This Week's Lessons: China and Ireland

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Includes: AIBYY, CNY, EIRL, FXI, FXY, IRL
by: Gregory Levine

China

Let’s dig into some of the particular stories of interest recently. First, in China, inflation accelerated in August. The market has read this in a positive light, assuming that inflation means people are spending more and internal consumption is increasing. However, there are a couple of details that prompt me to question this conclusion. First, businesses have been complaining of shrinking margins, which means that inflation is not being driven by final demand, but by input prices. Some of this is rising wages, which is good for consumption. But that's only true if wages rise faster than inflation. Second, the price increases are mostly in food. Hungry people are never good for political stability. My opinion is that inflation will become a major problem soon, requiring the authorities to tighten credit. I base this conclusion on the belief that China’s economic imbalances keep getting shakier and shakier. It seems a strange portent that asset prices are falling while food prices start to take off. The inflation situation bears close watching.

Another recent development is today's Financial Times story about how Chinese banks are fighting over deposits. The implications of this story are interesting, to say the least. Isn't China a nation of savers? If Chinese banks are having to offer such incentives for deposits as free vacations, they must be overstretched in light of pending reserve requirements. I draw two conclusions from this story. First, Chinese lending now faces the greatest probability of slowing down that we have seen in recent years. A slowdown in credit will be disastrous to Chinese asset bubbles. Second, the ability of China to subsidize exporters, state-owned enterprises, and asset bubbles is reaching the limit of its power.

I also feel compelled to comment on strange logic I have heard regarding China. Some have claimed that China’s selling of Treasuries over the last year has concentrated their holdings among shorter duration bills. Since the duration is shorter, this somehow puts pressure on Treasuries as the Chinese have to explicitly act to roll over expiring bills. First of all, it’s just as easy for China to buy, sell, or roll over any maturity of Treasury bond, so this line of reasoning is a spurious hiding of the underlying assumption that China is trying to pressure the U.S. Treasury market. However, we can see that this is not China’s intention at all when we look at the value of the Renminbi. If China wanted to pressure the dollar, they would let the Renminbi rise against it. But what has happened? A grand total of 1% appreciation since their "relaxation" of the currency peg. Compared to the Euro, the Yen, and the Pound, the Renminbi has fallen. The last thing China wants is a weaker U.S. dollar. But this is exactly what they get if they sell Treasuries. And the shorter the duration of the bond, the more cashlike it is. So selling short-term Treasuries is almost exactly like selling dollars, and guaranteed to push up the Rmb against the dollar.

Earlier this week, the Bank of Japan undertook to buy Treasuries with newly printed Yen. So, China's policy of buying Yen instead of dollars has become a daisy chain. No wonder Geithner is pressuring Congress to slap trade sanctions on China. This is the best way of implementing his strategy to devalue the dollar and bring jobs back to the U.S. The loss of foreign purchasing power is seen as an easy sacrifice for this goal.

Suppose that Geithner does indeed get his wish for trade tariffs or other sanctions. The dollar will be devalued, shrinking the trade deficit, increasing exports, and generally making dollar debt easier to pay back. Unfortunately, this might cause capital flight into gold, commodities, or offshore accounts. Whether or not this is constructive for bonds or not is a legitimate question. I need to put a lot more thought into this, and will as the situation unfolds. Until then, it's too early to trade on any speculation arising from this train of thought.

Ireland

Ireland is the model for austerity in Europe. They have bailed out their banking system, cut government deficits, and are attempting to stop the growth of government debt levels. Now, bailouts are not austerity. Rather, it's how Ireland got into this mess in the first place.

After joining the Eurozone, their economy boomed as Ireland wooed global corporations and government invested heavily in higher education. Unfortunately, the loose-credit policies of the ECB (European Central Bank) had side effects, the greatest of which was a housing bubble. This took down Ireland's banks, requiring national guarantees of all deposits. Right from the start, Ireland's policymakers took bold, decisive action, and they continue to do so. This transfer of debt from the banking system to the government pushed debt totals to unsustainable levels. Enter the austerity program. The government has cut back spending strongly even in the face of declining GDP. So strongly, in fact, that tax receipts have declined (I guess not all government spending is worthless). There is only one question left? Will it work?

Or, will tax receipts and GDP fall faster than deficits? This would become a debt spiral as government income falls short of servicing existing debt interest payments. Unfortunately, Ireland may not even get the chance to find out, since even the mere hint of a debt spiral may cause investors to refuse to roll over existing debt as it comes due, or lend for operating expenses. Yields will skyrocket, creating a different kind of debt spiral, driven by interest costs.

A Financial Times article today fingers a Barclays report for having a sickening effect on the Irish bond market today. After yields on two-year bonds jumped half a point to 3.63%, the ECB (European Central Bank) took the drastic step of buying bonds on the open market to stop the plunge in prices. Prices move inversely to yields, so a jump from 3.13% to 3.63% implies an approximate fall in price of 1%. In the bond market, this is apocalyptic. The risks are clear: the ECB is already bailing out Ireland. It may not be long before a full-fledged crisis erupts. Since Ireland is the poster-child for the benefits of the European Austerity Program, their failure will put into question the ability of Greece, Portugal, Spain, and possibly even Italy to pay off their debts.

Actions

The recent runup in the S&P 500, emerging market equities, fall in Treasuries, and general health of risky assets over the past two weeks has tested my resolve. However, these major stories, together with the inability of any major asset class to break out of technical resistance (except gold) has convinced me to stay the course with my major allocations of long gold, long Treasuries, and short equities.

Disclosure: Long gold in physical, option, and equity forms, long 30-yr Treasuries, short Chinese equities through FXI puts