth from China to the US (or to others likely at some point to buy cheap dollar assets).

Remember that at the beginning of WW1 something similar happened. In an urgent attempt to raise gold reserves to pay for the war, in the late summer of 1914 European belligerents dumped onto US markets what amounted to a far greater share of US assets than China currently holds. This caused about six months of havoc, and many sleepless nights in New York and Washington. But the US responded by putting into place temporary capital and stock market controls, and when the dust settled, the net effect was one of the most massive short-term transfers of wealth ever recorded from one group of countries, the European belligerents, to another, the US. European dumping caused a collapse in prices, and US investors ultimately scooped up the assets up very cheaply.

That doesn’t mean that there will be no cost for the US if China dumps, but rather that the cost might be absorbed fairly comfortably over a reasonable time period. I suppose I will be very unpopular for pointing this out — especially with people in the US Treasury department and among Chinese cold warriors — but please don’t blame the messenger. I am just trying to use the limited historical precedents to figure out what is likely to happen. We have seen asset dumping before, and on an even larger scale, and the US capital market is deep enough that it might easily absorb it.

Where I disagree with Krugman is with his claim that the chance of triggering a trade war is small. In fact, the day Krugman published his article, 130 US Congressmen sent an open letter to secretaries Timothy Geithner (Treasury) and Gary Locke (Commerce) demanding that China be designated a currency manipulator. They called for duties to be imposed on Chinese imports to counter the effect of the undervalued RMB. This raises pressure significantly, and I am sure in the next week or two there will be a lot more. There are also strong rumors of some high-powered and relevant Congressional session next week. Stay tuned.

Of course regular readers of my blog won’t be surprised by any of this. The logic behind a prediction of trade war is almost unchallengeable, and the two countries are simply the two most visible in a world in which trade tensions must inexorably rise. Just ask the Germans and their European partners. Trade relationships will continue to get much worse, largely because the cost of trade war for high-deficit countries is so much lower than for high-surplus countries, and there seems to be no real attempt on either side to tone down aggressive actions or rhetoric. We seem to be caught in a downward spiral, and the longer it goes on the harder it is for anyone not to participate.

But while I think the economic effect of a tariff war on the US is likely to be smaller than many expect (and much smaller than that indicated by some of the outraged yelping I saw on a CNBC show dedicated to the subject today), and maybe even employment-positive in the short term, I do not think it is in the longer term interest of the US. I think trade war would be very painful for China, and forcing them into such a difficult position will poison the relationship for many years. This is likely to be the most important global relationship of the next few decades, and we really need a better way to resolve these very thorny issues, but that almost certainly isn’t going to happen.

To return to the People’s Daily article, I think many in China have argued that a revaluation of the RMB may have a significant effect on China’s trade surplus without having an equivalent effect on the US trade deficit. The same would be true of tariffs on Chinese goods. In either case, say many in Beijing, China loses, but the US doesn’t gain, so why is the US so determined to force this outcome?

I think this claim is probably correct. An RMB revaluation in itself might not have as big an impact on the US deficit as many think. To see why, I thought I would try to outline what the impact of an RMB revaluation would be for China and the world by asking a few basic questions and coming up with my best possible answers. Here goes:

What will the balance sheet effect of an RMB revaluation be on China?

There are broadly speaking two different classes of revaluation effects, the economic effect and the balance sheet effect. By the former I just mean the impact a revaluation will have on the future development of China’s economy, and by the latter I mean the immediate balance sheet losses and gains for China. Obviously these two are related.

Let me begin with balance sheet impacts. Two weeks ago I posted a rather long entry on that very subject. For those who can’t bear reading or re-reading such a long post, the quick answer is that, contrary to common perception, a revaluation of the RMB is likely to have a very small, and probably positive, overall balance sheet impact on total Chinese wealth.

That is, however, not the end of the story. There is a significant transfer within China of wealth, which will create clear winners and losers. Basically any economic entity that is explicitly or implicitly long dollars (by which I mean any foreign currency not pegged to the RMB) and short RMB, will lose in a revaluation. Conversely, any entity that is explicitly or implicitly long RMB, and short dollars, will win. In my earlier entry I pointed out that the PBoC is the single biggest loser. It is long, if correctly counted, roughly $3 trillion in dollars, against which it is short an equivalent amount of RMB.

Exporters and manufacturers in the tradable goods sector will also lose. Their expected revenues (which can be conceptually capitalized as an asset) are mainly in dollars whereas their expected costs are partly or mainly in RMB. This means that the value of future revenues will drop relative to the value of future expenses, and so they will take a loss.

Finally in that entry I pointed out that any wealthy Chinese individual with a substantial amount of honest or ill-gotten gains stuffed in bank accounts abroad will also lose. But I forgot to mention another big group of losers — anyone in China who has stockpiled inventories of goods or commodities whose prices are set in international markets. Those prices will immediately drop in RMB terms upon a revaluation, and if the asset purchases were financed by RMB borrowing or assets, there will be a loss. So to the extent that companies or individuals are stockpiling iron, copper, chemicals, or anything similar, they will also take an immediate loss.

So who wins in a revaluation? Nearly everyone in China who has at least part of his consumption basket consisting of imported goods, which basically means every one in China except pure subsistence farmers. Because the rise in the value of the RMB causes the price of all imports automatically to fall, a revaluation increases the wealth of Chinese households by increasing the real value of their current and future assets and income.

