Playing With Fire?

John Mauldin points to a recent piece of research from GaveKal Research Limited (Hong Kong, Stockholm and New York) on the Chinese RMB peg to the US dollar. I cannot say I’ve seen their work before, but it is rather intriguing:

"As we never get bored of pointing out, structural bear markets and deflationary busts only happen when policy makers commit one, or several, of what we call the "five cardinal sins". The five sins are:

1. Protectionism
2. Tax Increases
3. Increases in Regulation
4. Monetary Policy Mistake
5. A War.

The common thread behind these five policy mistakes is that, when committed, they reduce the returns on invested capital and consequently, asset prices are pushed lower. And this puts the financial sector in trouble etc…

Now why do we return yet again to this long-held, and long-exposed, belief? For the simple reason that we are very confused by the recent protectionist rhetoric coming out of Washington DC. Indeed, the efforts to push China to revalue appear to us to be both clumsy, and dangerous.

It is dangerous because it is playing into the hands of the protectionist lobbies all over the world. It is clumsy for a revaluation, even a large one, would have no impact on the US current account deficit. Why? Because given the state of excess capacity in China in almost all industries, the costs of a RMB revaluation would simply be passed on to the margin of Chinese companies (already inexistent) and not unto the US consumer. In other words, if China revalued tomorrow by 20%, Wal-Mart would tell its widget manufacturer in Guangzhou: "last week you were producing this for US$1. This week, you will continue to do the same… Or I move my production to some guy in Shanghai/Saigon/Jakarta etc…)." So can China really afford a revaluation?

We will turn that question around and ask you to put yourself in the shoes of a Chinese policy maker. This is the situation you are facing today:

a) you have the world’s worst performing stock market which is hitting 8 year lows);

b) you have the world’s best performing bond market (Chinese 10 years have moved from 5.25% to 3.7% in the past ten weeks),

c) you have industrial production rolling over (weak oil consumption, weak iron ore imports, weak Baltic, weak steel prices, weaker industrial production numbers…),

d) you have real estate activity rolling over (our friend Simon Hunt reports that an "indicator of the real slowdown in real estate is that a major supplier of chiller tubes (chiller units are the central air conditioning units for all apartment and office blocks, hotels etc.) reports a 25% fall in 2nd quarter orders with no visibility for the 2nd half of the year. After talking with his customers, he was told that other suppliers are faring even worse…",

e) inflation has fallen from +5.3% to 1.8% in ten months,

f) M1 growth has fallen from +20% to +10% in the past year…

In other words, nothing in China’s economic data, or market performance points to the need for a RMB revaluation.

And yet, the Bush administration keeps banging on about it? Why?

Explanation #1: Could it be part of a greater geopolitical game? In other words, what President Bush is really worried about in Asia is North Korea. He does not really care about the RMB; he just pretends to care. This allows him, in negotiations with the Chinese, to say: "I will fold on the RMB, if you give North Korea up; in that way, you guys can give up your embarrassing ally without losing face".

Explanation #2: The Bush Administration, given all of the above, is getting worried about the potential for RMB devaluation and is kicking up a fuss to make sure that this does not happen.

Explanation #3: the Bush Administration is clueless and playing with fire.

Meeting clients around the US in the past ten days, it felt that 100% of our clients subscribed to the third explanation. Time and again, we were told that "no way are these guys smart enough for Options #1 or #2". And, while we have never been accused of throwing stones at the current US President, we fear that our clients might be unto something. The current administration is playing with fire.

Interesting. Personally, I find Explanation #1 the most compelling, but we’ll have to see how this plays out.


Playing With Fire?
GaveKal Research
via Outside the Box

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  1. fred commented on Jul 21

    GaveKal’s stuff is top-notch. Have been reading it for the past year or so.

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