Archive for the ‘china’ Category

There were about five pieces of news on Friday that delivered such a massive upside kick to oil.

1) Chinese oil consumption numbers came in much higher than expected.

Wall Street is still being blindsided by the impact of the Sichuan earthquake, and apparently most of it is ignorant that ~30 percent of Chinese oil/ natgas/ heating oil comes from Sichuan and Gansu (which was also thrown into chaos by the quake).

2) Shaul Mofaz rattled Kadima’s flimsy sabre at Iran, again. Anyone who took that seriously is ill-informed.

3) The dollar continued hemorrhaging. Brokers are cutting back trading with Lehman Brothers, and Bernanke will probably be called out on his fateful March 17 nationalization of banks’ default risk. He will have to throw hundreds of billions of dollars in Treasuries at Lehman’s crippled balance sheet, further debasing Treasuries specifically and US financial credibility generally.

4) Morgan Stanley said oil would go to $150.

5) The USD and EUR are both heavily overvalued. As long as China keeps its currency peg alive, the dollar and euro will both be overvalued. The only other large currency alternative is commodities, so that’s where money is going.

As I have said many times, government witch hunts against “speculators” never signal the top of a bull market.

Israel’s saber-rattling might have been good for 1 percent of oil’s gain. Obama’s triumph in the US presidential primaries multiplied that, for a total of maybe 3 percent.

In the meantime, Asia’s cracking currency regimes are effectively increasing their subsidies of fuel.

HONG KONG: Buckling under the weight of record oil prices, several Asian countries have cut or are thinking of cutting their fuel subsidies, which raises a pressing question for Beijing: Can China afford its own oil subsidies at a time when it is spending billions on post-earthquake reconstruction?

The short answer is yes, because China is blessed with both large trade account and fiscal surpluses. The reconstruction cost is projected to amount to about 1 percent of China’s gross domestic product, while the fuel subsidies account for another 1 percent, JPMorgan estimates.

Remember that China had a fiscal surplus of 0.7 percent of gross domestic product last year, or $174 billion. So even if spending on post-earthquake rebuilding and fuel subsidies were to cause a 1 percent fiscal deficit, that would still be very manageable.

But here is a more important question: Why should China keep domestic fuel prices at about half of the global average?

The usual answers are to keep inflation in check and stave off social instability that could result if prices were to rise too quickly.

But by distorting fuel prices, China is encouraging fuel consumption and discouraging the use of new energy. Since the Chinese still live in an $80-a-barrel oil environment, demand for anything from cars to chemical products will spiral higher and raise the risks of economic overheating.

Increasing subsidies on fuel will crowd out more investment in other areas, such as education or health care, to name two possibilities.

What’s more, a worsening fiscal situation might put downward pressure on the yuan. Fuel subsidies have exaggerated inflation in the developed world, while understating inflation in the developing world. China’s inflation could well hit 15 percent if Beijing were to free up caps on energy prices, Morgan Stanley estimates.

“If China is not able to take away the subsidy and cut down its demand, it will have huge implications for the world,” said Shikha Jha, a senior economist at Asian Development Bank.

Countries like China and India, along with Gulf nations whose retail oil prices are kept below global prices, contributed 61 percent of the increase in global consumption of crude oil from 2000 to 2006, according to JPMorgan.

Other than Japan, Hong Kong, Singapore and South Korea, most Asian nations subsidize domestic fuel prices. The more countries subsidize them, the less likely high oil prices will have any affect in reducing overall demand, forcing governments in weaker financial situations to surrender first and stop their subsidies.

That is what happened over the past two weeks. Indonesia, Taiwan, Sri Lanka, Bangladesh, India and Malaysia have either raised regulated fuel prices or pledged that they will.

Actions taken by those countries will not be able to tame a rally in prices though unless China, the second-largest oil user in the world, changes its policy. While the West is critical of China’s energy policy, there is little outcry for change within the country, except for complaints from two loss-making refineries.

By contrast, Indonesia has convinced its people that fuel subsidies benefit the rich more than the poor, because rich people drive more and consume more electricity. Jakarta rolled out a $1.5 billion cash subsidy program to help low-income Indonesians cope with higher prices. Although no country wants to build a system on subsidies, the cash subsidy at least makes fuel subsidy cuts politically feasible.

“The people need to wonder, who pays for the subsidies?” said Louis Vincent Gave, chief executive of GaveKal, a research and asset management company. “Most Asian countries are printing money to pay for them.”

Fuel subsidies compromise countries’ ability to control their own budget spending. If China and India can cut their subsidies, they would be able to spend more on infrastructure and education.

While Asian governments dole out cheap food and cheap energy, Asian currencies settle the bill. Morgan Stanley expects some emerging market currencies to face downward pressure, probably for the first time in a decade, as those countries unwind their fuel subsidies and domestic inflation shoots up.

China’s domestic fuel prices are among the lowest in the world, equal to about 61 percent of prices in the United States, 41 percent of Japan and 28 percent of England. The longer it waits, the more painful it will be when it tries to remove the subsidy.

China actually doesn’t have much freedom to splash dollars for fuel. Its entire macroeconomic policy can be summarized as “long USD, short RMB.” Not a good trade.

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Setser on the PBOC:

What cann’t go on still hasn’t slowed, let alone stopped (Chinese reserve growth)

… Back in 2004, it was considered rather stunning when China added close to $100 billion to its reserves ($95 billion) in a single quarter, bring its total reserves up to around $600 billion.. The dollar’s fall against the euro (and associated rise in the dollar value of China’s euros) explains around $15 billion of the rise. But at the time, $80 billion was considered a very large sum for China to have added to its reserves.

Now China has $1756 billion in reserves, after a $74.5 billion April increase. The dollar rose against the euro in April, so the underlying pace of increase – after adjusting for valuation changes – was more like $82 billion.

In a month.

And not just any month – in a month when oil topped $100 a barrel.

$82 billion a month, sustained over a year, is close to a trillion dollars. A trillion here, a trillion there and pretty soon you are talking about real money. If a large share of China’s reserves is going into dollars, as seems likely, this year’s increase in China’s dollar holdings could be almost as large as the US current account deficit.

The fact that one country’s government – and in effect two institutions (SAFE and the CIC) – are providing such a large share of the financing the US needs to sustain large deficits (particularly in a world where Americans want to invest abroad as well as import far more than they export) is unprecedented.

The real surprise in some sense is that the increase in China’s April preserves isn’t that much of a surprise. At least not to those who have been watching China closely.

Wang Tao – now of UBS – estimated that China added $600 billion to its foreign assets in 2007, far more than the reported increase in China’s reserves. Logan Wright (as reported by Michael Pettis) and I concluded that Chinese foreign asset growth – counting funds shifted to the CIC – could have topped $200 billion in the first quarter.

China hasn’t disclosed how much it shifted to the CIC, let alone when it shifted funds over to the CIC. But it seems likely that the surprisingly low increase in China’s reserves in March stems from a large purchase of foreign exchange by the CIC. Indeed, the CIC’s March purchase may have used up all of the RMB 1.55 trillion the CIC initially raised.