This is the key point. A revaluation shifts wealth from the Chinese government and the manufacturing sectors (and some wealthy Chinese) to Chinese households — which, by the way, is pretty much what is meant by “rebalancing” in the Chinese context. There are many other ways besides revaluation to shift income this way. The PBoC can raise deposit rates, wages can rise faster than productivity, companies can be privatized by giving away shares to the pubic, and so on. They all have the same effect. They shift resources to households and away from producers, infrastructure investment, and real estate developers. This allows household income to grow relative to national income, which ultimately increases the consumption share of GDP.

What will the economic effect of an RMB revaluation be on China?

So as things stand currently, the reason an undervalued RMB distorts international trade is because it transfers income from Chinese households (they have to pay more for imports) and subsidizes Chinese manufacturers in the tradable goods sector. This is one of the many mechanisms by which households are forced to subsidize production and investment.

A revaluation, then, is part of the rebalancing mechanism. It helps to reduce subsidies to manufacturers and returns the income to Chinese households, who can then increase their relative consumption. But there is a cost to this rebalancing. China’s current industrial policies sacrificed household income in order to spur manufacturing growth, and this had the obvious secondary effect of speeding up employment and, with it, household income. So in a way by repressing household income growth China was paradoxically able to achieve rapid growth in household income. Neat trick, eh?

But of course this growth wasn’t unencumbered. Much Chinese growth was based on concealing the true costs behind hidden subsidies, so that real economic growth was likely to be lower than recorded economic growth. More importantly, because everything in the world must balance, the imbalances within China required the opposite imbalances outside of China — which mostly meant in the US. Just as this global system implicitly taxed Chinese household consumption to subsidize Chinese manufacturing and employment growth, it also implicitly taxed US manufacturers in order to subsidize US consumers. American consumers got cheaper (foreign) goods, American manufacturers had to compete against lower (foreign) prices.

So Americans over-consumed and Chinese over-saved. The system worked well for quite a while, until, as happened with the Japanese case in the late 1980s, US debt levels and unemployment rose to economically and politically unacceptable levels.

For China and the US to adjust means both of them unwinding this trade-off. Beijing will have to enact policies that reduce the subsidies to manufacturers and return the income to Chinese households. But this automatically means depressing economic growth and, more importantly, depressing employment growth.

This shouldn’t be a serious problem if it happens slowly. As Chinese manufactures gradually lose their subsidies, they will rely more than ever on the consequent rising Chinese consumption, and so domestic consumption will replace subsidized foreign demand as the source of growth. Not only will China have a safer and more balanced economy, but it will be more innovative (consumption tends to drive innovation, not production) and much more efficient.

But China cannot adjust too quickly. If Beijing removes the implicit subsidies, including those caused by the undervalued exchange rate, too rapidly, that could force large-scale bankruptcies as Chinese manufacturers found themselves unable to compete globally or at home. If these bankruptcies forced up unemployment, then paradoxically even as the transfers from households to businesses are being reversed, household income would nonetheless decline as unemployment soared. In that case Chinese manufacturers would find themselves becoming uncompetitive in international markets just as domestic markets are collapsing.

The conclusion? A rebalancing is necessary for China, as nearly everyone in the leadership knows. This will involve, among other things, a significant revaluing of the currency. But rebalancing cannot happen too quickly without risking throwing the economy into a tailspin. That cannot and should not be a part of the US or Chinese policy objective. By the way if China is forced to revalue the currency too quickly, it will have to enact countervailing policies — lower interest rates, suppress wages, increase credit and subsidies — to protect the economy from falling apart, and these will exacerbate other imbalances that may be even worse than the currency misalignment. Currency revaluation, then, should be part of a broader adjustment process.

So how can the global system adjust?

If we abstract for a moment, and call all trade-deficit countries the United States, and all trade-surplus countries China, there are broadly speaking two ways the system can adjust. Remember that each domestic imbalance requires the other, so that if China adjusts, the US must adjust too, and if the US adjusts, China must adjust too. (For those more technically inclined, by the way, this is one of the points that Krugman makes in his second article, although using different terms: China’s exporting of capital must create capital imports somewhere else, and these capital imports are the obverse of the trade deficit.)

One way in which the system can adjust is for China to take the lead and reverse the policies that cause households to transfer resources to its manufacturers. As a consequence consumption will no longer be taxed to subsidize production. This will cause household consumption to rise as share of GDP — the good way by a surge in consumption, the bad way by a collapse in economic growth.

Either way, the rebalancing in China will force an equivalent rebalancing in the US. As the price of Chinese goods rise, the net impact will be to transfer resources from US consumers, who have to pay more for their imports, to US producers (US producers become more globally competitive). The rise in Chinese consumption relative to Chinese production would be necessarily matched by a rise in US production relative to US consumption. (Some readers will notice that I am ignoring the role of investment in economic growth, and of course changes in investment matter, but over the medium to long term the basic argument is unchanged.)

The second way in which the system adjusts is if the US drives it. The US can put into place policies that favor manufacturers at the expense of consumers. These include consumption taxes, manufacturing subsidies, penalties for consumer borrowing, subsidies for investment, or, more ominously, import tariffs. These can all have the same aggregate effect on the US trade account by shifting the relationship between how much Americans produce domestically and how much they consume. And of course as the US adjusts, China must also automatically adjust. Tariffs just on Chinese goods, by the way, will have a minimal impact on the US adjustment since trade may very well just shift to other countries.

