Those Clever Chinese

John Mauldin
July 23, 2005

Those Clever Chinese
Paris, London and Ouzilly

Last week I said that for this week's letter we would look at the US trade deficit and China, and in particular the possible revaluation of the currency and its effect upon the trade deficit. China obliged by revaluing the yuan (Renminbi). This is both more, and less, than it seems. There is a lot to cover, so let's jump right in.

Let's first look at what China did. They allowed the yuan to rise by 2%, with a daily 0.3% trading band based on the price of the previous day. While in theory this could allow for a significant price increase over a period of several months, in practice it is unlikely to do so. Allowing the yuan to rise too rapidly would be highly destabilizing to the Chinese economy. You can take it to the bank, even an undercapitalized Chinese one, that the Chinese government will do everything in its power to maintain stability.

Further, instead of pegging the yuan to the dollar, it is now going to be pegged to a basket of currencies. Because it is a basket reference rate, it will be possible for the yuan to both rise and fall against the dollar. Can you imagine the consternation of Congress if the dollar rises against the yuan? Let's look at how that could happen.

"The basket is likely to be heavily dominated by the USD. Using China's trade weights, normalized, a five currency basket would have the following weights: USD (27%), JPY [Japan](31%), HKD (Hong Kong] (24%), EUR (15%), and GBP [Great Britain](4%). The hard dollar pegs (USD and HKD) account for close to 50% of the basket. If you consider the JPY as a soft USD peg, the weight on the dollar could be as high as 80%. This means USD/RMB will still be very 'docile', with the index being 'sticky' relative to the USD." (Morgan Stanley)

In essence, only 20% of the potential basket proposed by Morgan Stanley would actually float in any real sense. If the euro and the British pound were to sell off against the dollar it would cause the value of the basket to fall relative to the dollar, and thus would have the effect of lowering the price of the yuan. This could be a real scenario, as the euro and the whole union are now in a great deal of uncertainty, not to mention really slow growth. The markets hate both.

And if the Chinese add in some local currencies like the Singaporean and Malaysian, which are managed against the dollar, it could be even more stable. Let's see what the ever astute George Friedman of Stratfor has to say about the Chinese situation"

"Chinese currency reserves stand now at some $711 billion -- more than $100 billion of which was added just this year. Beijing has been printing currency non-stop to balance this capital inflow, maintain the peg and prevent inflation. The increased political pressure on the government has only added to the inflow of speculative capital. Over the past year, the government has taken several steps to increase the outflow of capital, albeit in a controlled manner. It has raised limits on the amount of money students and tourists can take abroad, encouraged Chinese firms to invest overseas and is now loosening restrictions on the conversion and repatriation of money for foreign companies operating in China.

"But Beijing is constantly looking to the past in moving forward. It fears a repeat of the Mexican peso crisis or the Asian economic crisis. The Chinese economic reforms are at a critical stage: Unemployment is rising, both in official numbers and in unofficial estimates. Despite a 9.5 percent growth rate, China just cannot create enough new jobs for its growing population -- particularly as it modernizes the agriculture sector and faces continued challenges to its labor-intensive exports.

"Beijing has made many feints at changing the yuan peg -- most recently in early May, when an article in the online version of the official People's Daily stated a yuan revaluation was coming within a week. The article was later pulled and a retraction issued, saying the piece had been a mis-translation of a different article, but the idea was clearly floated -- and Beijing carefully monitored the international reaction. Thursday's 2 percent revaluation and the announcement that there may be more baby steps coming amount to just one more probe into the potential impact of a larger revaluation or a future move to a real float.

"For now, Beijing is moving cautiously. Thursday's announcement caught many off-guard, particularly as just a few days before, after a meeting of the PBoC heads and the heads of regional branches, the bank announced it would keep the yuan rate "basically stable" for the second half of the year -- a euphemism for no change in the currency rate. Thus far, reaction to the news has been somewhat muddled by a second wave of attacks in London. However, shortly after the Chinese announcement, Malaysia said it might modify its peg, and in trading, the yen and the won moved with the yuan change.

"This will not be the last adjustment by the PBoC, and its future alterations will be driven by politics as much as economics -- but always with an eye toward internal Chinese stability."

Those Clever Chinese

Right now we don't know what the basket will actually look like. It is doubtful that China will announce the make-up of the basket. Clever currency traders will soon be running a regression analysis that will give us a reasonable idea. Of course, it will be very risky to trade on that, because the Chinese could change the makeup of the basket at any time. My bet is they will do so from time to time just to cause a lot of pain to hedge funds so as to discourage speculation.

