Inflation, Deflation and the U.S.-China Relationship 23 comments
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Over the past several weeks I have read countless articles supporting conflicting positions on the Fed's ever increasing injections of capital into the banking system as well as the proposed 700 billion dollar bailout of the banks. Most authors have taken one side or the other, either agreeing with the massive injections as necessary or railing against the Fed and Treasury for leading us down an inflationary spiral.
I agree with those author's that have pointed out that the TAF and other liquidity injections to date have not increased the money supply. Unfortunately, this was not and is not the intent of the fed but a byproduct of a frozen banking system. The Fed's end goal is to increase bank lending which is by its very nature inflationary, as it increases the availability of money in the domestic and global economy.
Most commentators correctly note that banks are not lending, mainly because risk premiums are rising as liquidity dries up and the banks are primarily focused on swapping out (lending to the fed) bad collateral in a futile attempt to save their balance sheets. As long as FASB 157 and 140 mark to market rules are causing runs on financial company balance sheets and the failure of banks and insurance companies, you will not see monetary growth in the form of new loans. If I'm correct, you will not see lending growth for some time as the primary focus of financial firms is survival and moving bad assets off their balance sheets. This does not mean that the massive injections in the banking system will not eventually show up in the form of too much money or inflation.
Many authors have pointed to China as well as the sharp drop in commodity prices as support for there deflationary arguments. Having traveled extensively in China for the past several years, I have come to understand a little about how China's polices are engineered. China's primary reason for supporting the US treasury through massive investment in US dollar denominated assets (read Treasury bills and MBS securities) is simple: we're a good customer. Any business understands that you take care of your good customers and grant them credit on favorable terms. It's also the primary reason why the Fed had to head off the failure of Fannie (FNM) and Freddie (FRE) as this would have caused an immediate run on all dollar denominated assets by foreign central banks including China.
More to the point, China needs to create 24 million jobs per year just to break even and is financing the largest migration of rural workers to manufacturing jobs in world history. It makes our own industrial revolution, adjusted for inflation, look like a boy scout merit badge project.
There are serious forces at work inside China that clearly indicate that their end goal is to shift away from export growth to domestic consumption. Dramatic increases in construction, military spending and infrastructure continue despite the end of the Olympics. Many inside and out of SAFE (China's currency regulator) are urging the government to move away from supporting dollar assets. Unfortunately the probability of this happening just increased as China is now contemplating just how good a customer the US really is. Good customers pay their bills on time and are highly cherished in Asian culture, while those that don't pay their bills are dealt with much differently. When China ultimately makes the determination that it is in its best interest to redirect its efforts on internal consumption, the United States will see the flip side of exporting our manufacturing base and allowing China to finance its consumption.
Right now investors are experiencing the 'stag' as domestic asset values fall, drying up the availability of credit. The next punch is the 'flation' as China and others move to liquidate dollar holdings as the US is no longer considered a good customer. The continued fall of the dollar will increase import prices and re-inflate falling commodity prices.
Don't be fooled by a strong Euro. Now that the tide is starting to recede on the economies of Europe, we are finding out that most of them were also swimming naked in the credit pool. I suspect that the Euro is only just starting a long and protracted fall.
Similarly, don't be fooled by the short term absence of China in the commodity pits, the fall in the Baltic dry shipping index or the fall of Chinese equity prices. These all work in China's favor as the ratio of commodity and capital inputs to labor inputs is falling, thus increasing the strength of the underlying Chinese economy. Remember, China must keep GNP growth above 8% in order to support its political objectives of furthering the communist party as the right road for the Chinese people.
Unfortunately, no one is talking about the next shoe in the global liquidity crisis. I believe we in America are about to feel, and pay for, our headlong foray into globalization. While stagflation is never pretty, fortunately there are now strategies that individual investors can engage in to preserve their asset base and purchasing power. We continue to look for favorable opportunities to enter Chinese stocks and ETFs including FXI and CHN, as well as individual common stocks that will benefit from China's internal consumption growth.
The recent fall in Chinese B shares as well as all of the ADRs listed in the US represents a second chance to those who missed the huge run in these stocks that started in late 2005. However this time around, some serious homework will be required, as investors will need to focus in on those underlying social trends that will continue despite a global slowdown. Some of our favorite stocks will continue to benefit from the well established trends in education, dairy consumption, capital spending and travel. We continue to be short the dollar and are looking to re-enter various commodity ETFs on price declines.
Disclosure: Short the U.S. dollar.
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This article has 23 comments:
and you think china will stop supporting USD overning?? if i am not wrong they are the owner of 2 trillion USD in some form or fashion. if USD goes down 20% what will that do to their holdings??
what you are suggesting may happen one day......or may never happen, depends on how things play out.
if usa,europe etc goes into recession....china will suffer so much in the exports that its economy will be barely able to support enough jobs.
right now china's only goal is to increase its exports not decrease it.
yes every country in the world wants to become USA, ie, to have a huge consumer base supporting a big economy keeping employment below 6-8%.
but USA did not become one overnight, and it was definitely not planned....it happened by chance more than planning.