As a result, all of the increase in the foreign assets of China’s government seems to have showed up at the PBoC in April. Or almost all. China raised its reserves requirement in April, and the banks may have been encouraged to meet that reserve requirement by holding foreign exchange.

China’s current account surplus – adding estimated interest income to its trade surplus – was no more than $25 billion in April. FDI inflows were around $7.5 billion. Sum it up and it is a lot closer to $30 billion than $40 billion. Non-FDI capital inflows – hot money – explain the majority of the increase.

No wonder Chinese policy makers were so focused on hot money this spring. Hot money flows seem to have contributed to their decision to stop the RMB’s appreciation in April. But interest rate differentials still favor China – so it isn’t clear that a slower pace of appreciation will stem the inflows.

It certainly though helps to sustain the underlying imbalance that has given rise to massive bets on China’s currency.

The scale of China’s reserve growth suggests that China’s government is no longer just lending the US what it needs to buy Chinese goods. And it is now lending the US – and indeed the world – far more than the world needs to buy Chinese goods. Vendor financing is a fair description for China’s reserve growth in 2003 or 2004, but not now.

China’s government is increasingly acting as an international as well as a domestic financial intermediary. It has long borrowed — whether through the sale of PBoC bills of Finance Ministry bonds to fund the CIC – rmb to buy dollars, effectively taking the foreign currency domestic Chinese savers do not want to take. Now though it is borrowing from the rest of the world to lend to the rest of the world.

Most intermediaries though make money. Or at least try to. By contrast, China’s government is almost sure to lose money on its external financial intermediation. Selling RMB cheap to buy expensive dollars and euros is not a good business model.

China cannot be entirely comfortable with all the money that is pouring into China. But it isn’t at all clear that Chinese policy makers are willing to take the steps needed to shift decisively toward a new set of policies. It is clear that the costs of China’s current policies are rising.

Remember, China looses [sic] money on its reserves. More isn’t better.

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Apparently luck had it that every single Chinese ADR, and more than a few others, trooped to the United States to make their pitches to US investors. I got to listen to more than a few of them over the past four days (one reason why the post count has run low).

American institutional investors are quite concerned about the post-Olympic dampening effect, and are also concerned about inflation. The CFOs I talked to informed me that their internal inflation forecasts are running in the 12 to 15 percent range, basically dependent upon whether they think China’s price blowout (recently concentrated in food) is permanent or transitory.

While the meteoric increase in food prices has abated somewhat, oil and metals have gotten worse. Chinese manufacturers, refiners, and banks are eating fierce losses. The distribution of said losses among the three groups is unclear, but the existence of enormous losses is a matter of fact.

The CFOs I talked to generally represented IT companies, which are heavily insulated from raw materials inflation, if not wage inflation. I would imagine the outlook at more BTU-intensive companies is significantly worse.

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The Age (Aus.):

Justin Norrie, Tokyo

April 21, 2008

A 130% rise in the global cost of wheat in the past year, caused partly by surging demand from China and India and a huge injection of speculative funds into wheat futures, has forced the Government to hit flour millers with three rounds of stiff mark-ups. The latest — a 30% increase this month — has given rise to speculation that Japan, which relies on imports for 90% of its annual wheat consumption, is no longer on the brink of a food crisis, but has fallen off the cliff.

MARIKO Watanabe admits she could have chosen a better time to take up baking. This week, when the Tokyo housewife visited her local Ito-Yokado supermarket to buy butter to make a cake, she found the shelves bare.

“I went to another supermarket, and then another, and there was no butter at those either. Everywhere I went there were notices saying Japan has run out of butter. I couldn’t believe it — this is the first time in my life I’ve wanted to try baking cakes and I can’t get any butter,” said the frustrated cook.

Japan’s acute butter shortage, which has confounded bakeries, restaurants and now families across the country, is the latest unforeseen result of the global agricultural commodities crisis.

A sharp increase in the cost of imported cattle feed and a decline in milk imports, both of which are typically provided in large part by Australia, have prevented dairy farmers from keeping pace with demand.

While soaring food prices have triggered rioting among the starving millions of the third world, in wealthy Japan they have forced a pampered population to contemplate the shocking possibility of a long-term — perhaps permanent — reduction in the quality and quantity of its food. …

… Last week, as the prices of wheat and barley continued their relentless climb, the Japanese Government discovered it had exhausted its ¥230 billion ($A2.37 billion) budget for the grains with two months remaining. It was forced to call on an emergency ¥55 billion reserve to ensure it could continue feeding the nation.

“This was the first time the Government has had to take such drastic action since the war,” said Akio Shibata, an expert on food imports …

Biofuels companies are going to be destroyed by this. Agribusiness — especially anything having to do with genetically-modified food — will blast off. This isn’t going away in 2 quarters.

Thailand, one of the world’s biggest rice exporters, is only the latest country to be mauled by a massive drought.

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Things started getting very difficult with the internet about six months ago as the great firewall got tighter, but in the past few weeks internet access has been far more frustrating than it has ever been during my over six years living in Beijing.  It takes me hours (literally) to post anything on my blog.  My Peking University students tell me that they waste two or three hours a day more than they used to trying to access information on the internet.  When I ask them why it has become so difficult, they tell me that there are a lot more things now that the government doesn’t want them to know – although they don’t usually specify what that may be. …


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China’s chronic undervaluation of its currency implies that the country should have a rate of inflation approximately proportional to its persistent current account surplus. China’s current account surplus has been exploding recently, which means that China is in the throes of an inflationary monetary trap. It also means that you can look at China’s forex reserves as an approximate indicator of what China’s real rate of domestic inflation is.

One of the methods by which China has kept its (stated) rate of inflation so low has been by a haphazard series of price controls, especially since last fall (justified by chronic “one-off events” — pork disease killing lots of pigs, a big snowstorm, etc). However, that system is breaking down.

March 28, 2008 | 1307 GMT

For the first time since Beijing imposed a temporary ban in January on all price increases for essential items, China’s National Development and Reform Commission has allowed a price rise application to slip through. In reality, this ban was more effective at calming social unrest ahead of March’s politically sensitive National People’s Congress than resolving China’s inflation problem at the root. Going forward, the government will have to look for other, more effective ways of curbing inflation — if none is found, a temporary ban will likely be reimposed.


China’s third-largest dairy producer, Bright Dairy & Food Co., said March 28 it plans to raise milk prices by 14 percent in some regions after having obtained approval from the National Development and Reform Commission (NDRC), Shanghai Securities News reported.

For the first time since January, when Beijing imposed a temporary ban on price hikes from all major producers of essential items such as milk, flour, rice, noodles and cooking oil — subject to central government approval — the NDRC has given a major producer permission to raise the price of an essential food item. […]

Currency manipulation is today’s favorite mode of capital allocation by authoritarian governments. One of the side effects of Bernanke’s war on the dollar has been to dramatically raise the cost of this policy, which pegs the national currency to the USD at an artificially low rate to boost exports, and misallocate capital to the export sector, at the expense of domestic purchasing power. A cheaper dollar drags down all currencies pegged thereto, which means that the purchasing power of phony-currency pegs’ citizenries erodes further, which causes more social instability and unrest.

The power of the 1989 Riot Which Shall Not Be Named was in the population’s rage at food price inflation … not the seductive appeal of the “goddess of democracy.”

