Inflation, Deflation and the U.S.-China Relationship

by: Thomas Wagner

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.