Note that in either case both countries will rebalance, but rebalancing says nothing about how rapid economic growth must be. I addressed this in a blog entry last week when I discussed Japan’s dismal post-1990 rebalancing. In this context rebalancing just means that in China economic growth will be less than consumption growth, and in the US consumption growth will be less than economic growth. The problem is that China will try to adjust by pushing the cost of the adjustment onto the US, and the US will try to adjust by pushing the cost onto China. Each country can strive towards the good outcome (rapid economic growth) or find itself facing the bad outcome (declining consumption). This is why policy coordination and gradualism is so important.

Will a revaluation cause China’s trade surplus to decline?

Yes, all other things being equal, but of course all other things are not equal. Within China there are several things that will affect the trade surplus. Remember that the trade surplus exists because of the imbalance between Chinese domestic production and Chinese domestic consumption (technically the surplus is the difference between savings and investment), and so anything that affects the subsidies to manufacturers, or that affects household income, will also affect the trade surplus.

I have already argued that interest rates and wage growth that is lower than productivity growth can affect the trade surplus as much as the undervalued currency. In that case, if the RMB revalues, and at the same time real interest rates are forced down by a sufficient amount, or wage growth is restrained, the net result can easily be a rise, not a decline, in the trade surplus. It depends on the relative magnitude of the different factors.

The external environment also matters. If US interest rates decline for example, unlike in China where declining deposit rates is likely to spur savings, US consumption may rise even as the cost of Chinese imports rises because of a surge in the RMB.

Quite a lot of defenders of RMB stability have made the point that the rise of the yen after 1985 and the rise of the RMB after 2005 were most emphatically not associated with declining trade surpluses. According to their arguments, this clearly proves that the currency doesn’t matter.

This is nonsense, and even if it were true it seems more an argument in favor of revaluing than an argument in favor of not revaluing. But it isn’t true because in both cases there were countervailing changes. Perhaps most importantly, local interest rates in Japan and China declined in real terms, thus reducing local consumption, and US interest rates also declined, spurring US consumption (I know, I know, this sounds strange, but the wealth effect of interest-rate changes in the US is the opposite of that in Japan and China because of the differing structures of household balance sheets). All that happened in both cases was that the rebalancing effect of the currency revaluation was swamped by the exacerbating effect of other factors. The only thing that Japan after 1985 and China after 2005 prove is that the currency is not the only thing that matters.

Will a decline in China’s trade surplus cause the US trade deficit to decline?

Not necessarily. Beijing has pointed out many times that a contraction in the Chinese trade surplus does not necessarily mean an equivalent contraction in the US trade deficit. All it requires is an equivalent contraction in the rest of the world’s net trade deficit. This could easily happen with an improvement in the trade balances of Vietnam, Mexico, Korea or anyone else, enough fully to absorb the reduction in China’s trade surplus. In that case, the US trade balance does not improve, and the US gets none of the employment benefit of the RMB revaluation. China will simply import fewer jobs from abroad and some other countries will import more, or export fewer, jobs.

Remember that if the RMB revalues, this is the same as if all the currencies of the rest of the world depreciate. This will cause a shift in the rest of the world so that households will see a small reduction in their real income, and non-Chinese producers in the tradable goods sector will see a small increase in their competitiveness vis a vis the rest of the world (largely because Chinese producers becomes less competitive). This will reduce non-Chinese consumption and increase non-Chinese production, and the distribution of these changes among different countries, including the US, will depend on a vast array of factors.

So Beijing is absolutely correct in arguing that an RMB revaluation might not have a major impact on the US trade balance, although there is one important caveat. A number of other developing countries, especially in Asia, are concerned about excessively loose domestic monetary policy and inflation, and would like to raise the values of their own currencies. They cannot do so, however, until China does. During the crisis China has expanded its share of global net demand at their expense. If an RMB revaluation causes revaluation in other countries with large trade surpluses, the net impact on the much smaller “rest of the world” will be much bigger, and so simply as a function of arithmetic the US is bound to benefit.

This fact again argues in favor of globally coordinated action rather than an excessive focus on RMB bashing. If China is forced to revalue the RMB, in order to gain the optimal global rebalancing it should be done as part of a general realignment of currencies (although of course cynics will point out that surest way to ensure that something doesn’t get done is to coordinate it globally).

Is it only China that must act?

China will rebalance, but it cannot do so quickly. If it does, as I discussed above, it may easily fall into a spiral of declining competitiveness leading to rising unemployment leading to declining domestic consumption leading to more unemployment. Clearly this is not in China’s interest.

There is another problem. There are several countries with structurally low consumption and high production — Germany, Japan and China being the most important (and I leave out the OPEC countries for obvious reasons). Simply forcing China to adjust, in that case, might cause damage to Chinese growth prospects without helping the US rebalancing effort.

For example, a sharp rise in the RMB, especially if accompanied by a rise in other Asian currencies, will take depreciation pressure off the dollar. Since currently most of that depreciation pressure is borne by the euro, a revaluation of the RMB could easily also result in a decline in the euro, whose economies will then see a sharp improvement in their net trade balance. This means that a significant part of the benefits of Chinese revaluation may accrue to Germany, a country that has yet to resolve its own internal imbalances.