A 14 percent price increase is going to hurt a lot of pocketbooks.

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March 5, 2008 | 1331 GMT


Ten Australian tourists and their translator were taken hostage March 5 in the Chinese city of Xian, famous for its terra-cotta warriors.

A local Xian resident identified as Xia Tao boarded a tourist bus at around 9:52 a.m. local time, armed with explosives and threatening to blow up parts of downtown Xian. Local police negotiated with Xia, who released nine of the Australian hostages before transferring to another bus with one Australian and the translator and driving to the airport. Police shot and killed Xia as he approached a tollbooth near the airport. The remaining hostages were unhurt. Police have not released Xia’s motive.

I haven’t heard of a single incident like this before. But I suspect that generalized economic malaise, i.e. inflation, was what caused this. Inflation is the root cause of very serious latent social instability in China, about which Western investors are as clueless as ever. Inflation-driven unrest shook the Communist regime to its foundations in 1989, destroyed the Guomindang Nationalists in the 1940’s, and will shake China’s current regime to its core within the next five years.

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SAN FRANCISCO (MarketWatch) — In an effort to calm grousing consumers as prices rise to 11-year highs, China is raising minimum wages across the country, a move analysts fear could further stoke inflation.
Guangdong, China’s richest province, said it plans to raise minimum wages by as much as 18% in some cities starting April 1. The decision followed similar actions in other areas, notably the major cities of Shanghai and Beijing. Tibet, an autonomous region administered by China’s central government, raised minimum wages by nearly 50% at the beginning of this year.
The wage increases, aimed at relieving food and other price pressures, could instead fuel inflation, analysts said. Higher wages are also likely to raise prices of U.S. imports from China, and possibly reduce China’s attraction as the world’s manufacturing center.

China is wrestling with consumer inflation that accelerated to 7.1% in January, up from a 6.5% rise in December, the National Bureau of Statistics reported last week. …

China’s dilemma
Since last year, Chinese residents have seen prices of food and other staples increase more than their pay checks, a factor analysts said could potentially unleash social unrest. In light of that, some fear the minimum wage increase came too late.
“It’s a dilemma for China,” said David Riedel, president of overseas-stock specialist Riedel Research Group. “The reality of higher food and fuel prices has to be offset with higher wages. This is more wages catching up to where the market is today.”
The wage increases could feed inflation, he said, explaining that companies absorbing higher wages have to pass those costs onto their customers.
Guangdong will increase the province’s minimum wages by an average 13% on April 1, the province’s labor bureau said in a news release last week. The southern China province produces about 13% of China’s economic output, the most among the country’s 32 provinces.
Minimum wages in the capital city Guangzhou will rise to 860 yuan ($120) per month from 780 yuan, an increase of 10%. Wages of other cities in the province will also get a boost, with those in some inland cities up nearly 18%.
China’s other provinces took similar actions earlier this year. Starting Jan. 1, four provinces hiked their average minimum wages by more than 20%, with the increase in Tibet topping the list, according to data collected by Citigroup. Five other provinces increased average wage caps by more than 10%.
Beijing and Shanghai, China’s two biggest cities, last year raised their minimum wages to 730 yuan and 840 yuan respectively, in the face of rising consumer prices.
Average minimum wages in China have risen 15% in 2007, Citigroup said in a report, and 21% in 2008 based on available data.
Higher inflation
The wage hike came as some analysts were already reconsidering their estimates for Chinese inflation.
“The current consensus view is that this year’s inflation should peak in the first quarter,” said Lan Xue, an analyst at Citigroup, in a separate research note. However, Xue said “we are getting nervous that not only may we not see a moderation in the second quarter,” but that inflation could even continue rising into second half or even 2009.
Recent inflation has even spread to home appliances, one of the most oversupplied goods in China.
Haier, China’s biggest appliance producers and an exporter of mini refrigerators and other appliances, said last week it will raise domestic prices of refrigerators and washing machines by 7% to 10% in response to higher producing costs.
The prices rises are notable because winter is usually the slowest season for selling appliances, according to Citi’s Xue, who added that it is “probably the first time in the past 15 years that we have seen price increases” in that sector.

Guangdong province, whose minimum wages will be the country’s highest as of April, is China’s largest manufacturing center for home appliances. That could put even more upward pressure on appliance prices.

Vindication for those of us who have never trusted Chinese statistics. “7.1%” Chinese CPI is a total fabrication. When the China myth has collapsed, common sense and a smidgen of on-the-ground experience will have trumped Wall Street’s credulous, all-too-fashionable quants and permabull prophets yet again.

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I have told anyone who will listen that China is a deflationary depression waiting to happen. Banks that neglected their cultural homework, ignored preposterous P/E valuations, and brushed off gaping macroeconomic inefficiencies, such as Morgan Stanley, are now paying the price of being too fashionable too late in the race.

Morgan Stanley’s Chinese prize loses some shine

By Jamil Anderlini, Paul Betts and Andrew Hill

Published: February 25 2008 18:25 | Last updated: February 25 2008 18:25

More than 12 years after it helped set up China International Capital Corp, Morgan Stanley is preparing to sell its 34.3 per cent stake in the top underwriter of initial public offerings in the world’s biggest IPO market.

Most likely the stake will go to one of a handful of US private equity firms.

But while access to the largely closed Chinese brokerage industry is tempting, bidders for the stake, including TPG, Bain Capital and others, are realising the prize is not as sweet as it first looked.

For one thing, the Chinese stock market is down nearly one-third from the highs it reached last October, trading volumes are around a third of what they were at their peak in the middle of last year, and just yesterday the securities regulator said it planned to rein-in large secondary listings in the domestic market.

As for CICC itself, Morgan Stanley has been sidelined by Levin Zhu, the firm’s powerful chief executive, who is also the son of former Chinese premier Zhu Rongji. Many in the Chinese financial world privately say Mr Zhu rules CICC like his own kingdom, while Morgan has progressively ceded control.

Anyone who buys a piece of CICC could be buying a troubled relationship.

The vast majority of Chinese “capitalism” is the same old Communist clan networks, thinly veiled with “capitalist” ownership structures. The subservience of economics to politics, lack of respect for spirit of contract, institutional inefficiency, and state subsidies have not really changed. Once the Chinese lower class realizes how quickly the pie is shrinking, “red capitalism” will join dirigisme, METI, and Nixonism in the trash heap of economic history. Anyone who read “Mr. China” or “One Billion Customers” would have considered those facts before blowing billions of dollars on a luridly overpriced bank purchase.

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Satyajit Das:

Trompe L’oeil Markets

Emerging market equities, especially the Shanghai and Mumbai markets, have decoupled. Bizarrely, they “de-couple” only if the US markets fall but “re-couple” if the US market goes up!

Increases are driven by substantial short-term capital flows fleeing developed markets and the US dollar. The assumption is that valuations and earning growth are sustainable. Some prices in India and China are reminiscent of the surreal valuations of the dot.com and (earlier) Japanese equity bubbles. The quality and performance of recent initial public offerings have been variable and (in some cases) poor.

