More Dead Money and China's Approach to Devaluation

* Dead Money - Part 2: On Tuesday I presented the concept of “Dead Money” which is my way of describing what happens to US dollars once we ship them overseas. With the exception of the interest payments the US makes on this debt, it is analogous to what happens when the US Post office sells stamps to a stamp collector. In all likelihood, the money just sits on the balance sheet of the countries which choose to hold these dollars. Along the way, these countries have sent the US TVs, cars, and all sorts of goods which have improved our standard of living. In return, we have sent them paper currency, or the electronic equivalent of it. 


Why am I spending so much energy on something which seems to be esoteric and disconnected from our day to day reality? When I started this blog, it occurred to me that given my place in the US’s financial system, and propensity to understand the fine print, that the answers to what will happen in the future will come from an understanding the current financial inter-relationships amongst our trading partners, as well as from within our own system. To that end, I think this “Dead Money” will play a relevant role in what happens in the future. I do not believe that China’s $2.6 trillion in currency reserves will remain “Dead Money” forever. Rather, there will be an end-game which can settle itself amicably, or result in great disappointment for many. For now, the presumption is on an amicable ending, but given the size of China’s hoard, and the trillions scattered amongst many other countries, this will remain the big wild card going forward. Clearly, the situation with Greece should be taken as a warning shot across our bow. But as long as Obama is allowed to spend the US into irrelevancy, a Greek outcome is not impossible.


Theoretically, these ‘dead dollar’s are allowed to just pile up overseas. In turn, these dollars have become the backing for the financial systems of many developing countries, with China being the most obvious example. What is most remarkable is that these countries primary assets are US dollars, which we seem to print at will. The reason why this system works is because these countries can take the US dollars, and use them to purchase goods, or resources from the outside world in return. What happens if the price of oil, copper and other such resources goes up? Then the value of the US currency in terms of what it can purchase will determine the viability of the US currency, and by definition, the underlying value of their local currencies.


There has been much press about how China needs to allow their currency to float freely, and in the process, appreciate versus the dollar; that the Chinese are currency manipulators, and are taking advantage of the US by virtue of its low currency value, which in turn, keeps Chinese exports cheap. 


From China’s perspective, there are many ways to skin the cat. If China allows the Yuan to appreciate from 6.8 Yuan/dollar to 6 Yuan, then all of a sudden, the value of China’s $2.6 trillion on foreign currency reserves (assuming it is all in dollars), falls from $17.7 trillion Yuan to $15.6 trillion Yuan. In order for China to balance their books, they need to make up for this drop in Yuan. Since China has issued bank credit and currency against their dollar reserves, they would need to withdraw 2.1 trillion Yuan ($350 billion) from the economy’s money supply and credit. This would be over 10% of the country’s Central Bank’s balance sheet. I do not see that happening, as it would be extremely deflationary.


If the Yuan is allowed to appreciate to 6 Yuan per dollar, then the 2.1 trillion Yuan drop would need to be made up by $350 billion of trade surplus. Based on 2008 and 2009 export measures, this would take 14 to 18 months to make up, without impacting the money and credit in the Chinese economy. So, theoretically, China could choose to allow their currency to appreciate, and it would then take them 14 to 18 months to re-accumulate that amount of a trade surplus to make up for the drop in the local value of their foreign currency reserves, which serves as backing for their domestic credit and currency. Should this occur, then the cost of imports will all of a sudden rise, since they are denominated in dollars. The net effect of this is that China will wind up sending us $350 billion of stuff to make up for the appreciation of the currency. This is why China is so reticent to do allow their currency to appreciate.


There is another approach which China could take, and seems to be their prefered outcome. There were news stories in Japan’s press yesterday suggesting that China will embark on a plan to double the wages for their factory workers over the next 5 years. According to the article, they will accomplish this by increasing workers wages by 15% a year, on their current base of $4,300 a year. This is important from a domestic policy standpoint, since it is important for the Chinese government to keep their worker class vested in the success of the overall economy. By actively promoting higher wages domestically, which is very consistent with China’s booming property markets, the government will remove the need to let their currency appreciate. In fact, the more domestic prices increase, the less China will need to allow their currency to appreciate. And if you are the Chinese, it would be far more productive for them to allow domestic wages and real estate to rise, than having to export $350 billion of goods, just to stay in the same place. I actually think what the Chinese is doing is just fine. 


However, this is not the case with how the Obama administration is approaching the Chinese. During Geithner’s recent visit to China, there was no statement on the Chinese’s currency valuation. In light of how much the Yuan was appreciating against the euro, I am sure they were not that interested in discussing what they can do allow the Yuan to appreciate against the dollar. However, Geithner has delayed his report to Congress on currency manipulators, from April to sometime in the future. In fact, Geithner is talking to Congress today about China, and their currency policy. Nonetheless, it will eventually become a point of contention with Congress, who will be on the warpath for something from China.


And who are we to talk? China owns the largest percentage of our debt of all holders. I can spin a bunch of theoretical outcomes, which invariably could knock the global apple cart off its wheels. Clearly, what happens will likely be driven as much by political events than anything else, and is something to ponder going forward. I have nothing else to add right now, except to emphasize the pact that we will need to pay attention to this pool of dead money, cause it will not remain dormant forever.


* In yesterday’s blog, I presented a sequence of charts which linked the bearish nature of the stock market with the Euro, and opposite the flight of the bond market. It is entirely probably, that these markets will diverge going forward. In other words, if US stocks fall through their 1040 support shelf, it is likely that the Euro might not follow. I just wanted to keep you in the loop that just because some assets have been correlated over the last 6 weeks, it is not required that this pattern continues going forward.


And lastly let me add that I view the markets clinically, and allow current price observations to cloud my view of the future. In other words, if the 1040 support shelf is taken out, then my immediate view becomes all of a sudden very bearish. Call it the tail wagging the dog if you like. I know that it is tough to make longer term investment decisions on this basis, so I will repeat my long term mantra: Stocks will go much lower. I just cannot tell you if there will be an intervening rally during the summer. And if you followed my advice in 2007 and sold stocks then, then missing the rally of 2009 to 2010 did not matter cause you did not watch your portfolio drop by over 70% from 2007 to 2009. And so it will be that I am willing to forego any stock market rally should the 1040 support shelf hold.