China's Ambitious Plans

* The risk markets are reacting favorably this morning to China’s announcement that they are going to start to allow their currency, the Yuan, to float in the international exchange markets. There is a limit to how freely China can actually let their currency float for a number of reasons. For starters, if international demand for the Yuan, which is going to start to look attractive as an emerging reserve currency, could create an unprecedented amount of demand. And if China were to print enough currency to meet these demands, there is a secondary problem of what foreign holders of Yuan will do with it. Last week, China sold some government issued debt, but the size was rather small, on the order of a few billion dollar (equivalents), so there is a problem as to where the money will go if China printed enough money to meet foreign demand. And if China does not create enough money so foreigners can invest, then it is likely that the Yuan will rise rather sharply. 


Meanwhile, domestic Chinese policies are feeding double digit increases in real estate, and wages are set to double over the next 5 years (that’s 15% inflation in this category too). In other words, as fools rush into the Chinese currency, China is promoting policies which will effectively devalue the currency. A quick way to determine the future value of a currencies exchange rate is to compare the relative inflation rate between the US (our currency) and the inflation rate of the currency you are investing in. If there is a 10% difference in inflation rates, then it is likely that the currency will depreciate at a rate of 10% a year. And once an equilibrium level is determined by market forces, this is likely to happen with China. For now, the operative issue is to figure out what the correct exchange rate should be.


This is not to say that there are not investments which one can make in China, but your benchmark for a flat return needs to be something in the low teens, because that is what inflation will be running in China for the foreseeable future, and if your Chinese Yuan investments cannot outpace inflation, then that suggests that you will lose on the currencies depreciation in the future.


That is how things would work in a normal environment, yet this is not a normal environment. For one, there are plenty of deflationary forces at work in the global economy, so despite China’s best intention to create rising prices, my guess is that demand for Chinese products will drop as the global economy slows. Nonetheless, inflation is likely to remain many percentage points higher in China than in the US, so that will likely call the shots over time, which in turn will act as a haircut on whatever great returns you earn in Yuan terms.


In the press release issued by China, the Chinese did suggest that the Yuan is not undervalued versus the dollar. This is a general concept which I have espoused in previous blogs as well. 


And why is this so important to us? It would seem to many that this shift in policy will not have any direct impact on us. Let me suggest that since China is embarking on a program of flexible exchange rates, this will keep the protectionist forces at bay. In turn this is helpful to our general outlook going forward, although it will not save the day in my estimation. What worries me most however, is the fact that the underpinnings for the Chinese financial system is about $2.6 trillion of US dollars and euros. In short, I am convinced that tomorrow’s problems are going to arise from a combination of domestic US issues, and the inter-connection which the Chinese have with the US. I believe that the details of how the financial calamity of the coming decade will play itself out, is buried here: within the inner workings of the Chinese and US’s financial systems. Rest assured, that you will be hearing more from me on this going forward.