Earnings quality is variable and sometimes questionable. Earnings growth has increasingly been driven by investment income – stock market and property speculation. In a strong market, this accentuates earnings as higher investment earnings feed increasing share prices in a virtuous cycle. In a falling market, this works in reverse accelerating losses.

Returns on capital investment are variable. Chinese state funded businesses with access to cheap funds are not earning investment returns anywhere near the cost of capital. Many projects are predicated on high, continued economic growth well into the future.

The Indian and Chinese stockmarkets are trompe-l’oeils – paintings designed to deceive the eye. They provide a dangerous illusion of a modern economy for foreign investors. Electronic trading, complex financial instruments and (at least in the case of China) gleaming glass and steel structures mask deep structural problems.

The markets are far from being free and transparent. There is a nagging suspicion that prices are prone to being influenced by insiders and their associates. In the case of China, most traded shares are in government enterprises that continue to be controlled by the State. Chinese shares aren’t even really shares as they don’t convey full ownership rights equally to all shareholders.

The Indian and Chinese markets have been driven by a number of initial public offerings generously priced to provide investors (themselves privileged insiders) with large gains. A few shares contribute disproportionately to market performance. The rise in India’s Sensex Index in late 2007 was driven by few stocks. This reflects the lack of liquidity in many stocks. In China, restrictions on foreign investments by domestic investors and the lack of investment alternatives has contributed to the sharp increase in the price of Chinese stocks. Borrowings by corporations and individual investors have been channeled into the stock market creating dangerous levels of leveraged exposure to share prices.

Both markets fall a long way short of true financial markets designed to channel savings to productive investments.

Decouplings and Recouplings

De-coupling assumes that emerging markets will not be significantly affected by a US slowdown. Emerging markets fortunes generally are tied to the vagaries of globalised trade. Exports account for one-third of Chinese economic growth and 10% of GDP. India is dependent on export growth. Russian and Brazilian growth depends on commodity demand and high commodity prices. 80% of Asian intra-regional trade is driven by demand for outside Asia. A slowdown in the USA and Europe will affect growth.

Europe has the added problem of a weak US dollar. EADS (Airbus’ parent) recently complained that the strong Euro placed the firm’s viability in question – the plane maker’s chief executive used the phrase “life-threatening”.

Belief that domestic consumption can take over from exports as the growth engine in emerging markets is untested. Any Xie (a former Morgan Stanley economist writing in the South China Morning Post) speculated recently that: “In China, people make money to, well, make money. Happiness comes primarily from counting the money, not spending it.” The total number of the mythical middle class consumers in emerging markets that obsesses Western analysts is probably exaggerated.

India and China also face infrastructure constraints. Shortages of educated and skilled workers are forcing up labour costs rapidly. Essential infrastructure gaps like transport and power in India will take years to correct. Inflation from imports (energy and commodity costs) and rising domestic costs is driving local currency interest rates up. In China, concern about speculative bubbles driven by debt has led the central bank to both increase interest rates but also limit lending. This may choke off growth. A widening interest rate differential against the US dollar also causes currency appreciation attracting capital flows whilst reducing local currency earnings of exporters.

There are feedback loops. Corporate earning growth in developed countries assumes an increased contribution from sales to rapidly growing emerging markets, just look at the Boeing and Airbus projections. Any slowdown in emerging markets will in turn hit corporate earning in the USA, Europe and elsewhere. Commodity prices and the fortunes of commodity producers are underpinned by the emerging market growth story. In an origami moment, the “flat world” actually folds back on itself.

Some emerging markets are also dependent upon foreign capital. For example, India is running a trade deficit of around 10% of GDP and a budget deficit of around 3%. This must be financed. To date, this has been financed by foreign capital – both portfolio investments and foreign direct investment. Changes in global financing conditions may adversely affect India and its growth prospects.

The additional risks of emerging market investments are also not properly priced. Enforceability of property rights, good corporate governance, equal access to timely, accurate financial information, corruption and political risks are being ignored.

China’s Shanghai market is down about 20% off its recent highs. In late 2007, the Indian market recorded an intra-day move of around 14 % (8% down followed by 6% up) when regulations regarding foreign investment were mooted. Such volatility is de-stabilising.

Tellingly, savvy and well connected investors from Singapore (GSIC and Temasek Holdings (a government controlled investment fund)) are steadily divesting from China and switching to other assets including distressed bank stocks in Europe and the USA.

Narrative Fallacies…

The risks of the new investment orthodoxy are high and largely ignored. As Keynes observed: “It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree when we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”

I knew India’s trade deficit was pretty high, but I didn’t know it was 10 percent of GDP …

India has excellent “long long-run” prospects, but for now, it’s probably at least as overbought as China is.

China’s growth hurdles aren’t going to come from Beijing’s monetary tightening, because Beijing isn’t tightening at all. Even if it did, the provinces would ignore the directive (you could argue that that’s exactly what they’re doing now). Michael Pettis, channeling Victor Shih, has already informed us that the PBOC’s “loan curbs” have been a joke.

Not to dump on Das too much, but he is committing the typical Western error of believing that because Beijing made a pledge about something, they will therefore follow through on that pledge to a significant extent. Beijing does not have the ability to curb lending, because the provincial Chinese elites are even more addicted to cheap credit than Beijing is. China is trying to one-up Japan for the dubious mantle of “greatest asset price deflation of the past 100 years.”

China‘s Credit Boom



The rest of the global economy may be experiencing a credit crunch, but not China, where easy credit has fueled a spectacular run-up in real estate prices and stock markets. Despite a cascade of State Council decrees restricting bank lending this year and a high-profile Politburo meeting in November that focused on the risk of inflation, bank lending last month grew by over 800 billion renminbi ($112 billion) — equivalent to 22% of the total loan quota that Beijing’s technocrats meted out to state-owned banks for 2008.



This rate of credit expansion is similar to the rate last seen in the second quarter of last year, when China’s economy grew by nearly 12% from a year earlier. And it comes just as the Party is trying to ratchet down inflation, which in January hit 7.1% year-on-year on consumer prices.



Technical factors don’t fully explain why the monetary base grew with such fervor in January. The lunar new year holiday took place earlier this year than usual, driving up demand for cash. However, new year cash spending usually means withdrawing one’s savings, not borrowing from banks. A severe winter snow storm forced the central government to release tens of billions of renminbi in funds to pay for emergency spending. But this amount would be a blip in the Chinese monetary landscape, which runs into the trillions of renminbi in a given quarter.



More convincingly, major borrowers are pressuring banks to lend out as much of the credit quota as possible. Companies want to take advantage of low real interest rates and lock in cheap cash for the remainder of the year. Although large firms, many of which are powerful state-owned entities, are undoubtedly exerting pressure on banks, State Council loan ceilings precisely seek to minimize the effect of firm pressure by coordinating all banks simultaneously to cut back on lending. However, bankers called the technocrats’ bluff and proceeded to lend with gusto. In effect, they are daring Beijing technocrats to enforce the credit ceiling and risk a widespread liquidity shortage in the latter part of the year.



