Tuesday, May 15, 2007

Finance Surfers

Think of global liquidity as a series of waves cresting and crashing on our shores, with hundreds of surfer-financiers delightedly rushing to frolic in the surf. What creates all those waves, where does the motion of the ocean come from?

In my opinion, there are currently two major wave machines and both are located in Asia: one is the yuan-dollar peg and the other is the grossly undervalued Japanese yen. The yen funds the "carry trade" that is responsible for speculation across the globe, while the mercantilistically pegged yuan creates a ready receptacle for dollar-denominated debt issued by governments and private institutions alike. In essence, the present situation of both currencies creates huge monetary imbalances that propagate across our interdependent economy, to end up as huge waves of liquidity on every shore on the planet.

Can the wave machines suddenly stop, causing the happy surfers to smack against the rocky outcroppings of Mavericks beach? Yes, they can and at least one of them - the yuan peg - looks like it's ready to conk out since the imbalances are now affecting China itself. I am referring to the rampant stock speculation mania that now grips the very soul of Chinese society (see previous posts), threatening the savings of tens of millions. In simple terms, the liquidity has turned inwards and is causing a flash flood of "hot" money.

Chinese authorities have spoken out firmly against such foolishness, but words have had no effect, so far. Individual speculators have morphed into a solid LeBon "crowd", with its own psychological attributes, chiefly that it does not listen to reason. Engulfed in passion, it completely disregards solid fact and chases after rumors, innuendoes and tips.

In every major bubble in history the pathways and outcomes are always the same: repeated warnings issued by authorities are ignored until regulators are finally forced to take drastic action to settle things down, precipitating a violent correction as drunk-happy speculators suddenly sober up and head for the exits en masse. The longer the action is delayed, the worse the correction and thus the potential damage to the economy.

In the case of China the only sensible thing to do is to revalue the yuan ASAP by a sizeable percentage, say 8-10%. It will not only send a stern message to rampaging speculators, it will also eliminate the rising pressure from the US Congress seeking to impose trade sanctions. It will also lead to a welcome shake-out in manufacturing, as borderline factories that depend solely on ultra-cheap labor to produce export goods drop out or, better yet, turn to the domestic market. One way or another, the rising overhang of production capacity will be absorbed or eliminated.

In the case of the yen, things may look different on the surface but they really aren't - it's just the mechanics that change. Again, the artificially low yen exchange rate is creating incoming liquidity from the export industry, which is then channelled to speculation through the yen carry trade, as both domestic and foreign speculators take advantage of low interest rates. In this case a bubble is not as apparent in domestic markets, because unlike the yuan the yen is freely exchangeable to any other currency and thus liquidity is spread out amongst all global financial markets, creating bubbles all over.

It is more difficult to regulate this yen liquidity because the Japanese domestic economy is certainly not as vibrant as China's and cannot easily withstand a major administrative hike in interest rates or an FX revaluation. And yet... this type of wave machine is also vulnerable: it may fall victim to its own success. There are now hundreds of billions of dollars of yen loans supporting speculative open market positions; if markets show major signs of weakness speculators will rush to repay margin loans, causing the yen to spike upwards. We saw this clearly in the February-March correction.

And what could bring about a major correction? Why, the other wave machine, of course... In a seeming paradox, a yuan reval may also cause the yen to move up and we may end up with BOTH wave machines seizing-up at the same time and liquidity waves suddenly disappearing all over the world.

In surfing terms, we won't have 50 ft mongo waves all day, everyday...


  1. While I agree that the Yen carry trade and the Yuan peg to the dollar are major contributors to the global asset inflation we are currently experience, I don't believe the Chinese govt will accept a sudden revaluation of the Yuan under any circumstances. Nor will the Japanese refrain from intervening to devalue the Yen in the event it begins to revalue significantly against the dollar from the unwinding of the carry trade.

    From the perspective of China and Japan's govts it is better for political stability to let people lose their savings in the equity markets or real estate bubbles than to choke off the job creating export machine. It is certainly the lesser of two evils. The lesson learned from the 1985 Plaza Accord is that it is always better to export deflation to another country than to experience it at home.

    The real danger for China's govt is the possibility that there are not enough jobs available to soak up the massive migration from the rural areas to the cities. Sure people who lose their savings will be cursing under their breath and upset about losing their savings in the stock market but they will have a hard time blaming the govt for their own stupidity especially after they were warned and will be too busy trying to rebuild their savings to protest or riot. Ultimately it is wealth transfer from one group of Chinese to another so there is no real net loss from a bursting of the equity bubble.

    On the other hand, if large numbers of people lose their jobs because export factories operating on thin margins are suddenly no longer competitive that is a far different scenario. Then you have a situation where large numbers of pissed off workers are suddenly thrown into the steets with nothing to lose and plenty of time on their hands.

    China is counting on the fact that Walmart and other multinational companies who stand to lose the most from protectionist measures in the US will be able to logjam the legislative process long enough to prevent any real substantial decline in exports to the US.