What those clever Chinese have really done is take some of the wind out of the sails of the protectionist camp. This new currency regime is essentially the same as that of Singapore. You don't see anyone in the protectionist camp ranting about the unfair currency manipulation of Singapore. The Chinese will be able to, quite correctly, point out that if we have no problems with Singapore then we should therefore have no problems with them.

In practice, what I think the Chinese will do is to slowly allow the yuan to appreciate. By slowly, I mean 2-3-4-5 years and by 5-10-15%. This is going to be like watching paint dry. It will not be the stuff that great speculations are made of. And since local Asian currencies are really pegging themselves to the Chinese yuan, it will mean slower appreciation in most of those currencies as well.

Think about it from the Chinese viewpoint. Using round numbers, say we buy $100 billion of a variety of widgets from the Chinese. If they were to allow the yuan to appreciate by 20% in one year that would mean we could still spend $100 billion, but we would only get 80% as many widgets as we did the year before. Or we could spend $125 billion to maintain our supply of widgets, but that would mean a greater trade deficit. And it would also mean that the American consumer would have to find another $25 billion from somewhere.

Of course, in reality it does not work that way. China is starting to have a huge excess capacity problem in many areas. In the real world, Walmart says I want you to give me the same number of widgets per dollar or I go somewhere else. This could mean your competitor in the next province or in another country. This would mean that the profit margin of many Chinese companies get squeezed as they try to maintain market share to get cash flow to service loans and pay employees, when profit margins are already quite low. You can only squeeze so much.

I met veteran China hand, Simon Hunt, last April in London (of Simon Hunt Strategic Services). He spends a great deal of time touring China and meeting with both business and government leaders. He is "wired." I pay attention when he talks about China. He sends this note:

"The issue of surplus capacity has become very worrying for policy makers in Beijing also, because there is no pricing power and, therefore, there will be an impact on the financial sector. Every company will need a piece of the same pie. Prices will fall even more. Companies will need more loans to survive and so on. The deflation story, so frightening to Greenspan, will grow into a live problem in China. Even with rising demand, prices continue to fall because of this chronic surplus capacity. There is a risk of a large knock-on impact on the financial sector, less on the big banks, but more focused on the local and regional banks and money co-operatives, of which there are about 120 of the former and 30,000 of the latter category.

"Let me illustrate this central government concern with a simple story. About a year ago, I had dinner with a top policy advisor. We chatted at length on this subject, because it had been a concern of mine for two or three years. My friend listened, but made no comment so I got the distinct impression that the subject was not on their horizon. A month ago I again had dinner with him. Before the drinks arrived, he told me than unless China's bubble of surplus manufacturing capacity was pricked China would have a recession. So, clearly, the issue is now very much on their minds.

"Two days later I was in Ningbo with an industrial friend, who is well respected in the local government and banking circles. Only a few days prior to my arrival, the governor called in the leading local industrialists and told them the following:

1. Businesses that only focus on creating capacity without regard to profitability will not receive local government support

2. The new focus must be on return on capital investment

3. Businesses must go up the value added scale. This means introducing new technology, more expenditure on R&D, taking out more patents etc., and

4. You are encouraged to go further inland if you want to expand. Funding for expansion in Ningbo is now very tight and land licenses difficult and expensive to obtain.

"The last point is very important. It is the cornerstone of new government policy, which will be seen when the new 5-Year Plan is brought out either late this year or early in 2006.

"Urbanization of coastal cities will be slowed sharply. Costs have become too expensive and how to manage the migration of workers is a difficult issue. Instead, new development of industry will be encouraged to go into the rural sectors, where transport systems have improved, where land costs are a fraction of that in the coastal cities and where wages are one-third or less."

So the upshot is that we are going to see more factories in areas where labor costs are even less. Right now, per capita income is China is about 3% of that in the US. It is much higher in the cities but less in the countryside, where development is going to go.

So the Chinese revalue their currency by 2% and over the fullness of time by another 8% or so. In terms of the cost of labor to their competitiveness, that is meaningless. You could give every worker in China a 20% raise and it would have a much smaller pricing effect on finished products.

Simon illustrates what he means by capacity glut. The Chinese keep building factories and production lines even when they clearly don't need any more. Every town and province wants its own widget factory, and the state banks fund them. He cites many factories which are expanding capacity even though their markets have a serious surplus of capacity.

