Sean Daly's  Instablog

With talk of a “double dip” in the air, I thought I’d revisit General Mills, a name that I looked favorably upon in late 2008 as a recession-resistant company and one that seems to sprint upward in the first weeks of a broader market rollover.  

Sure enough, as the broader markets tanked in late April, the stock  has performed bouyantly  –up from 34.75 to 37.50.  And a ten year chart shows an even more pronounced de-coupling:


 

I’ve enclosed what I wrote about the company back in October 2008 as many of the demographic factors still hold.  The fact that GIS is completing a two-for-one stock split this week is a wonderful coincidence.

Enjoying the Sweet Spot:

With falling commodity prices and consumer belt-tightening, General Mills is set to experience tasty profits and hearty outsized performance.

By Sean Daly

Last Update: 11.59 EST Oct. 17, 2008

With the recession of 2009 looking to “serve it up” deep and wide, food companies are likely to receive a new found respect from investors in the coming months.  Shell-shocked by the credit crisis and a steep drop in consumer discretionary spending, portfolio managers are apt seek shelter in those large-cap consumer staple stocks best known for bullet-proof earnings and steady dividends.

General Mills (GIS) in particular will find new appreciation.  Its strong brand portfolio commands resilient pricing power and the loyalty of generations of Americans.  With the S+P 500 down 35% for the year, GIS shares are up a buoyant 14.88%, one of only 30 in the index to stay positive.  The company ranked ninth globally in 2008 stock performance, according to a recent survey of global companies by Bespoke Investment Research.   And this recent 10 month success has an impressive broader context: the company’s dividend history stretches back to 1898 and it was recently listed by one analyst as one of only three stocks to outperform the S+P 500 from 1953 to 2008.   That is the precisely the kind of “comfort food” investors are looking for right now.

What constellation of factors place GIS in the proverbial “sweet spot”? 

Most broadly, they include:

1. Widening profit margins due to the “commodity bust” – Just as price increases passed through to consumers in the spring have “stuck,” the inputs of their products have fallen precipitously.  This clears the way for robust earnings.

Last spring’s price increases will stay high for the duration.  Food companies typically enjoy decent pass-through rates on price increases, with GIS in particular able to offset 60-80% of its commodity prices.   Grocery prices have risen all year and were up 7.6% in September (year over year), driven by a 14.2 % increase in cereal and bakery prices.

Corn, wheat, and oil prices have dropped like a stone since the early summer and are likely to continue to drift downward.   Commodity prices, once poised to scale the heavens, have been trashed by expectations of a global recession.   Corn was $3.84 a bushel Thursday October 16 --well down from $7.50 in June.   Wheat and soybean are down 50% from summer highs.  Likewise, oil has been halved.  This is very good news for food companies as they pocket the savings.

Of course, the company had approached the past four years of escalating prices with smart cost cutting.  According to one recent article, the company reduced the number of pasta shapes in its Hamburger Helper line to nine from 25. For its Yoplait yogurt brand, it stopped using different colored lids to signal different, keeping the color differences to the plastic container. With all lids now silver, the company estimates it saves $ 2 million yearly on that simple change.

Now that the “commodity bust” puts the wind at its back, GIS will find these measures a boon to earnings. They also make the firm a lean/mean competitor.

2.   Higher demand --Recession-era conditions will trigger price sensitivity and home-bound, “back-to-basics” eating patterns. 

Today’s demographic trajectory and the steep debt deflation cycle may make this recession quite severe.  This is the first consumer-led recession in 17 years and the median age of an American is now 39, much older than back in 1991.  (Older people typically spend less and retrench more rapidly).  In the early 1990s, the late baby boomers --born 1959-1963-- were still poised to start families. They would buy the minivans needed to restore Chrysler and the McMansions needed to settle the new ex-urban sprawls of Orlando, Atlanta, and Riverside, CA.  That demographic uplift will not be coming this time.