So limiting the whole rebalancing discussion just to China and the RMB may end up not helping much. It is true that the US could force through a rapid domestic rebalancing of its own, including by raising import tariffs generally (and not just on Chinese goods), if it really wanted to, and the benefits to the US would be a surge in employment and manufacturing at probably little real long-term economic cost. But unilateral action on the part of the US risks creating at least some problems for the rest of the world, especially China, Japan, and parts of Europe.

So what must be done? Clearly there is a problem with the undervaluation of the RMB and with Chinese domestic imbalances. But just as clearly there are also problems with a number of other major over-consuming and over-producing countries. In addition Chinese producers have become so addicted to a wide variety of implicit subsidies, besides the currency, that they cannot possibly adjust very quickly. It will take years of continuous adjustment to wean them away from an undervalued currency, too-low interest rates, excessive credit aimed at SOEs, and sluggish wage growth.

That suggests that if we want to resolve the global imbalances in an optimal way that maximizes global growth and equity, we would need all the major problem countries to work out a program, perhaps over 8 to 10 years, in which China, Japan and Germany take concrete measures to shift subsidies away from manufacturers and return the income to households, and the US, the UK and other deficit countries shift income from households to investment.

Of course the cynic in me says getting a global solution will prove impossible. Each country that benefits in the short term from stonewalling on any aspect of the complex adjustment process will do so. So I guess that just leaves trade war. This is the year of the Tiger, after all.

Michael Pettis is a professor at Peking University’s Guanghua School of Management, where he specializes in Chinese financial markets, and a Senior Associate at the Carnegie Endowment for International Peace.

Tags: Bill Gross, China, China Currency, Chinese Central Bank, Chinese New Year, Commodities, Curren, Currency Manipulator, Currency Policy, Deputy Governor, Financial Times, Guanghua, Last Thursday, Michael Pettis, Obama, Peking University, Rmb Revaluation, School Of Management, Trade Tensions, Treasury Department, Us Treasury Department, Wall Street Journal, Year Of The Tiger, Yuan Exchange Rate
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Chinese Stocks – Finely Balanced

Thursday, March 18th, 2010

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As reported over the weekend (via US Global Investors), the latest Chinese inflation figures surpassed the one-year deposit rate of 2.25%. Negative real interest rates may provide an additional incentive to drive asset prices higher, increasing the likelihood of the Chinese central bank raising interest rates from a five-year low.

Source: US Global Investors – Investor Alert, March 12, 2010.

Fears of further monetary tightening in China have recently been weighing on the Chinese stock market. Of all the bourses, the Shanghai Composite Index (3,046 at the time of writing) is the only one trading below its 200-day moving average (3,059), albeit after yesterday’s good performance by only 13 points. Clawing back to above this key line and also breaking its high of March 4 (3,097) would be bullish signs. However, the February low of 2,935 must hold in order for the cyclical bull market to remain intact.

Source: StockCharts.com

The Chinese stock market was the first to turn the corner after the credit crisis sell-off – a full five months before the majority of indices bottomed in March 2009 – and is being watched closely to ascertain whether this market would be the first to spell danger for global stocks, i.e. the proverbial canary in the coalmine.

The Yuan Currency Play

Thursday, March 18th, 2010

This post is a guest contribution by Rebecca Wilder, author of the of the News N Economics blog.

Don’t let anybody tell you they know what the Chinese government will do with the yuan because they don’t. If you are interested in the pros and cons of yuan revaluation, some time ago Michael Pettis wrote a nice article worth revisiting. Basically, all signs economic point towards yuan appreciation.

The fact is, that nobody in the entire world, except for a handful of people of course, knows the plan for the yuan. Markets have become more and more convinced the yuan will appreciate over the next year.

The chart above illustrates the implied currency rate for the value of the US dollar (USD) in Chinese yuan (CNY) one year from the date shown on the X-axis, as derived from the 1-yr ahead non-deliverable forward. For some time, markets have “thought” the Chinese would let the yuan appreciate against the U.S. dollar (a movement down the Y-axis is an appreciation of the yuan and a depreciation of the U.S. dollar).

But ex post, markets have no clue.

The chart above illustrates the implied currency rate for the value of the US dollar in Chinese yuan by the 1-yr non-deliverable forward one year before the X-axis date in blue. The current ex post spot rate one year later (the date on the X-axis) is in red.

Basically markets are just fine at predicting trends, i.e., the positive correlation between the spot and forward rate spanning 2006 and 2007. But the reality is that markets have absolutely no idea how the Chinese will value the yuan in one year, as illustrated by the -0.47 correlation coefficient spanning the years 2008 to current. In fact, markets were looking for further yuan depreciation one year ago, but guess what: the yuan hasn’t budged since 2008, roughly 6.83 CNY per USD.

Source:  Rebecca Wilder, News Economics, March 15, 2010.

Tags: China
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Pressure Increasing on China to Revalue Yuan; What Can Go Wrong?

Wednesday, March 17th, 2010

By Michael ‘Mish’ Shedlock

Pressure on China to do something about its allegedly undervalued currency is mounting by the day. Please consider the following articles.

World Bank Calls For Stronger Yuan

The World Bank Says China Must Pare Stimulus to Counter Bubbles

The World Bank indicated that China, the world’s third biggest economy, should raise interest rates to help contain the risk of a property bubble and allow a stronger yuan to help damp inflation expectations.

The nation’s “massive monetary stimulus” risks triggering large asset-price increases, a housing bubble, and bad debts from the financing of local-government projects, the Washington- based World Bank said in a quarterly report on China released in Beijing today. The group raised its economic growth forecast for this year to 9.5 percent from 9 percent in January.