This is an unusual game of chicken. China’s major banks, all of which are majority state-owned and run by managers appointed by the Communist Party, are simply ignoring decrees issued by the highest authorities.. In a state-dominated banking system, this is as unexpected as mid-level managers blatantly acting against the wishes of both the CEO and the board of directors. Formally the technocrats have the full backing of the ruling Communist Party and can dismiss any banker at any time. However, senior state bankers do not behave as if they take the threat of removal seriously. They’ve stared down such threats before, anyway — in China, elite political discord has often compelled banks to disobey formal decrees.



Politics may be at work here. First, the increasingly vocal National People’s Congress, China’s rubber-stamp legislature, is slated to open its new session at the beginning of March. Many top technocrats, including central bank governor Zhou Xiaochuan, will receive new appointments. Others will simply be reappointed to their posts. Thus, technocrats may hesitate to enforce loan ceilings because they do not want to anger regional and industrial lobbies represented in the NPC that want easy credit. But although the NPC formally votes to appoint ministers, in reality, their appointments are decided by the Politburo Standing Committee — the same body that voted to support retrenchment policies in November. Thus, the technocrats should not feel threatened by the NPC, even though the NPC may not prefer retrenchment.



There are plentiful historical precedents for these kinds of politically driven loan surges. In the 1980s and ’90s, feuding elite factions cheered their provincial followers to borrow heavily from the banks. Banks, knowing that elite politicians in the Communist Party’s Politburo supported loose lending, felt they had little choice but to open the monetary spigot. Likewise, because the technocrats knew that banks were lending due to elite political pressure, they could do little to punish banks. Both the technocrats and the banks served the same master — the political elite in the Communist Party. This often led to serious inflation trouble until the faction with the most to lose from an economic crisis decided to support senior technocrats and crack down on lending, thus ending loose lending policy and stifling inflation.



Something similar may be happening today. When faced with rising inflation late last year, President Hu Jintao decided to support Premier Wen Jiabao’s retrenchment policies. There were signs, however, that not every member of the ruling Politburo Standing Committee agreed with retrenchment policies. Days before the November meeting, for instance, Premier Wen announced on a trip to Singapore that lowering asset prices was a high priority. Yet, the Politburo meeting did not endorse this policy goal, strongly suggesting that some members of the top elite opposed it.



The most likely opponents of strict monetary policies are powerful “princeling” officials — children of the Communist Party’s founders — who have close connections with economic interests in China’s big coastal cities. Some of these interests, which include manufacturers and real estate developers, have suffered from the tight monetary environment. Detecting elite discord on retrenchment policies, bankers are then emboldened to disregard central decrees, betting that their elite supporters would protect them from the wrath of the technocrats.



The Chinese government needs to continue monetary tightening by raising interest rates and the bank’s reserve requirements. Furthermore, Messrs. Hu and Wen need to overcome internal opposition and make it clear to bankers that flouting central decrees begets serious consequences, including dismissal. Otherwise, they risk allowing inflation to spiral toward dangerous levels. In the opaque Chinese political system, strong signals, in addition to decrees and laws, continue to be necessary ingredients of credible policies.

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According to JPMC’s Global Data Watch, the People’s Bank of China will ignore the latest “temporary” spike in inflation — because, naturally, it’s all the snowstorms’ fault.

PBoC to ignore January inflation spike

China’s exports jumped in January, echoing the results in Taiwan and Korea, and confirming that regional activity accelerated sharply in advance of the lunar new year holidays. Export and IP growth will be correspondingly weak in February. China’s government will release January and February data for IP, fixed investment, and retail sales together in mid-March, so this month’s data reports will be limited. The government will report January inflation next week, however.

The CPI is expected to reach a new cycle high of 7%, reflecting the dual impact of the approaching holidays and recent snowstorms. The central bank is not expected to respond to this development, recognizing that the inflation spurt is temporary. Indeed, policymakers recently have been emphasizing the need to maintain stable growth amid a deteriorating external backdrop, rather than focusing on inflation and overheating risks as before.

Every month since at least August has seen inflation at or above 6.5 percent. Yet the issues remain “temporary.” Just like the credit crunch remains “temporary.”

Although I think real Chinese inflation is well into double digits at this point, nobody–and that includes Beijing–has any clue what Chinese macro aggregates are. It’s just too big of a country.

Meanwhile, from the realist school of Chinese economics, comes the latest from one of my favorite China watchers, former Bear Stearns bond trader and now Beijing finance professor Michael Pettis:

According to today’s Bloomberg, “China‘s trade surplus jumped more than economists estimated in January, a sign that the world’s fourth-biggest economy may keep powering global growth as a recession looms in the U.S.  Data released by the Chinese authorities yesterday showed a trade surplus of $19.5 billion for January.  This is below December’s $22.7 billion (which tends to be swelled by Christmas shipments), but it is 23% higher than last January’s $15.9 billion.  More importantly it was also higher than the consensus estimates, of just under $17 billion.  Exports rose by a very high 26.7%, to $109.7 billion for January, while imports increased by 27.6%.


Although the number surprised substantially on the upside (yet again), a number of analysts tried to downplay or explain away the higher-than-expected surplus, and to predict (yet again) that things will improve.  “Such strong export growth is unlikely to be sustained. I think it’s abnormal,” said Li Yushi, vice-director of a think-tank under the Ministry of Commerce, according to an article in today’s South China Morning Post. …

26.7 percent. …

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One thing that has especially confused me about the recent train of economic events is that in terms of macro aggregates, the “global savings glut” has accelerated, not slowed down. Similarly, any monetary indicator you use shows a massive acceleration in the money supply.

Longtime readers will remember the FRED graphs of MZM, bank credit, and the value of the dollar. True to form, here they are again, in their most recent incarnation:



The first graph compares bank credit and “cash” (money at zero maturity, MZM) in absolute terms, with the “dollar index” (the value of the dollar in terms of a global currency basket). The second graph is the same, except that TOTBKCR and MZM are in year-on-year percentage change terms, instead of absolute terms.

Bank credit of commercial banks (TOTBKCR) is by far the largest private lending aggregate out there. You could argue that certain smaller indicators (eg, “TOTCI” in FRED, if you want to check it out) are more forward-looking, but they are all a lot smaller than MZM.

Anyway, for the uninitiated, “money at zero maturity” is my favored indicator of “broad cash,” and thus the money supply. Excepting 9/11, the MZM growth rate is equal to, if not exceeding, the rate in 1997-8, when Asian and Russian money fled the Asian financial crisis and the Russian debt default. You would have to go back to good old 1987 to find a faster rate of growth in the US money supply. Similarly, commercial bank credit has sustained an extraordinarily rapid pace of growth over the past two years, and as of January 30, it hasn’t slowed down.

Meanwhile, the global savings glut continues to accelerate at an incredible rate:

Foreign Official Reserves Now Over US$6.4 Trillion
February 15, 2008

By Stephen Jen | London (Lisbon) & Charles St-Arnaud | London

Summary and conclusions
Total world official foreign reserves reached US$6.4 trillion around end-2007, and continue to grow at roughly US$150 billion a month, with Asia accounting for half of this growth, and oil exporters another third of this increase.  We pay particular attention to Japan’s reserve accumulation, which has been more rapid in recent months than can be explained by what we know about the asset composition of Japan’s reserves.  Rather than surreptitious interventions, as some have speculated, we believe that this is due primarily to the large EUR/JPY interventions in 2000, and the lack of rebalancing since then.  It is also possible that there might have been some EUR/USD purchases (i.e., dollar diversification) in 2007, by either the BoJ or the new division within the MoF that aims to enhance the return on Japan’s foreign reserve holdings.