The poor lending practices and easy credit that led to the recent real estate bubble will now in turn led to the “pauperization” of a large swath of America’s working class.  Easy credit fueled consumption and masked a decade-long flat-line in real wages for the average non-managerial workers.  Millions of consumers will find themselves in foreclosure or burdened with debt costs that appear absurdly high for the value of the now deflated asset.  Bank de-leveraging, government revenue falloffs, and consumer retrenchment will have a chilling effect on discretionary purchases in 2009.

What will be the new habits of a retrenching Middle America?
 

A.  Eating at home a lot more, cutting restaurant meals out.  Eating cereal for breakfast at home is one of the first cost-cutting efforts consumers are likely to utilize, saving their “eating out” money for evening events of social importance.   And as the typical American will still remain overworked, this forced regime of “eating in” means that convenient preparation times and comfort food menus will be the order of the day.

B.   Buying at discount retailers –BJs, Costco, Walmart.  This is great for GIS as purchases are made in bulk from a far more narrow selection than non-discount grocers offer.

C.   Coupons and price reductions will carry more importance in down times. Manufacturer coupons are the realm of large cap companies, bent on driving volume.  Organic, high margin, or niche brands can’t leverage this technique, and generally shun it during boom times when consumers indulge their curiosities or taste for higher quality.       

3.   Innovation within the company –General Mills is moving to online, viral and alternative advertising techniques to tap Gen Y, that echo boom generation less likely to be watching TV or reading newspapers.  Coupons that can be carried via cell phones might even give the practice –so long reviled by youth as the desperate trait of middle aged soccer moms—a social cache, if the recession is long enough.

Likewise, the company's focus on new products in two categories -- health / wellness and convenience -- is also making GIS stand out from its competitors. According to one Edward Jones analyst, though Fiber One bars were only introduced last year, the product line now worth over $100 million in sales.  It obviously tapped an important concern of older people with an eye for convenience. 

Targeting select demographic segments and employing new media techniques pioneered elsewhere, General Mills —a textbook mass marketer for decades— will prove an agile giant, well prepared for the economic downturn.

Company Analysis:

Comparing GIS to the S + P 500 (according to the metrics provided by the table below), one is struck by its super low Beta, comparable dividend, lower P/E, and higher Return of Equity.   An investor is taking on a lot more risk to seek out performance beyond the firm.  

General Mills is certainly a more expensive stock for its industry, but its ROE, ROA and yield put the company light years a head of most of its competitors. 

Finding General Mills’s stock value using the Gordon Dividend Discount Model:

GIS‘s present dividend = $1.10

Three year dividend growth =  7.37%

Five year dividend growth rate = 7.84%

Required Return = 10%

(GIS corporate bond of 6% and a 4% risk premium)

Time frame = 5 years

Looking at GIS’s impressive history of dividend growth, I estimate that the dividend growth will revert back up towards 7.84% as earnings increase, rising from its present 7.37%.  I require a rate of 10% and envision a five year time frame. 

Gordon’s model suggests a stock value of 77.75, a significant appreciation from its present 64.69

According to S+P, Analyst Estimates for 2009 foresee a big bump in this coming quarter’s earnings –up from $.79 to $1.23:

Technicals:

Throughout most of 2008, GIS had avoided the market collapse of most other S+P 500 members, running in a channel from January to October, before falling in the two week capitulation that followed.  Assuming that the international financial system stabilizes, but the world recession is still on, I expect that GIS –if it breaks its new resistance /old support at 65 and the broader market is benign—will resume in this channel, bumping between 65 and 71 over the next month and half.

The MACD likewise suggests an updraft in the stock price and a decent entry point:

(First Published --April 12, 2010 / c.2010 Sean Daly)

Crippled banking systems tend to bring on deflations. And crippled banking systems seem to result from the bursting of asset bubbles because of the sharp decline in the value of the collateral backing bank loans.

                                            –Paul Kasriel, Northern Trust

We are on the brink of one of the worst commercial real estate financing markets ever. The banks are healing now, but the (CRE) industry is about to smack them next.

                                           --Phillip Blumberg, CEO Blumberg Capital

A thing long expected takes the form of the unexpected when at last it comes.