The World Bank’s call echoes the assessment of private economists — analysts at Morgan Stanley this week said higher reserve requirements for banks may be “imminent” and interest rates could start to climb as early as next month. China’s economic rebound has also sparked increasing calls for an end to its exchange-rate peg to the dollar, adopted in mid-2008 to help shelter exporters amid the global recession.

Senate Considers Currency Manipulator Regulation

Bloomberg is reporting Senate May Force Obama to Take Tougher Yuan Stance

Five senators including Charles Schumer of New York and Lindsey Graham of South Carolina introduced legislation yesterday to make it easier for the U.S. to declare currency misalignments and take corrective action. Even if the bill stalls, it may have “ripple effects” that lead the Treasury Department to declare China a currency manipulator, William Reinsch, president of the National Foreign Trade Council, said.

Obama’s goal of doubling U.S. exports in five years depends on his ability to get China to raise the value of its currency, said Sherrod Brown, an Ohio Democrat and co-author of the legislation. China’s intervention in currency markets to keep the value of the yuan, or renminbi, at a set value acts as a subsidy to exports and tax on imports, Brown said at a news conference yesterday.

Senator Debbie Stabenow, a Michigan Democrat, and Sam Brownback, a Kansas Republican, are also supporting the legislation. Graham is a Republican and Schumer is a Democrat.

The senators said the U.S. recession could boost the political prospects for the legislation, which Schumer has proposed in various forms since 2003. Schumer said the Senate proposal will be attached “very soon” as an amendment to “must-pass legislation.”

“The only way we will change them is by forcing them to change,” Schumer said.

The yuan is undervalued by as much as 40 percent, which is “blatant protectionism,” Bergsten said. Brown and Schumer quoted the analysis of Bergsten and Nobel Prize winning economist Paul Krugman in support of their efforts.

Business Sours On China

Please consider Business Sours on China.

China’s relationship with foreign companies is starting to sour, as tougher government policies and intensifying domestic competition combine to make one of the world’s most important markets less friendly to multinationals.

Patent rules imposed Feb. 1 threaten to increase costs in China for foreign innovators in industries such as pharmaceuticals, and let authorities force foreign drug companies to license production to local companies at state-set prices.

A year ago, in a move foreign critics called protectionist, Chinese regulators rejected a bid by Coca-Cola Co. for China Huiyuan Juice Group Ltd., saying it could crowd out smaller companies and raise consumer prices. The two combined held just a fifth of China’s juice market.

In July, four executives of Anglo-Australian mining giant Rio Tinto were detained, initially accused of stealing “state secrets,” amid tense negotiations between global miners and China’s steel industry over iron ore prices. Rio Tinto denies wrongdoing by the men, who await trial on reduced charges of bribery and theft of commercial secrets.

Google Inc.’s woes highlight the angst. The search company, long troubled by Chinese censorship rules, threatened Jan. 12 to depart China after it said a Chinese hacking attack penetrated its computer network. Related attacks hit dozens of other multinationals. Google is expected soon to close its Chinese site, Google.cn., leaving local companies dominating an Internet market of 400 million users.

“The Google issue has had a crystallizing effect,” says Lester Ross, managing partner in Beijing for U.S. law firm Wilmer Cutler Pickering Hale and Dorr. “It raised the consciousness of government and of the boardrooms and other stakeholders” about the difficulties of doing business in China, he says.

Krugman Wants To Take On China

Inquiring minds are reading Taking On China by Paul Krugman.

Tensions are rising over Chinese economic policy, and rightly so: China’s policy of keeping its currency, the renminbi, undervalued has become a significant drag on global economic recovery. Something must be done.

Today, China is adding more than $30 billion a month to its $2.4 trillion hoard of reserves. The International Monetary Fund expects China to have a 2010 current surplus of more than $450 billion — 10 times the 2003 figure. This is the most distortionary exchange rate policy any major nation has ever followed.

So how should we respond? First of all, the U.S. Treasury Department must stop fudging and obfuscating.

If Treasury does find Chinese currency manipulation, then what? Here, we have to get past a common misunderstanding: the view that the Chinese have us over a barrel, because we don’t dare provoke China into dumping its dollar assets.

It’s true that if China dumped its U.S. assets the value of the dollar would fall against other major currencies, such as the euro. But that would be a good thing for the United States, since it would make our goods more competitive and reduce our trade deficit. On the other hand, it would be a bad thing for China, which would suffer large losses on its dollar holdings. In short, right now America has China over a barrel, not the other way around.

Looking At Half The Equation

For starters, Krugman conveniently ignores one side of the equation.

A sinking dollar is good for exports, however, given China’s regulatory policies as noted in Business Sours on China, it’s not at all clear exports to China would rise by much. Indeed, I suspect that China’s regulatory restrictions are a far bigger impediment to trade than currency fluctuations.

Furthermore, one cannot (or at least should not) ignore what would happen to the price of imports. A falling currency is not a free lunch.

While I agree with Krugman that China would not dump US Treasuries, the idea that the U.S. has China over a Barrel because is preposterous. Mutual deadly embrace with unbalanced winners and losers is more like it.

What China Can and Cannot Do With Reserves

Please consider What the PBoC cannot do with its reserves by Michael Pettis.