Key features of the world’s official reserve growth
We make the following observations:

·      Observation 1.  Total reserves are now US$6.4 trillion.  The world’s official reserves continue to grow at a rapid pace, reaching US$6.4 trillion around end-2007, from US$6.0 trillion in September 2007.  The average pace of the world’s reserves is around US$150 billion a month.  This is an acceleration: the average pace of the world’s foreign reserve growth was only about US$30 billion a month in 2005.

·      Observation 2.  Asian exporters and oil exporters remain the key reserve accumulators.   Of the total stock of reserves, Asia and oil exporters account for US$3.9 trillion and US$1.2 trillion, respectively.  In terms of monthly growth, they account for US$75 billion and US$50 billion, respectively.  With US$1.57 trillion, China is the largest reserve holder in the world, followed by Japan (US$996 billion) and Russia (US$483 billion).

·      Observation 3.  Interventions dominate reserve growth.  Of the US$150 billion in monthly reserve growth, making some assumptions, roughly 70% of the total may have come from outright interventions, while only 12% came from interest earnings on the underlying assets and 18% from valuation changes (i.e., EUR appreciation).  In particular, the pace of China’s interventions has most certainly accelerated recently, not ‘despite’, but because of, the acceleration in the pace of CNY appreciation.  As investors recognised Beijing’s new policy on the CNY in November, they stepped up their speculative buying of CNY, which meant that capital inflows actually increased, forcing the PBoC to intervene even more than before.  In other words, by accelerating the pace of CNY appreciation, Beijing may have introduced more inflationary pressures.  Similarly, the expectation that some of the GCC (Gulf Cooperation Council) members’ pegs may be brittle has meant that capital flows into the GCC have also accelerated.

·    Observation 4.  Japan’s reserves are growing suspiciously fast.  Japan’s foreign reserves expanded from US$946 billion in September 2007 to US$996 billion in November, an increase of US$50 billion in four months.  Assuming a 2.5-3.0% return on the underlying assets, Japan should only be enjoying US$25-30 billion in annual investment earnings, or US$6-8 billion a quarter.  Further, it is widely assumed that Japan has the bulk (90%) of its reserves in USD, and the MoF never diversified away from USD.  With such low holdings of EUR, valuation changes – from the rise in EUR/USD – should not have been a major factor generating gains in reserves.  Indeed, what is embedded in our reserve tracker file  assumes 90% USD holdings.  Our presumptive calculations identified a US$13.7 billion gain during September-January due to the returns on the underlying assets, and another US$18 billion from valuation changes, leaving US$18 billion of the reserve increases unexplained by our metric.  Could the MoF have conducted secretive interventions worth US$18 billion?


Bottom line
The world’s official reserves continue to grow very rapidly, by around US$150 billion a month, reaching US$6.4 trillion around end-2007.  In terms of both stocks and flows, Asia and the Middle East dominate official reserve holdings.  At the country-specific level, Japan’s rapid reserve growth in 4Q07 was a puzzle.  We do not believe that the MoF conducted stealth interventions, but suspect that it may have bought EUR/USD, i.e., diversified, and the rise in EUR/USD exposed the higher weighting on EUR, which we guesstimate to be around 21%, compared to what we had presumed to be the case (10%).

(via the Morgan Stanley Global Economic Forum front page)

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Chinese Q4 gold support

Mind you, this was before China commenced gold futures trading on the Shanghai stock exchange.

BEIJING, Feb. 15 — China surpassed the United States as the world’s second-biggest retail gold market after India in 2007 by volume despite rocketing prices of the metal.

Total consumer demand in China’s mainland, Hong Kong and Taiwan reached 363.3 tons, up 23.5 percent from a year earlier, the World Gold Council said in a research report.

India had a gold demand of 773.6 tons last year, while the figure in the US sat at 278.1 tons.

Mainland gold demand, including jewelry and retail investment, topped 326 tons, up 26 percent from 2006, and the first time it surpassed the 300-ton level. Mainland gold-jewelry demand reached 302 tons in 2007, a year-on-year growth of 23.5 percent.

What makes the Chinese market stand out is the growing demand in the fourth quarter, when most other markets saw demand drop as costs soared.

Gold prices hit a three-decade high and topped more than US$900 an ounce on concerns over inflation, global economic uncertainty, the likelihood of an American recession and a weak US dollar.

In the fourth quarter, mainland gold demand rose 18 percent to 94.3 tons. In India gold demand tumbled 64 percent to 83.9 tons and in the US it fell 15 percent to 110.7 tons.

“It’s a milestone for China’s gold industry with demand surpassing the 300-ton level,” an industry veteran said yesterday.

Concerns over domestic inflation and the volatile stock market also added to the investment drawing power of gold as a haven.

China’s gold demand this year is again unlikely to be affected by rising prices as Chinese tend to buy at high prices in the hope of even further increases, World Gold Council veterans said in January.

Chinese gold demand was stagnant during the late 1990s and early 2000s but started going upward from 2003. China’s gold sales volume stood at 207.6 tons in 2003, a 2.0 percent rise to end a five-year wane.

The gold-sale rise is also in line with the country’s economic take-off.

China is expected to have a gold consumption of 600 tons in 2010, according to industry insiders.

The nation last year surpassed South Africa as the world’s biggest gold-mining country. 

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Ben’s helicopter, grounded by Fitch

Today demonstrated that the bond insurance agencies hold more near-term economic power than does the Federal Reserve. Implied volatility plunged from 28 to below 25 after the Fed’s 50 basis point rate cut (the higher end of the expected range), and then rose to nearly 28 again after Fitch downgraded bond insurer FGIC from AA to A. Moody’s and S&P downgrades of FGIC are coming, to say nothing of MBIA and Ambac. A single downgrade of one bond insurer by one ratings agency turned a “Fed rally” into a “Fitch rout.”

Spot gold reached $935 an ounce; the dollar’s weak January rally has been cut off at the knees, and one euro once again buys almost $1.50 ($1.4850 to be precise). Note that the value of the dollar is very close to its November trough, when gold was at about $810 per ounce, yet gold is now over $920 per ounce. Gold has appreciated nearly 15 percent in real terms in the past two months, and foreigners have been doing most of the buying this time around.

Overblown bond insurance fears

MBIA, Ambac, and FGIC collectively insure nearly $2 trillion in bonds. Basically, a bond insurer offers to guarantee significant repayments to creditors in the event of the creditors’ bond defaulting (hence “bond insurance”), in return for a fee. The bond insurance companies are somewhere between “technical insolvency” and “long past bankruptcy.” Ratings agencies Moody’s, S&P, and Fitch are not interested in playing Arthur Andersen for the bond insurance industry, and bond insurance downgrades are imminent. (more…)

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Required reading

I am a huge fan of Professor Michael Pettis’ “China financial blog“. He has two long but very worthy posts up for anyone interested in a less in-the-clouds, more realistic perspective on the Chinese economy:

  • The new China-Europe-US world order” :: Prof. Pettis heaps scorn upon the latest outbreak of Sinosupremacism, a typically in-the-clouds piece by an NGO baby who (yet again) extrapolates China’s bogus figures out 30 years into the future and prognosticates the end of American hegemony.
    • There is a longish and much-discussed article in this Sunday’s New York Times (“Waving goodbye to hegemony”) by Parag Khanna, a senior research fellow in the American Strategy Program of the New America Foundation, which strikes me as a sort of compendium of a lot of fashionable and muddled thinking about the evolving geopolitical order. […]  when it comes to the hugely symbolic acts of rising powers, I think Japan in the 1980s blows out all of the current contenders – although perhaps Khanna is not old enough to remember.