                                                                    --Mark Twain

Is the great “Inflation vs Deflation” debate finally ending? It has animated pundits for two years but it seemed to be drawing to a close last week as the Inflationistas declared victory.   The positive jobs number, stronger US consumer spending, and the end of Bernanke’s QE on Easter Sunday all enlivened their speculations.   

Outwardly, these headlines conform to their general thesis:  that to combat the financial crisis, central banks flooded the system with liquidity, but that once the economy recovered, the massive money supply will flood the system and ignite serious inflation.  Perhaps even Weimar-like hyperinflation is in the cards, a few have stated, suggesting commodities and farmland will be the order of the day.[1]

Yet the greater danger may be the one we've been fighting all along: deflation, an outright decline in prices.  Even if we do see technical recovery this year, the chronic unemployment, vast global overcapacity, and the general impairment of bank lending may keep price increases minimal --if they don't actually fall-- throughout most of the decade.  

The deflation camp might take solace from the following less publicized news items last week:

1.      Wage deflation in March.

 Though the April 6, 2010 employment report was the strongest in three years --outwardly an evidence of inflation-- average hourly earnings fell by two cents an hour. 

According to David Rosenberg, chief economist at Gluskin, Sheff: “To see a contraction in wages in any given month is practically a 1 in 100 event and the last time it happened, in April 2003, Alan Greenspan and Ben Bernanke were busy building a ‘firebreak’ around deflation.”[2]

2.   US Business demand. 

On April 7 it was reported that office vacancy rate rose to 17.2% in the first quarter of 2010, a level unseen since 1994. “Effective rent” in the last months of 2009 was 7.4% lower from a year earlier.[3]  

3.      Municipal spending.

The City Controller of LA said the city will be broke in a month. This was one of countless news items nationally suggesting a catastrophic drop in local government spending in the future.

4.      Global consumer demand. 

Core consumer prices –stripped of food and energy—rose by a record-low 1.5% in February from a year earlier in the 30 countries that compose the OSCD. Goldman Sachs sees core inflation falling further this year, to about .3% in the US and .2% in the Euro zone.[4]

5.      Lending Reductions for Chinese residential and commercial construction.

 A real estate downturn in China may eviscerate commodity demand and complicate stimulus measures in the only major economy presently growing.

All of these factors will likely precipitate intense deflationary forces long term.  All are worthy of exploring in depth.  But in the following pages I will try to sketch out the looming impact that the commercial real estate (CRE) bust will have on the US economy in the future, specifically the 2011 to 2014 period.   I also will tease out those factors unique to the industry that might make the bust more severe than anticipated.  

The Next Heavy Shoe:

Though commercial real estate (CRE) has long been seen by analysts as the “next shoe to drop,” recently it has been downplayed as an issue.    "Commercial real estate is a train wreck, but it's already happened," the illustrious Jamie Dimon of JP Morgan Chase said during a company-sponsored conference last month.  He pointed the 38% drop in CRE prices in the past two years.

Just last week Alan Greenspan said: “With prices already down and adjusted, if we were going to get severe secondary reactions, they would have occurred, and they would have occurred if it weren’t for the fact that the rest of the economy is showing some degree of buoyancy.”[5]

Indeed, after 13 months of consecutive declines, overall commercial property values climbed 1%, according to the most recent monthly reading by Moody's/REAL Commercial Property Price Index. 

So it’s all over, right? 

If only it were so simple.  Let’s sketch out the origins of the problem.

The boom in commercial real estate (CRE) started several years after the residential market had heated up: 

The industry as a whole had been chastened 15 years before in the early 90s and had assiduously avoided overbuilding.  But as graph 2 suggests, the industry was lured into a spasm of speculative activity starting in 2005. Beginning that year, commercial real estate prices began to depart from a 20-year trend of 1.4% annual growth.

Because commercial real estate loans typically have five year terms, the industry’s loans are continuously being refinanced. The problem is that loans made at the height of the boom -- 2005 to 2008 -- were based on inflated asset values and often “easy” origination terms.  Up until now, very few of these “boom era” loans have reached maturity --though the delinquency rate on all CRE loans is up.

