China and the Declining Dollar

Yesterday a reader sent me a copy of a Chinese article blaming the US for intentionally devaluing our currency, at the expense of the hard working Chinese, and other developing countries. From the eyes of the Chinese, this article makes the point that the US is deliberately exploiting our position as the originator of the world’s reserve currency, to monetize our debt and devalue our currency, as a weapon of wealth transfer, from the countries who hold our debt/currency to us.


The bottom line is that countries such as China adopted the dollar as their reserve currency because they did not have the chutzpah to do something else with the dollars they earned from their trade surplus. Along those lines, in 2004, when the Fed was raising interest rates, the Chinese bought 10 year treasuries, and this buying forced a flattening yield curve as short term interest rates rose. At the time, it was remarkable that long term interest rates were not rising, while the Fed had tightened 425 bps. Alan Greenspan expressed public surprise about this fact, while the Fed was raising short term rates. From May 2004 to June 2006, the Fed raised the funds rate from 1 to 5.25%, and in this same time period, the 10 year treasury rose only 0.3%. In all fairness, 10 year rates rose 1% from March to May, 2004, largely in anticipation of Fed tightening action. But once that anticipatory increase in rates occurred, long rates stayed anchored as the Chinese were the big buyer of 10 years at the time. No one told the Chinese to buy the 10 year, but they did. Perhaps they incorrectly had faith in the dollar since the Fed was in a tightening mode.


The article in the China Daily cited the forced devaluation of the Japanese Yen in the 1980s as causing Japan’s asset bubble, and subsequent lost decade, as a lesson for the Chinese to take heed of today. In other words, the article incorrectly contends that if the Chinese devalues their currency, then it will result in an asset bubble, and a subsequent lost decade. To illustrate why this is a false assumption, here is a quick recap of what happened in the 1980s with Japan:


In order to depreciate the dollar, the countries of Germany, Japan, Great Britain and the US intervened to sell US dollars, and force the dollar lower, so as to help the US out of its recession, and to correct the US’s trade deficit, which was then running at a rate a 3.5% of GDP. From 1985 to 1987, the German mark doubled in value, from 3.2 marks/dollar to 1.7 marks/dollar, the Yen went from 240 Yen/dollar to 124 Yen/dollar, while the British pound did virtually nothing. The resulting slowdown in Japan was met by easing by the BOJ, which in turn is credited for spurring an asset bubble within Japan.


I am going to interject at this point that economies which run consistently large trade surpluses naturally invite bubbles into their own shores, by virtue of the rewards of their successful export driven economy. Money, the rewards of the trade surplus, has to go somewhere, and it remains the responsibility of the trade surplus country to manage this experience. While Japan lowered their rates to get their economy going in the face of a doubling in value of the Yen in the 1980s, they also allowed liberal use of credit, as loans with LTVs over 100% fed a property bubble. On the back end of asset prices declining, the financial duress which followed left Japanese banks holding these 100+% LTV loans, while the under-lying asset prices were dropping.


The China Daily articles author incorrectly translates currency appreciation as equating to causing asset price bubbles, and the recession which will surely follow. This is faulty logic, but seems convenient. It is also notable, that even though the exchange rate of the German mark doubled, the dire consequences which befell Japan, did not happen in Germany. 


In fact, if China wants to quell its property boom, which is running at double digit rates, then it should restrict credit terms, such as maximum LTV ratios, and the like. On that front, they are currently not doing enough, as property prices are running at double digit increases. And this is without much change in the value of the yuan in today’s environment.


What I find fascinating about this article is that it points out that the Chinese are concerned about US policies which are resulting in a devaluation of the dollar. Notably, the Chinese are not blind to the consequences of our policies. Knowing how much the Chinese have at stake, they seem oblivious to our needs to balance our trade surplus, in some fashion or another. They are equally determined to create an organically grown technological infrastructure at home, by utilizing foreign technology to spawn their own home-grown industries, instead of letting foreign companies operate freely in their country. In other words, the playing field is not even when it comes to encouraging US companies to operate in China. This would be one of the ways in which China can alleviate its trade surpluses, or the US’s trade deficit with them. But that is not what the Chinese want, so it will not happen, and this sort of contention is fueling the trade/currency war between the US and China. At the end of this blog, I have attached a copy of the article which appeared in the China Daily, last week.


The article appears to be how the Chinese might want to intellectually stake out their claim, that devaluing the Yuan is not the solution to the US’s trade concerns. I agree with that, but I think the article sounds more like the school house bully claiming he was kicked in his shin when he wasn’t looking. 


What the Chinese needs to do is to start to spend their dollar and euro hoard, to purchase products from both the US and Europe. The article about the Chinese doubling the tariffs on US chicken imports, worth only a few hundred million a year, is a perfect example of what NOT to do.


* Trading Points: as I have been contending for a few weeks now, the markets are going into over-bought territory on a number of fronts, and I expect some sort of correction, or complete turnaround in many markets, sometime soon. While the markets are likely pricing in some form of a republican shift in the House and Senate, the event which I do not think the markets are factoring in, is what happens when the Fed announces some version of QE2 – light. In other words, unless the Fed announces that they are committing to buy treasuries, to the tune of a hundred billion a month, as far as the eye can see, then it is likely the markets will have over-anticipated the Fed. Accordingly, I will be even more skeptical of the markets sustaining a further rally (stocks, bonds, gold, oil and FX) after the Fed announces their plans, following next Wednesday’s conclusion of their 2 day meeting. Here is a short guide to what I think is happening in various markets:


* Gold – traced out an (Elliott) 5 waves down from the high, and appears to be in the process of staging a counter trend rally, which might set up a great shorting opportunity from 1350 to 1370, with a buy stop above 1390.


* Interest Rates – Bonds formed a double top in late August and 2 weeks ago, while 10 year notes made a higher high 2 weeks ago, reflecting a steeping of the 10-30 year treasury yield curve. The rate complex has been in a bit of a correction for the last 2 weeks, and this is likely to continue into next weeks meeting. To the extent that rates rise another 20 bps or so, I will consider this a good place to enter this market for an intermediate term holding period. QE in any form will directly benefit bond prices, and owning bond duration should be a good bet, assuming we are afforded a chance to do so at somewhat higher yields, lower prices.


* Stocks – make no sense to me, but that is becoming a common theme. For now, I have eliminated all put positions, and most shorts, in deference to stocks continued rise. A break below 1159, last weeks low, would be the first sign that stocks have turned around. For now, I will respect the rally. On average, I have noticed that most rallies fail once higher levels are attained, but the market has shown amazing resiliency about going back and reclaiming the high ground, once a correction has occured. I will sell either a break-down below 1159, or might try to take a swing at selling new highs (with tight stops), should they occur.


* FX – its a toss-up here over the near term, as the dollar is near its recent low, with no assurance that it cannot make another new low. The Yen made another 15 year high yesterday at 80.40 yen/dollar, and is close to its all time high of 79.75, recorded in 1995. I expect the Yen to go and kiss that level, and perhaps run a bit through it, before correcting with every other asset category.