It is a real toss-up as to which generates more bizarre comment in the international press: Beijing’s long-feared dumping of US Treasuries, or the use and value of the PBoC’s central bank reserves. The revelation last week that Chinese holdings of US Treasury obligations fell in December by $34.2 billion, to $755.4 billion, generated a frisson of fear and excitement, leading one prominent newspaper to worry that “If there is one thing that gets investors twitchy, it is the fear that China is losing its appetite for US government bonds.”

Remember that China has a large current account surplus which necessarily must be recycled abroad, and the US has a large current account deficit which necessarily must be funded abroad. It would be astonishing if, under these circumstances, total Chinese holdings of USD assets declined, and of course it is impossible that they declined faster than the willingness of other foreigners to replace them.

If China runs a current account surplus, it must accumulate net foreign claims by exactly that amount, and the entity against which it accumulates those claims (adjusting for actions by other players within the balance of payments) ultimately must run the corresponding current account deficit. And as long as China ran the largest current account surplus ever recorded as a share of global GDP, and the US the largest current account deficit ever recorded, and especially since China also ran an additional capital account surplus (i.e. other non-PBoC agents ran a net capital inflow), it was almost impossible for the PBoC to do anything but buy US dollar assets. Given the sheer amounts, a substantial portion of these assets had inevitably to be USG bonds.

This was not a discretionary lending decision. It is the automatic consequence of China’s currency regime, in which it pegs the RMB to a foreign currency, in this case the dollar. Why? Because when the PBoC decides on the level of the RMB against the dollar, it does not do so by passing a law, and making it a capital crime for anyone to trade at a different price. What it does is far simpler. It offers to buy or sell unlimited amounts of RMB against the dollar at the desired price.

If it stops buying dollars, it must let the market decide by itself on the new equilibrium price of the dollar. In that case the value of the dollar has to plunge in RMB terms (or the RMB soar, which is the same thing) in order for buyers and sellers to match up and for the market to clear. The moment the PBoC stops buying, in other words, the RMB will rise in value – and so it cannot stop buying in anticipation of the RMB rising in value, as the FT article suggested.

Here is where things get interesting. China’s reserves are often thought of as if they were a treasure trove available for spending. They are not. They are simply the asset side of the mismatched balance sheet. If the PBoC wanted to “spend” $100, say for example to recapitalize a bank, it could do so, but this would automatically create a $100 dollar hole in its balance sheet. – it would still owe the RMB that it borrowed originally to purchase the $100. To put it another way, the reserves are not a savings account, free for the PBoC to spend as it likes. Reserves are effectively borrowed money.

So what are reserves good for? As long as China maintains its own currency and denominates all domestic transactions in RMB, the PBoC reserves cannot be used in China. They cannot go to pay doctors’ salaries, to build bridges, to lower taxes or to subsidize consumption. They can only be used to purchase or pay for things from outside China. This means that reserves ensure that China can import foreign commodities and other goods as long as it can pay for them domestically. It also means that the PBoC can ensure the availability of dollars to repay foreign debt and foreign investment. …..

… if the RMB is revalued by 10%, the value of the PBoC’s assets will immediately decline by $250 billion in RMB terms. Since the Chinese measure their wealth in RMB, isn’t this a real additional loss for China?

No, because remember that the only thing you can do with reserves is pay for foreign imports or repay foreign obligations. And just as the value of the reserves drops 10% in RMB terms, so does the value of all those foreign payments – by definition they must go down by exactly the same amount in RMB terms.

This means that China takes no loss. It can buy and pay for just as much “stuff” after the revaluation, and with less implied PBoC borrowing, as it could before the revaluation – and the real value of money is what you can buy with it. So the real value of the reserves hasn’t changed at all – just the accounting value in RMB, but this simply recognizes losses that were already taken long ago when the trade was first made, and should be a largely irrelevant number (except perhaps for conspiracy theorists).

Yuan is Undervalued by as Much as 40 percent?!

For the sake of argument, let’s assume The RMB is undervalued by 40%. Who is the winner?

To answer the question let’s return to a snip from Pettis:

“generally speaking China is likely to gain from a revaluation because after the revaluation it will be exchanging the stuff it makes for stuff it buys from abroad at a better ratio. The value of what it sells abroad will rise relative to the value of what it buys from abroad, and if we could correctly capitalize those values on the balance sheet, it would probably show that the Chinese balance sheet would improve with a revaluation of the RMB.”

If that is true generally speaking, then the US is a beneficiary now, generally speaking. This implies we should be careful of what we ask. However, the situation is more complex because as Pettis explains there are individual winners and losers:

“..it is not whether or not China as a whole loses or gains from a revaluation that can be measured by looking at the reserves, and I would argue that it gains, but how the losses are distributed and what further balance sheet impacts that might have.”

Shock Effect

Let’s consider the global shock effect of a sudden large revaluation of the Renmimbi. The key is the RMB does not float. To get a 40% rise in valuation, China must buy or sell unlimited amounts of RMB against the dollar to maintain the desired price. That might mean a huge hike in Chinese interest rates to make holding the RMB attractive.

In turn, sharp interest rate hikes would likely cause a huge slowdown in China, decreasing China’s demand for imports. This is yet another factor that Krugman and those crying “currency manipulator” miss.

And should the US impose a revaluation via tariffs, I would like to point out a little thing called Smoot-Hawley.

By the way, I am all in favor of a huge slowdown in China. I think China is on an unsustainable course, and the sooner and harder China slows the better for everyone in the long run.

