March 2010

Chinese Fortune Cookie

While I was going to write about all the reasons that people in the first half of their work life ought to be pounding down debt so that they can make life changing investments over the next several years in equities, commodities and real estate, the U.S. and China relationship came to the fore as 130 Congress people decided that China was a currency manipulator.  While there is a lot of politics being played, what most needs to be understood is that China will do what is good for China regardless of what the United States asks for in terms of currency revaluation or trade policy.

So, the question is begged, what is good for China?  Ahhhh, that is a good question.  Let's look at it mainly from the standpoint of the Chinese.

What is Good for China?

China is a huge creditor nation, constantly running large quarterly surpluses with other nations.  Also, their people save over a third of what they earn, in fact, approaching half.  When a family has enough to buy a home, they do not get the equivalent of an FHA 5% down payment loan, they put down half- and this in what many are calling a real estate bubble.  If they want a second home, they generally pay cash, or close to it.  It certainly is a different world in China.

On the way to saving money, the Chinese work.  As it stands right now, about half of the population is still very poor, another quarter is poor and many are looking for work.  With numbers like that, civil unrest is tough to thwart.  High growth rates and hope for the future might be all that keeps China from having major internal problems to put down (which they have shown they will do).  It should be blatantly apparent that the Chinese are not going to do anything that would slow their growth rates and ability to employ more people.  The U.S. representatives however are asking that the Chinese do just that.  It's not going to happen.

China's most pressing issue in maintaining production is not what many in the United States think, which they believe is having the United States to export to.  The biggest issue the Chinese face is having low cost natural resources.  There has been an argument made by the U.S. that the Chinese should raise the value of their currency versus the dollar in order to get those natural resources cheaper.  In general, stronger currencies pay less for goods than weaker ones.  The Chinese appear to realize there might be another way.

Importantly, the Chinese home market might be near the point where internal consumption, via a gradual spending of its international reserves could suit the Chinese just fine, rather than transferring the assets back via what they perceive as unfavorable currency policy.  Think of things from the Chinese point of view, they feel as if they earned it, they can spend it how they want.  That is certainly not much different than our mentality the past thirty years.

What Will China Do?

In his article "The Time for Lying Low Has Ended" in the Financial Times, Ian Bremmer discusses that China is beginning to embark on policies that decouple China from the United States.  Why are they doing this?  As mentioned above, in the simplest terms, because they believe they need to and they can.  This does not mean that the United States and China will stop doing business, that will continue for many decades, however, it does likely mean that instead of exporting higher standards of living to us, they will keep that standard of living at home.  That is understandable.

Over the past decade, China has been one of the main countries to support the United States by refinancing its debts.  That day might be coming to an end as it could be in China's best interest to force our interest rates to go up through purchasing fewer of our treasuries.  If the Chinese do this, and recent indications in bond market auctions are they have begun the process, American markets will likely continue to face some deflationary pressure as interest rates rise.

American politicians have asked for a stronger Chinese currency, interestingly, we will get one if the Chinese force our interest rates up since they are pegged to our currency.  There are several moving parts here, but the easiest thing to understand is that would mean both the dollar and Yuan Renminbi would appreciate against other world currencies.  For the Chinese that could be the best of all worlds, lower commodity prices, their largest export market would remain very open and a competitor on exports would gain no advantage.

Now, I do think the Chinese will throw the U.S. a bone in the form of a small adjustment to the currency parity, but it will only be enough to smooth over some flak they have been receiving from companies that export to China (which in the end lose usually anyway as the Chinese just copy whatever they were importing) and some financiers they sleep with from time to time.

Interestingly, one author discusses a potential Chinese currency devaluation.  While I do not think that is likely, the argument applies to the Chinese holding their currency near the levels it is currently at.

What is Good for Americans?

At the crux of the 130 U.S. Congressmen's complaint about Chinese currency manipulation is that China's currency is incorrectly pegged to the U.S. dollar at a depressed price.  That is bad for a small handful of U.S. exporters, but not many, and some financiers who have placed currency bets.  It is probably good for U.S. citizens in general that the Renminbi does not drastically appreciate as it keeps our currency stronger in relative terms which means our imported oil and other imported goods are cheaper.  It is a moot argument, but it is also doubtful that the Chinese currency would float much higher even if it were allowed to.

The Chinese do not let their currency float because they do not want their currency manipulated by investors.  Rightly or wrongly, they presume that would happen.  So think about it, if your currency was going to be manipulated, wouldn't you rather be the one doing it?

While many want to blame the Chinese for American problems, rational informed people know that is not the case.  Had we not outsourced so much of our manufacturing and had embraced on a different set of social and corporate standards the past few decades, we would not be in the pickle we are in of not having enough good paying jobs.  Our problems are our own.  Using China at this point as a whipping boy, and embarking on a crusade against the Chinese is a dangerous game as John Mauldin discusses in his recent letter.  Better to find our solutions at home at this point as there is no going back in time.

It is my opinion that jobs in the United States will only come as we rebuild our infrastructure and that the money from those projects and jobs flows again through the economy.  Getting money changing hands is very important in the equation of whether we can sustain a recovery.  Mauldin also discusses the issue of money velocity in a recent article.  Once again, I will bang the drum for more renewable and nuclear energy development as the core to an improved long-term economy.  The Chinese are doing it.  Given recent developments in solar power and having seen a couple clients move to get their red badges at nuclear sites under construction, I suspect we will follow the path of energy system modernization, hopefully not too slowly.

So, while the Chinese are doing what is good for them, it is about time we did what is good for us, and that we not mistake what that is.

Your still looking for normalization, being guarded short term and cautiously optimisic long term, index ignoring advisor.


Kirk Spano

This newsletter contains forward looking statements that may not come true.  Past performance does not guarantee future results.  This letter is intended for informational purposes only, and reflects only my thoughts and opinions in general, and do not constitute individual advice.  Opinions expressed may change without prior notice.