For myself speaking I never understood that the Chinese did not pull the plug in the Spring of 2004.
Yet the Chinese folks did not do this and so the troubles only grew bigger and bigger.
__________
From the statistical point of view it is nice to observe that China needs about 24 million new jobs every year or about 2 million new jobs a months.
For the USA these numbers vary from author to author but the USA needs about 100 to 150 thousand new jobs to keep up with demographic growth.
In this light you must view the latest NFP release:
A decline of 159 thousand means a damage of about 300 thousand...
stock up on your gold and silver.
But lets not be under any illusion, the USA is not falling behind on payments. How can they, when all they need to do is print more USD.
China has no choice but to carry on business as usual.
The question is not whther the USA will pay them back, but what the dollar will be worth when they pay them back. Something that they hold full responsibility for as a result of their currency regime. These were the terms of the agreement.
In terms of consumption, impossible....
The Chinese will take 20-30 years to reach a high level of consumption and they won't be buying chinese made goods. Ask any Chinese person if it easier to sell to foreigners or Chinese and see what there answer is. The next generation maybe...not this one.
Also the consumption trends of the past will stay in the past.
People are hitting the harsh reality that wasting money daily buying stuff they dont need is the wrong thing to do.
In short the golden age of easy Chinese growth is finished, now every penny of GDP that China generates will be far far harder than it has ever been. Large economies take a long time to mature. China has certaintly got to second base, but very far away from home run status.
I also have a thought for everyone.....
What is structually different from what the USA has done over the past 10-20 years when compared to Europe, parts of Asia, UK etc.
Everyone seems to believe that the US caused the contagion. When the reality is their system was just the first to blow up.
Every aspect of society is leveraged up very seriously. Not just the banks. Most people's personal balance sheets are highly leveraged.
This delevarging of business/personal finances has just changed the rules.
Business as we know it has just changed dramatically. It will a few years for people to realise.
In short order, the correction will be inevitable. Don't fall for their "don't panic" BS.
China is way behind in infrastructure construction and environmental protection. I can assure you that every road, bridge, and rail will go somewhere. Increase in infrastructure construction is one of a few choices they have.
www.greenfaucet.com/bl...
good luck
Everyone seems to assume that they will sell those dollars for another currency when they might just as easily spend it on supplies like oil, steel, copper, concrete, etc.
They might continue taking $US in trade, but there's no reason for them to keep piling them up in the vault.
I think readers should understand that I have spent the last 7 years traveling to mainland china, Ive visited 37 cities with a focus on central and western china. So unlike most analyst that base there conclusions on public data sources, my conclusion are the product of 7 years of collecting my own data. Ive been on the ground and kicked the tires, traveled to countless factory floors, trade shows and local pubs. Ive also met with more than my share of crooked municipal govt representatives, expats, and Chinese Shylock's. I was in the middle of the SARS epidemic and fought my way out of a contruction worker protest. In short Ive seen the good the bad and the ugly in China. Furthermore I believe Im begining to understand the Chinese mindset having lived in china with my Chinese wife and relatives
The first two respondent's raise very valid issues. Mainly that SAFE must continue the sterilization US dollars as long as they have a trade surplus with the US. Similarly, the Chinese treasury cannot immediately divest itself from dollar denominated assets. Secondly, communism has generally been a very poor allocator of capital. While also imperfect capitalism is a far better allocator albeit with the unenviable byproduct of volatility.
However, I would submit that China is not a true communist country and the US is not a purely capitalist country . In my next article i will fully address how china's currency regime has supported a virtual one way flow of capital while avoiding the adjustments that free market equilibrium models normal exhibit. Ill also look at the some of the policies I expect to see the Chinese to employ as it becomes more apparant that the US is headed into a very long period of recession. I will also address how the quantitative easing by the US fed and massive increase in US treasury debt are furthering these huge imbalances in the global equilibrium model.
\Very simply the US govt is running out of options and is now engaging in poorly thought out politically driven actions that may in fact change the America way of life for a very long time .
In the meantime, keep the comments coming as I will attempt to answer everyone who takes the time to post.
Thanks
Thomas E Wagner CFP
planneronline.com
I see the military growing bigger and stronger, reaching further around the globe. I am depressed with the US and World economy and can trust only in my faith in God. No one anywhere is smart enough to fix this mess and there is not enough money anywhere in the world to replace what we lost at 40:1 lending and inflating of asset values all over the world.
I would appreciate your insight into the condition of China's commercial real estate. Are loans based on a reasonable valuation premise or power of the borrower? Are banks as stressed as they are everywhere else in the world?
Thany you Thomas for your article.