However, the consequences of such a slowdown would be huge on the commodity exporters like Canada and Australia. Moreover, a slowdown in trade would slow global consumption.

I happen to think those are necessary adjustments along with more debt writeoffs, but believers in free lunches and Keynesian claptrap sure won’t see it that way.

Hopefully this gives you a bit more of an idea as to just what might go wrong with all these simplistic “the Yuan is 40% undervalued – so label China a currency manipulator” ideas floating around.

Mike “Mish” Shedlock
http://globaleconomicanalysis.blogspot.com

Tags: Asset Price, Bad Debts, Bloomberg, BRIC, Canada, Charles Schumer, China, China Beijing, Commodities, Corrective Action, Economic Rebound, Economic Trend, Global Recession, Government Projects, Housing Bubble, Inflation Expectations, Lindsey Graham, Michael Mish, Mish Shedlock, Morgan Stanley, Private Economists, Ripple Effects, Sherrod Brown, Treasury Department, Trend Analysis, Yuan
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China Construction: Boom or Bust?

Monday, March 15th, 2010

It would not take too much guessing to figure out where the bulk of the world’s construction activity is taking place. Of course, it is in China, but who would have thought global construction would decline from a year-on-year rate of almost 20% to close to zero once China is stripped out? This is what the fascinating chart below by CRU, WSD and Mcquarie Research (via Agora Financial’s 5 Min Forecast) highlights.

“The Chinese are laying highways like nobody’s business,” added Agora’s Chris Mayer. “By the end of 2008, China had an estimated 60,000 km of highway. The US has 75,000 km. Over the next few years, China plans to have 85,000 km of roads.”

Is building activity in China a boom or a bubble? Please share your thoughts with readers by posting a comment. (Click on “Comments” below the heading of this post and type away.)

Source: Agora Financial’s 5 Min Forecast, March 10, 2010.

Tags: Advertisement, Agora Financial, Bust, China, China Construction, Chris Mayer, Construction Activity, Construction Boom, Emerging Markets, Global Construction, Heading, Highways, Mcquarie, Share Your Thoughts, Wsd
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Emerging Markets Highlights (3/15/2010)

Monday, March 15th, 2010

Emerging Markets

Strengths

• The number of people living at or above the level of “medium development”— considered to live in reasonable conditions and have access to education, health care, clean water and electricity—has grown by more than 2 billion people during the past several decades. That is more than the entire global population in 1900.
• The Asia Pacific region provided 234 names to the latest Forbes World’s Billionaires list released this week, up from 130 last year. The region accounted for 23 percent of the total 1,011 billionaires globally.
• China’s February exports grew by a higher-than-expected 45.7 percent year over year due to a strong rebound in exports of textile, steel products, televisions and motorcycles. Imports rose 44.7 percent in February from a year earlier thanks to a large swing of crude oil prices from last year.
• Brazil highway traffic in February rose by 6 percent year over year. It was driven mainly by heavy vehicles traffic (up 11.9 percent) and passenger traffic (up 4.3 percent).
• Brazil’s budget minister says his country is likely to see 6 percent GDP growth this year and the creation of 2 million jobs.
• January retail sales in Brazil increased 10.4 percent year over year.
• Industrial production in India in January rose 16.7 percent and was driven by higher activity in the mining sector (up 14.6 percent) and manufacturing (up 17.9 percent).
• Turkish new-car sales in February jumped 42 percent year over year, aided by tax incentives and a low base. The rise was above industry expectations.

Weaknesses

• China’s growth in fixed-asset investment moderated to 26.6 percent year over year in January and February combined, compared with the stimulus-driven rate exceeding 30 percent between March and October 2009, as the government wound down new public investment projects.
• Despite restraining government policies, property prices in 70 cities in China climbed another 10.7 percent year over year in February, the fastest pace in 23 months, after January’s 9.5 percent gain. New and existing home prices increased 1.3 percent and 0.4 percent month over month, respectively.
• All three publicly traded airport groups in Mexico reported declines in passenger traffic during February.
• Turkey ended IMF negotiations without a loan agreement. In absence of the IMF loan, there will be little upside to 4 percent GDP growth projections for 2010.

Opportunities

• If home-buying sentiment in China has shifted toward “wait and see,” auto purchases have remained very strong as the government maintained policy incentives. Even in the seasonally slowest month of February, 1.21 million vehicles were sold. The combined 2.88 million units sold in January and February was 84 percent higher than the same period in 2009. Such strength is likely to carry into March and April, typically strong months for car sales, as potential auto buyers rush to purchase before subsidy programs are withdrawn. Opportunities still exist for Chinese automakers and steel mills.

• It is estimated that damage to Chile’s infrastructure from recent earthquakes will be $20 billion to $30 billion, and will result in a massive government revival program. Dealing with effects of the earthquake is going to be a priority for the new president, Sebastian Pinera. Chile has a very healthy fiscal position and should easily fund the program from its copper fund, as well as from local and external debt.
• After years of neglect, there is a structural shortage at the residential end of Russian real estate market. New strategy announcements from the Russian real estate companies suggest that they are coming out of hibernation and are planning to launch construction and start pre-sales.

Threats

• While China’s central bank governor said February’s 2.7 percent increase in consumer prices from a year earlier was in line with his expectation, the latest inflation figure did surpass the one-year deposit rate of 2.25 percent. Negative real interest rates may provide an additional incentive to drive asset prices further ahead, creating fears of imminent monetary tightening that may introduce short-term volatility into the market.