    However, I think something the Chinese ultimately cannot prevent is the bursting of the debt bubble in the US. As you have pointed out in prior posts, absent a sudden rise in real income levels, higher debt burdens and depreciating real estate values will ultimately result in significantly reduced consumer spending not just in the US but throughout the developed world. I think this will be the real show stopper.

    Protectionist measures are merely symptomatic of an unsustainable debt bubble as it finally reaches its apex. They are not the cause of the monetary deflation which is the inevitable outcome of central bank policies designed to maintain near term price stability.

  2. China desperately needs to decouple its economy from the export model, if only because the major foreign consumers are now tapped out AND their credit is rapidly running out.

    If PBOC does nothing to stem the rising stock mania it may end up with a crash in shares at the same time export markets are drying up.

    China needs to develop its local consumer economy, i.e. to somewhat transform worker/savers into consumer/spenders and thus keep its factories operating. But if those savings are instead vaporized in the market this plan is DOA. Internal wealth transfer is ineffective if it goes from the vast (potentially consumer) masses to the very few "smart" operators who only buy imported luxuries.


  3. I'd have to agree with Alex on this - The yuan peg is an employment scheme to keep the masses happy. There is little chance of a domestic Chinese market in the near future - per capita income is too low, and their society is not consumer based lit ours. If people lose money speculating then the government can say -'we warned you, see the dangers of capitalism?'

    Jason B

  4. hellasious,

    I agree that the equity market bubble bursting will not help China move toward a consumer oriented economy.

    But from a political standpoint, if the govt is deemed responsible by local investors for bursting the equity bubble and the ensuing fallout, the social unrest will be tremendous. Better for people to perceive that the equity bubble bursted of its own accord despite govt warnings to investors.

    Furthermore, the Chinese govt would rather be in a position where they can cry foul because the US govt instituted protectionist measures than revalue their currency and subject themselves to the deflationary forces that Japan experienced as a result of its Yen revaluation pursuant to the 1985 Plaza Accord.

    Because China's value add to its exports is only about 20% and exports represent 60% of its economy, Chinese workers, for the most part, cannot afford to buy the end products they make. This will eventually change but China is not currently in a position to make the necessary transition to a consumer based economy quickly enough.

    Contrast this with the US where exports represent only 11% of the overall economy and the value add for exports is much higher particularly in high tech industries and services. Unfortunately the US is squandering its competitive advantage by piling on too much debt to buy imported consumer goods while failing to invest sufficiently in education and training, renewable energies, public transportation and basic infrastructure projects.

    Nevertheless, it will take a long time before the average Chinese worker can afford to buy the products he makes for export and create a truly significant consumer market particularly as China must compete with other developing countries including India.

    Meanwhile US equity markets continue racing toward new record highs as "goldilocks" gets a new makeover.

  5. Dear Alex,

    I have to believe that governing a nation as old and important as China involves more than a "blame game", i.e. those running the country are surely looking after the best interests of the people - at least most of the time?

    A yuan reval could rapidly increase the value added of local mfg., as intermediate good imports used for making exports go down in price.

    And finally a stark observation: China is now the world's second largest economy. Forgetting everything else, can it long operate within a global monetary system with a fixed currency that cannot be freely exchanged? I believe not...

    Thks for your valuable input.

  6. hellasious,

    You must be winding me up.

    In what country do politicians play anything other than a blame game.

    If by "people" you mean the political and economic elite, I couldn't agree with you more. Govt. always looks after their interests first. The trickle down theory doesn't just apply in a democracy like the US.

    At least in a democracy, the govt can usually claim legitimacy derived from having been voted into office. In a communist state, however, it is necessary to deliver on a utopian society.

    Rapid gains in wealth by a relatively small group of people breeds envy when income disparities become too pronounced even if overall prosperity increases. There are certainly plenty of staunch communists in China, lurking in the background, just waiting for an opportunity to take down the newly emerging bourgeois classes and commence another cultural revolution should the opportunity arise.

  7. It has been reported recently that many investors in China decide that a share of stock is a good buy if it costs less than a portion of pork meat. This makes all those American anecdotes about being able to tell a top in shares when Taxi drivers start giving out tips seem more than a little quaint.

    When faced with this sort of stupefying (pig meat) logic, it seems unlikely that the Chinese government will be adequately equipped to deal with the inevitable dashed hopes of the new, wink, wink "investor" class.

    After all, epic bubbles of the sort that is in full bloom in China always end very badly no matter what the authorities try to do to prevent disaster. Whether the crash will come as export markets are imploding is hard to say, though it is easy to imagine that the mere whiff of the end of the export game could be all that is needed to prick the bubble once and for all.

    Alex wrote:

    "Rapid gains in wealth by a relatively small group of people breeds envy when income disparities become too pronounced even if overall prosperity increases. "

    This is true but also a contradiction. Overall prosperity, by definition, can't exist if the increase in wealth is essentially cornered by a small group. When things are skewed in such a manner, then one has entered the realm of "lies, damned lies and statistics" In short, Bullshit.