      Khanna supports his analysis by pointing out that in the past two years he has visited forty countries around the world, but at the risk of sounding like a world-weary snob, this does not impress me much – in fact I am a little worried by the Starbucks school of comparative politics.  It reminds me of something a Canadian China scholar once told me – for him the biggest difference between China experts who have never visited China and those that visit twice a year is that it is sometimes possible to convince the former when they are mistaken.

  • Things have gotten grimmer in China” ::
    •  Last Thursday Premier Wen Jiabao told the State Council that 2008 was going to be an extremely difficult year – an extraordinary admission by some accounts and indicative of how much pressure he is under.  Rising inflation and energy shortages have been made worse by the huge snowstorm that has hit the country, severely damaged crops, and closed train lines just as Chinese families were gearing up for the all-important Spring Festival, driving food inflation before this all-important family holiday much higher.
      Rumors are flying about the possibility of a reversal of the tightening measures announced last October. […]

      … On the other hand overheating has been a serious problem for the Chinese economy and if 2008 were to experience the same breakneck growth as it did last year, the adjustment will almost certainly be more difficult.  If the US slowdown is not as great as some think it might be, or if its impact on Chinese exports is less than many worry, expansionary policies in China may set off one last, crazy bull run.


      On the inflation front the news is even grimmer.  The rate of inflation will almost certainly rise in January. To above 7% from 6.5% in December and 6.9% in November, even in spite of downward pressure put on it by recent government measures to make holiday conditions as good as possible – selling off food reserves and freezing price increases.  That almost certainly means that there will be more inflationary pressure in March and thereafter as these measures are unwound. …

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Rupert Murdoch has not had a good run of late. “Fox Business News” is possibly the greatest fiasco in MSM memory, with the only Nielsen figures showing that FBN has about 8,000 daily viewers; at that level, I’m sure Fox gets more viewership out of laughter (see: “Shitigroup”) than out of genuine interest.

Then there have been Murdoch’s two attempts at political gamesmanship, assisting center-leftist powermongers Gordon Brown (UK) and Hillary Clinton. (Tony Blair counts too, although he wasn’t cut from the Brown-Clinton mold.)

Apparently Murdoch’s ventures into China have been equally disastrous; one wonders how Murdoch has ever managed to make a dime. (FBN, with its 50 Cent, Jermaine Dupri and other rapper interviews, “Wall Street Happy Hour” evening specials at strip clubs, etc., has been a particularly stunning case study of top to bottom corporate catastrophe.)

Again and again, Murdoch is taken for a ride by the Chinese. First, there was Richard Li, the son of the legendary Hong Kong entrepreneur Li Ka-shing, who in 1993, at the age of 23, sold most of STAR TV, a Hong Kong-based satellite service, to News for more than $500 million even as the company was hemorrhaging money.

Li forgot to tell Murdoch that Chinese consumers were pirating the signal. “Despite the tens of thousands of cable operators surreptitiously downloading the STAR TV signal and distributing it across the nation to tens of millions of subscribers,” Dover writes, “Murdoch was unable to collect a single cent in return.”

The Chinese would also clone the programming News was churning out, copying everything. Soon after the purchase, Murdoch made a monumental blunder during a speech extolling the virtues of satellite TV, when he uttered this fateful sentence: “And satellite broadcasting makes it possible for information-hungry residents of many closed societies to bypass state-controlled television channels.”

Within a month, China had banned the distribution, installation and use of satellite reception dishes anywhere in China. Murdoch’s access to top officials dried up. It took four years, and hundreds of millions in losses, before he was rehabilitated in Beijing, but the Chinese were far from finished ripping him off. Writes Dover: “Many of [those] who had been provided with all-expenses-paid trips to the UK to see the BSkyB [satellite] platform in operation loved the Murdoch concept and set about implementing it. They just excluded Murdoch from his own plan.”

I would never invest a dime in China. The Chinese economy is an eighteen-wheeler hurtling down an eight-lane superhighway to nowhere. Every fifty years or so, a “one billion customers” China craze devours unbelievable amounts of Western money before cannibalizing itself. (1850, 1910-30, 1980’s+)

This one will be over after the Olympics.

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This is pretty staggering.

^AORD All Ordinaries 5,222.00 12:11AM ET Down 408.90 (7.26%)  
^SSEC Shanghai Composite 4,596.67 1:15AM ET Down 317.77 (6.47%)  
^HSI Hang Seng 21,709.63 1:30AM ET Down 2,109.23 (8.86%)  
^BSESN BSE 30 15,344.40 1:30AM ET Down 2,260.95 (12.84%)  
^JKSE Jakarta Composite 2,236.55 1:45AM ET Down 249.33 (10.03%)  
^KLSE KLSE Composite 1,439.49 Jan 18 Down 21.22 (1.45%)  
^N225 Nikkei 225 12,573.05 1:00AM ET Down 752.89 (5.65%)  
^NZ50 NZSE 50 3,607.13 Jan 21 Down 39.77 (1.09%)  
^STI Straits Times 2,764.57 Jan 21 Down 152.58 (5.23%)  
^KS11 Seoul Composite 1,609.02 1:02AM ET Down 74.54 (4.43%)  
^TWII Taiwan Weighted 7,581.96 12:46AM ET Down 528.24 (6.51%)  

I have never recommended buying Asian stocks to anyone. That’s about all I can say. This is an epic rout, with India’s BSE down 12 percent and Hong Kong almost 9, but this forest fire has a very February/March 2007 feel to it. Are things really this bad? Compared to bonds, are stocks this unattractive? The markets had already priced in an extremely dovish rate cut schedule, and stocks had already punished forward P/E’s in anticipation of a moderate recession.

Now, there is the money-pumping issue. But the dollar has strengthened recently, not weakened. Fed pumping or not, the last several days have not been marked by capital flight from the dollar. The euro, yes; the dollar, no.

I have to sleep on this for a while. But the next four days will be crucial. If the US Congress and Federal Reserve succumb to the wider panic, the current plunge will be as fleeting as the plunge in February and March: there will be a quick bounce, followed by a longer run reflation, followed finally by another monster crash and another inflation-or-panic fork in the road.

If the market is allowed to finally bleed itself out, Ambac and/or MBIA will blow up, there will be a lot more blood, and the markets will have achieved some painful, but permanent, evolution.

As a gold bull, I have always bet on the former. If the S&P lock limits down tomorrow, the panic will be pretty extreme, and gold will blast through 1,000 before the quarter’s end.

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I can’t believe I’m saying this, but I think US equities are significantly undervalued right now, recessive realities notwithstanding.