In an area he knows well, Simon points out that if the plans or "silly practices" (his term) in one industry are carried through, China will have the capacity to supply the entire world with the tubing required for air conditioners. Chinese firms are selling tubing anywhere from 35-70% less than competing companies in Europe and Asia, and at below the real costs of their competitors, and maybe below their real costs.

So, is the whole world all going to be buying Chinese goods? Should we just pack it all in? In a word, no. "Moreover, China is no longer being considered the first choice for new investment by manufacturing companies in Taiwan or S Korea; the first choice is now being given to other countries in Asia, such as India, Vietnam and now Malaysia....For instance, only on Friday, Flextronics, the world's leading contract electronics maker, announced that it would expand its Malaysian manufacturing facilities to counter rising costs in China. Peter Tan, the company's Asian President, said 'Its pretty clear that in China there is only one way that costs will go, and that is up, given the fact that China is so dependent on the rest of the world for its energy needs...There are a lot of odds being stacked up against our existing presence in China'."

The Chinese are up against the proverbial wall. Their problems are not without precedent and will require some pain to solve, but they can be solved. But they do not need some shock, such as a too rapid currency revaluation, to upset what is already a delicate equilibrium.

Over time, the dollar will fall, and perhaps significantly, against the yuan. But it will be, as Paul McCulley is wont to say, in the fullness of time.

The entire world needs to re-balance. Perhaps it is that we are always in the act of re-balancing, but today the lack of balance seems pronounced. The US trade deficit is growing. China is building too much capacity. Politicians have promised benefits to the boomer generations in the US, Europe and Japan that the next generation cannot hope to be able to financially deliver, and therefore they will not. There will be adjustments (a rebalancing) to the promises. Globalization is stressing the labor markets of the world. Governments everywhere overspend and mostly over-tax.

All of this high wire rebalancing act will take place in the fullness of time. There are those who think the dollar is going to break under the weight of the trade deficit. It could happen any moment. Then again, I would suggest the trade deficit could go on a lot longer and get a lot worse before the new world balance comes about.

Today the trade deficit is running close to $700 billion. The US is exporting electronic dollars and the rest of the world gives us their widgets. Then they take those dollars and buy our debt, helping keep our interest rates low. As I have documented in previous letters, foreigners are taking an increasing percentage of the new US debt supply, as our government debt is going down faster than projected. (I should note that this is because tax receipts are up and not because of congress holding down spending.)

At some point we are told, foreigners will get tired to buying US assets. And I agree, that is true. But it could be a lot longer than most of those with a bearish mindset think. We have $44 trillion (or so) in assets in the US. This total asset base grows every year by several times more than the trade deficit. So while the trade deficit as a percentage of GDP is staggeringly high, as a percentage of assets it is modest.

This game will go on as long as Asia decides to take our dollars. It is pretty much that simple. There are simply too many dollars and yen and yuan and baht and pesos and euro, and too few opportunities. That money has to find a home. And, for better or worse, the current home of choice is the US.

So, going back to a previous point, China needs stability while it works through some very serious problems. That means they need the US consumer to continue to buy products so they can provide jobs and slowly build their own consumer society and their won opportunities. To be able to take advantage of their internal opportunities they need sophisticated capital markets and banking institutions. They are years away from that. To have a consumer society, that means they have to increase the incomes and find jobs for hundreds of millions of people. To get sophisticated financial institutions, you have to train a generation of managers. It takes time. You don't do that by getting off the treadmill they are on.

The same goes for Korea, Thailand and the rest of developing Asia. We saw Malaysia drop its dollar peg within 24 hours of China. They, too, will have a basket. Eventually, I believe most, if not all, of Asia (including Australia and New Zealand) will create their own de facto currency basket and probably a currency unit of some kind based on that basket, as well as a free trade market. But that is eventually.

In the meantime, and until time's fullness, things will go on as they are because the governments of Asia, by and large, cannot afford to do anything else. What government is going to deliberately slow down growth in their country when it would mean so much personal short term loss? By personal loss, I am not referring to the citizens of the respective countries, though there would certainly be that. I am referring to the loss of the positions held by the politicians. Politicians hate losing power. It is a universal truth that they will avoid causing problems for which they can be blamed, if they can help it.

The hope of each of these governments and central banks is that if they go slowly enough their own country will build its own consumer engine and they can wean themselves off their dependency upon the US consumer who pays in electronic dollars. They hope to grow their own economies to the point that investment dollars stay in their own country rather than looking for safety and growth in the US.