So, what exactly is the magnitude of the problem?  The total value of outstanding commercial real estate-backed loans in the US stands at $3.7 trillion.  Between 2010 and 2014, about $1.4 trillion of these loans will mature and need to be refinanced.  As the following graph suggests, the destructive height of this loan tsunami crests in 2012-2013:

Nearly half of the loans are presently “underwater” – i.e. the borrower owes more than the underlying property is currently worth. Commercial property values have fallen more than 38% since the beginning of 2007.  

Vacancy rates, which now range from 8% for multifamily housing to 17.2% for office buildings, are at levels not seen since 1994. 

Rental rates fell an average of 0.8 percent in the first quarter of 2010, a less steep decline than seen last year. Asking rent fell 4.2 percent from a year earlier. Add in months of free rent and landlord contributions to space improvements for each tenant, and “effective rent” of 1Q 2010 was 7.4% lower than the year before.  And that pressure will likely to continue for six more quarters.  According to Reis Director of Research Kyle MacLoughlin: 

“As the labor markets stabilize we expect occupancies and rents to require another 12 to 18 months before showing signs of improvement, given the typical lags in commercial real estate.”[6]

PricewaterhouseCoopers also suggests that commercial real estate vacancies will increase in 2010.     

So even if the recovery began last quarter, rents on CRE will “suck fumes” well into 2011 and perhaps 2012.  These pressures already are choking operating incomes, causing defaults even before the re-financing crucible.   The following graph makes this clear:

The Weapons of Mass (Bank) Destruction:

So what will make the commercial real estate market of 2011-14 so devastating?  Here are the three main issues:

1. Falling Operating Income

As noted above, increasing vacancy rates and falling rental prices pressure all existing loans. Decreased cash flows will affect the ability of borrowers to make required loan payments.  As vacancy rates climbed in some cities a full two years after the 2001 recession, it would not be unlikely to see a similar momentum this time. Note the US average on the following graph:

Fortunately, over the past decade, the Commercial Mortgage Backed Securities (CMBS) market was far smaller than its residential counterpart.  But the income flows will be similarly affected.  The following bar graph offers a wonderful glimpse at the destructive time delay conjured by contemporary finance, with “boom era” loans haunting the CMBS income streams until 2017:

2. Few lenders / more stringent underwriting standards

The frothy “easy liquidity” period (2004 – 2007) resulted in the origination of many commercial real estate loans based on weak underwriting standards. These loans assumed overly aggressive rental or cash flow projections sustainable under bubble conditions.  Hedge funds, Private equity, and the “shadow banking sector” started to enter the field, offering loans with higher levels of allowable leverage –say 80% instead of 65%.  Offering more loan for less collateral, these are analogous to the famous “Alt-A” residential loans.  

Since the credit crisis of 2008, all these more specious sources of financing have dried up. When those “easy” loans come due in 2011, the originators will have been long gone from the field. Those eager “shadow bankers,” hedge funds, and private equity firms from 2006 are out of business –or at least out of that line of business. The traditional sources of commercial financing--with max LTV ratios of 65 percent--are all that remain.  

By the old measures, the 80% LTV ratios are impossible to accept –even if the value of the property had remained constant.   Another “financial innovation” made extinct by the bust.

Even the more respectable CBMS origination market, which may have created demand for new loans, was snuffed out in the crash:

3. Falling Property Prices / Wrecked LVT Ratios

This factor is the most punishing, and may cripple the economic prospects of the next decade.

Falling commercial property values result in higher “loan-to-value” (LVT) ratios, making it harder for borrowers to refinance under current terms regardless of the soundness of the original financing, the quality of the property, and whether the loan is performing.  The collateral is worth less than it was a few years back, placing the loan out of contention for refinancing.  The owners are essentially locked out.