I wonder if the market is paying too much heed to the yen-dollar relationship (now at its lowest in years, at 106.82), which has traditionally acted as the canary in the coal mine as far as major moves are concerned. I have heard anecdotally that China has been buying huge amounts of yen recently, to allow the yuan to appreciate against global currencies without letting Japanese exports become too competitive relative to Chinese exports.

And the market barometer of implied volatility, the VIX, only went up by .44 today (about 3 percent) while the market had an awful day. When implied volatility goes up, that can technically mean that stocks could soar, but when the market climate is as negative as it is these days, a spike in volatility has very negative implications for equities.

Anyway, it’s very odd that the VIX barely tiptoed upwards while the markets dropped so much. The inverse relationship is usually way more pronounced. Somebody big blew up, or somebody else is paying too much attention to the formerly predictive, but currently not predictive yen-dollar relationship.

Fidelity did re-open its Magellan fund to new capital/ new investors yesterday, and judging by their tech- and China-heavy portfolio holdings as of October, their “75th percentile” performance has gone down in flames in the last three months. A $2bn Fidelity CDO was also put on the chopping block by Moody’s. Maybe they were forced to puke, somehow.

Anyway, I think equities are in for a major rally tomorrow.

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Just as I loudly trumpet my correct calls in gold and sterling, I must also eat crow for my missed calls. I predicted a dollar rally that didn’t happen, and a fall in the euro which also didn’t happen.

I recently prematurely declared that the European Central Bank’s $500 billion repo “injection” amounted to unconditional monetary surrender (a “Vichy moment”) on the part of the European monetary authorities. It turns out that the ECB had a large amount of repo rollovers due, and did not actually inject liquidity: the “injection” was a smoke-and-mirrors media event of little real consequence, much like the Federal Reserve’s cutting the discount rate (not the funds rate) at the end of August.

However, the fact remains that the ECB has to devalue the euro, or the Portugal/ Italy/ Greece/ Spain “PIGS” will leave. A richly valued euro is very good for northern Europe (Germany, Austria, the Netherlands and Scandinavia), and extremely punitive towards southern Europe, whose economies rely on low- and medium-end manufacturing exports. A strong euro crushes those exports and renders imports (i.e., Chinese goods) even more artificially competitive. Club Med unemployment, already stratospheric, will only go up under the euro framework, triggering more political volatility and louder calls to exit the euro currency union. Club Med budget deficits are also extremely high, and an appreciating euro makes those deficits more difficult to repay.

Any currency trader knows how volatile currency trading can be, and more and more currency movement is now subject to more and more unpredictable central banking decisions than ever before. Meanwhile, competitive currency devaluation by China, the United States, and soon the European Union will only erode the value of individual forex traders’ positions. Meanwhile, the prognosis for the sterling is the worst of all.

My worldview of competitive currency devaluation remains unchanged. I am extremely bullish on commodities; extremely bearish on bonds; neutral to mildly bullish on equities; and I am still betting on reflation. I believe the current Merrill Lynch and Citigroup write-downs and recapitalizations mark a bottom in the market in the medium term. Unless the dollar drops drastically, there is simply too much money in the market for it to continue dropping in nominal terms.

While the media continues to drown out valuable information with regards to the “credit crunch,” I simply do not see one happening across the dollar spectrum. Obviously, many traditional financial institutions are facing a brutal crunch. But hedge funds, particularly John Paulson’s funds, Citadel, Medallion and others, have made tens of billions of dollars which need to go somewhere. I can only look at monetary and lending aggregates and wonder, “What credit crunch?”


The dark red and blue lines represent two different methods of valuing the dollar relative to other global currencies. The “narrow” valuation is the one more commonly quoted, because it’s the more apocalyptic of the two. The “broad” trade-weighted valuation includes the Chinese yuan and other currencies which do not trade much outside the country of issue, but which remain hugely important in global trade. According to the less apocalyptic and more accurate dollar valuation, the dollar is worth the same now as it was in the beginning of 1997, before the Asian financial crisis; a 75% collapse in the price of oil; the default of Russia; and European preparations for a new, common currency, all caused savings to flee French francs, German deutschmarks, Russian rubles, Thai baht, won, and Saudi riyals in favor of the US dollar. When examining global macroeconomic trends, it is essential to keep in mind how exceptional the late 1990’s were, and how favorably those various dominoes fell out, all to the enormous relative benefit of the United States.

Getting back to the aforementioned graph, as of January 2, 2008, commercial credit including foreign-related institutions, i.e., hedge funds, is expanding at its most rapid year-on-year rate ever since the TOTCI lending statistic was born on January 2, 1973. That does not look like a credit crunch to me. In my ill-fated medium-term forecast from two months ago, I became bullish again. I had added up the quarter trillion dollars pumped into the economy by the Federal Home Loan Banks, the sixty-plus billion added by the Federal Reserve’s Term Auction Facility, and unknowable but significant “temporary” billions in Fed repurchase agreements. I was not at all surprised to see the 2007 “Minsky moment” reverse itself, and commodity prices soar.

Here is the same graph, from January 1 2005 onwards:



The credit “crunch,” i.e., the slowing in the rate of growth of commercial credit (dark green), began in late 2006. Its temporary denouement occurred at the end of February 2007, when the Shanghai markets hemorrhaged 20 percent in three days. Then, at the end of July, what we know as the “credit crunch” began in earnest. Unfortunately, the Federal Reserve persuaded itself that it could repeal the laws of the business cycle and erase bad debt via inflation.

The latest FOMC futures predict a coin toss between 50 and 75 basis points’ easing by the Federal Reserve at its upcoming January meeting. Seventy-five basis points strikes me as absolutely incredible, given the explosive appreciation of gold, the acute permanence of dollar weakness, and so on.

I predict an exodus of money from bonds, and significant gains in equities in the near future. For the value-focused investor, bonds have become radioactive. The trade-weighted convertible-currency value of the dollar (the blue line, and the “narrow” metric of valuing the dollar) fell from 83 to 73 – a decline of 12 percent – in 2007. Treasuries appreciated 7.3 percent in nominal terms in 2007, but after adjusting for the loss in value of the USD, Treasuries depreciated by 4.7 percent.

In any case, the commodities boom – now a derivative of Chinese hyper-capitalization – will continue until the Beijing Olympics are over. Until the ECB devalues the euro, the commodities boom should continue, and global imbalances should become more pronounced, not less. Oil will stay in the clouds until China comes to an internal reckoning over soaring and massively understated domestic inflation. Until the Europeans and Americans force the Chinese to float the yuan, a la the Plaza Accord to float the yen in 1985, the commodities gold rush will continue.


  • Gold/ commodities: very long

  • Dollar: neutral

  • Euro: neutral

  • GBP: short

  • Equities: long

  • Bonds: short


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I’m not sure which piece of news is worse: the raw size of the writedown (nearly 20 percent of shareholder equity), or the fact that China balked at participating in a recapitalization of Citigroup. Historically, the Chinese have been far too hungry for Western banking assets (not to mention a place to put their USD) to have ever turned down an opportunity to acquire a chunk of a strategic Western asset.

But apparently even the cash-glutted Chinese have their limits.

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