• Mexico’s official inflation in February rose 0.58 percent month over month (vs. 0.50 percent expected) and was up 4.8 percent on an annualized basis. While the rate is still within the 4.75 percent to 5 percent target range, we will closely monitor the trend in coming months.
• The issue of exiting from monetary stimulus becomes pressing in countries like Brazil and Turkey, where inflation pressures are building. The chart below shows Citi’s estimates of upcoming rate increases in emerging countries in 2010.

Tags: Asia Pacific Region, Asset Investment, Billionaires List, Brazil, Budget Minister, China, Cities In China, Crude Oil Prices, Education Health Care, Emerging Markets, Forbes World, GDP Growth, Global Population, Heavy Vehicles, Highway Traffic, Img Src, India, Industry Expectations, Investment Projects, Motorcycles Imports, New Car Sales, Openx, Passenger Traffic, Public Investment, Random Number, Russia, Steel Products, Target, Tax Incentives
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Why Gold is Declining (The King Report)

Friday, March 12th, 2010

We received several inquiries about why gold is declining.
 Our view is gold is retrenching because:

• UK QE has ended (for now)
• US QE will end in three weeks (for now)
• The ECB did a massive €295B drain (can you imagine the market reaction if Bennie Mae drained
$500B in one shot?]
• China is signaling that it wants to rein in inflation by tightening credit, hiking real estate down
payments to 50% and allowing the yuan to appreciate
• Europe’s sovereign debt crisis has ebbed (for now)
• Food commodities have broken down
• Gold stocks have greatly underperformed gold since mid-January (gold stocks tend to lead)
S&P

S&P 500 Index, Gold and Gold Stocks (GDX) – Gold stocks out-performed gold until late October. Then they traded together until mid-January. Since then gold stocks have under-performed gold.

Source: The Big Picture, March 12, 2010

Tags: Advertisement, Big 12, Big Picture, China, Commodities, Debt Crisis, ECB, Europe, Food Commodities, Gold Source, gold stocks, Imagine, Index Stocks, inflation, Inquiries, Lead, Mae, Qe, Real Estate, Sovereign Debt, Yuan
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Get Ready for a Little Emerging Markets Inflation

Friday, March 12th, 2010

Today I was thinking about tightening cycles in emerging markets, and more specifically about those in China. Because let’s face it, China matters. China matters to the rest of Asia via competition for export income. China matters to Europe via competition for jobs. China matters to Brazil via domestic production via imports. China matters.

The inflation pressures are building in key emerging economies, especially in the BIICs (Brazil, India, Indonesia, and China) – see this previous post regarding my new acronym, and this article at the Curious Capitalist (curiously posted just shortly after my post), which leaves my omitted “R” but relays the intuition behind the second “I”.

Although the inflation is not prevalent in any BIIC except India, really, I wanted to comment about why it will build…quickly.

First round, the construction of consumer prices is heavily weighted towards food and energy costs across the BIICs. Indonesia, India and China are highly susceptible to food price shocks (either driven by shortages or demand growth). Expect this as a first-round driver of inflation as the global economy recovers further. It’s already  happening.

Second round, the BIICs are growing quickly and nearing, or are already at, potential. Annual industrial production growth has recovered or surpassed its pre-crisis rate in China, Brazil and India – 19%, 16% and 17%, respectively. This is expected, given the drop-off in world trade (an illustration can be found from this May 2009 post), but unsustainable as the output gap closes.

Third round, interest rate differentials. This year, the BIICs’ central banks are expected to raise policy rates. In fact, Brazil, China and India have already boosted reserve requirements. But with US rates expected to stay low for an “extended period”, international interest rate differentials will change and monetary flows will shift. Capital inflows can lead to inflation if not properly sterilised.

To date, inflows have not been properly sterilised, as evidenced by the ongoing accumulation of reserves and rising money-supply growth (again, I refer you to my previous post on M1 growth rates.

The chart above illustrates the one-year-ahead nominal interest rate differential between the two-year forward government rate for each respective BIIC country versus the two-year forward US Treasury rate. The forward differentials for China and India are on a steady upward trajectory, while those for Brazil and Indonesia are simply steady. I believe this appropriately represents the sterilisation efforts and monetary policy management on the part of the BIICs’ central banks: more managed in Brazil and Indonesia, not as much in China and India.

So where does this analysis leave us? With a very interesting policy mix in the emerging-market space. In fact, in my view this is the riskiest part of the emerging-market cycle: the recovery. If policymakers get this wrong, we could see a lot of price action, final goods and assets alike, on the horizon.

Source: Rebecca Wilder, News N Economics, March 11, 2010.

* Rebecca Wilder is an economist in the financial industry. She was previously an assistant professor and holds a doctorate in economics.

Tags: Acronym, Biic, Brazil, BRIC, Capital Inflows, Central Banks, China, Curious Capitalist, Emerging Economies, Emerging Markets, Energy Costs, Export Income, Food Price, Gap, Global Economy, Illustration, India, India Indonesia, Indonesia, Inflation Pressures, Interest Rate Differentials, International Interest, Intuition, Jobs Brazil, Monetary Flows, Output Gap
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How China Sees the World

Thursday, March 11th, 2010

Source: The Economist, May 19, 2010 (hat tip: Atlantic Asset Management).

Tags: Asset Management, China, Economist, Hat Tip, World Source
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