In the meantime, and in a deflationary world, those dollars are not yet bad things. They can buy real stuff like bonds and GE and Microsoft.

Think about this. Last year Steve Jobs and Apple were responsible for $1 billion or so of our US trade deficit. Yet he grew the net assets in the country by $20 billion. Will that value hold in a recession? No, but is Apple a valuable franchise that will be around for a long time? Yes. And at some price below today's price, I would be a buyer of Apple.

Or mortgage backed bonds. Or oil companies. Or real estate. Foreigners take those dollars because not only does it keep their economy going, but they can buy something that is generally acknowledged as being of some value with them. And at $44 trillion and growing, there is a lot of stuff they can buy.

I think it was Business Week where an article in 1955 first decried the profligate American consumer. Each decade it gets worse. Consumer debt is now higher than ever, especially in terms of percentage of disposable income.

Is this a sustainable trend? Of course not, but it can go on longer than we think. As a national policy should it? No, as one day when it reverses it will cause us some very decided economic grief. But no individual thinks of national policy when he borrows more money. He thinks of cash flow and whether he can afford the payments for pleasure today.

In short, the move to revalue by the Chinese changed nothing, except maybe takes off some protectionist pressure. Good trade for them. Clever the way they did it. But since they have decided that "to get rich is glorious" and started down the yellow brick road of capitalism, they have been fairly clever at most points.

And it does start the process. So that is something. It was Mao who said the journey of a thousand miles starts with a step. This was a small one, but it was a step.

And I leave you with one final staggering statistic and thoughts from Hunt:

"Thus, China's economic future will be based on two foundations. The first will be to increase the share of consumption as a percentage of GDP, hence the focus of policy on the rural sector. The second will be to accelerate the growth of the private sector, which means, also, to encourage banks to lend more to this sector. As an integral part of this program, government intends to privatize as many as 170,000 state companies, at prices, which could be as much as 20% below book value.

"Despite the negative undertone of the issues I have raised today, I am encouraged by the growing willingness of China's leaders to discuss these very issues openly and the healthy variety of opinions one can find amongst government advisors. They will see China through this transition period to a market economy.

"Future growth, which will probably average around 7-8% a year over the next ten years, will be a much better mix between activity, education, social welfare, and the environment with the rural sector being the cornerstone. China is going through interesting times, but that is nothing new, not least in the last 25 years, but more especially throughout its long history."

Think about that. 170,000 companies privatized at below book value and unleashed to compete. My bet will be that most will fail. But then 80% of companies that are started in the US fail within 5 years. Failure is the sign of a healthy competitive process, for the 20% that make it drive an economy.

How do you get rid of excess capacity? Most of it is in government companies. So you privatize them and let them sink or swim. Slowly. Carefully.

The world will rebalance. It will be a bumpy ride, but we will get there. I am more convinced than ever that Muddle Through is going to be the order of the decade.

Paris, London and Ouzilly

This Sunday afternoon I leave with seven kids and a daughter-in-law for Paris for a few days, then down to friend Bill Bonner's chateau in Ouzilly (and Elizabeth and their six kids and even more relatives) for four days and then off to London. Off course, kid is a relative term in my family, as six are over 20 and the other two are 16 and 11. Bill's family is in that range as well. It should be a really fun time. I see a huge Texas BBQ in Bill's back yard.

I am personally looking forward to London, as I have been there many times but have never done the tourist thing. I will take in a few meetings, but on the whole this is actually vacation, and I need it. This should be one the family remembers for a long, long time.

There will be a guest essay next week, and then if jet lag has not gotten to me, I will return to write the next weekend.

As many of you know, I have an office physically in the Ballpark in Arlington. Tonight, the Texas Rangers are playing the Oakland A's. Writing a letter during a game can be a bit of a distraction, especially a high scoring game as there is a lot of fan noise. Pitching contests tend to be quieter and I can get more done. Looking out the window, it looks like my Rangers are going to lose again. It is 8-6 in the 8th inning. Oops, make that 9-6. I don't think I am going to have to plan for play-off parties in October. As I do a final read, it is now 11-8. They are throwing batting practice. Rats, it ends 11-10 with the runner thrown out at home. We wuz robbed.

Enjoy your summer. I see museums, some great books and lots of family and friends in my near future, and maybe a few bottles of wine. And Bill has this wicked local moonshine. It will cure what ails you. Can it get any better?

Your 'on the road again' analyst,

John Mauldin
email: John@frontlinethoughts.com
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