As one example makes clear, refinancing becomes impossible:

Adjusted property value: $80 million (down from $123 million in 2007)
Loan amount to be refinanced: $80 million
Maximum LTV ratio: 65 percent
Maximum new loan amount: $52 million (65 percent of $80 million)
Shortfall: $28 million
Result: impending bankruptcy[7]

All of the fundamentals of a good commercial real estate investment may still be intact –fully occupied, good tenants, positive cash flow, “location-location-location,” etc.  The problem is not inherent to the building itself.  It is the new pricing environment, but it's still deadly.   Like a perfectly healthy “hot house” flower that will die now that all the windows of its green house have been shattered mid-winter, the building’s financing was not designed for the new financing milieu.

Goldman Sachs forecasts that the average commercial LTV ratio will reach 117 percent by 2010 and that 81 percent of commercial borrowers will be looking at negative equity.[8]  PricewaterhouseCoopers also suggests commercial property prices will ultimately fall further, dropping from today’s 38% to a full 50% of the 2007 highs. 

This gives owners an incentive to simply walk away and cede an underwater asset to the bank, creating another terrible liability for the banks.

Death by a Thousand (Deflationary) Cuts: CRE’s Impact on America’s Regional Banks

Liquidity is a function of two factors, money supply and collateral.   But the impact of available collateral is far more critical to maintaining liquidity than the money supply.  A decline in the value of the entire asset base of the US Commercial Real Estate sector will have a real effect on banks.  The Japanese experience is clear:

“When the bubble burst, the debtors could not keep current on their loans and turned back the collateral to the banks.  The market value of the collateral was less than the amount of the loan outstanding, thereby inflicting huge losses of capital on the Japanese banks. With the decline in bank capital, the banks could not extend credit to the private sector, even though the Bank of Japan was offering credit to the bank at very low nominal rates of interest.”[9]

As residential lending and the CDO conveyor belt became a key part of the big banks’ profit center, the smaller regional players could not keep up.  So instead they funded local commercial real estate projects.  The big investment banks did some CRE, but only for the most prestigious projects.

So the coming CRE crisis will not implode Wall Street high rollers like Lehman or AIG.  Unlike the residential mortgage meltdown or the derivatives blow-up, commercial property loans will hit the regional banks, not the big 20.  And as 70% of total banking assets sit with the top 100 banks, the international financial system will thus stay intact.  The center will hold. 

But the “vast periphery” --the 8,088 smaller banks-- will be ravaged. And these smaller banks are responsible for 40% of small business loans.

This is one of the main reasons that bank failures in 2010, 2011, and 2012 will be likely higher than 2009’s total of 140.  As the chart from the preceding page suggests, a total of 2,988 Banks have been flagged with “CRE Concentrations” by the US government.  Banks will continue to take on a defensive stance, bracing for this new wave of debt deflation to hits their shorelines.   

They will not be able to lend. 

At present, the banks have been reluctant to mark down the value of their CRE assets. Goldman Sachs estimates that banks are still carrying the commercial mortgages at an average of 96 cents on the dollar.[10]    This might not be a problem for big banks with low CRE exposure –say Citibank, at only 3% of all loans.  But regional banks out West look vulnerable:  Las Vegas-located Western Alliance Bancorp (WAL) has 65% of its loans in CRE; Zions Bancorp (ZION) in Salt Lake City has 56%; Third Fifth Bank (FITB) has over 50% exposure.  The list goes on.

The “stress testing” conducted last year was only for the 19 major financial institutions and their capital reserves were examined only through the end of 2010. The hungry, boom-town regional banks in places like Atlanta or Phoenix were never subjected to anything remotely like a stress test, and nothing that looked out to 2014. 

A recent Congressional Oversight Panel calls for such assessments. The February report stated that for the nation’s roughly 7,000 community banks, those with less than $10 billion in assets, the average CRE exposure equals 288% of total risk-based capital. 

To put that more baldly:

The average community bank has about $3 in commercial real estate loans for every $1 set aside to cover possible losses.  And the collateral for those loans just lost half their value.  . . .

Conclusion:

There is a commercial real estate crisis on the horizon, and there are no easy solutions to the risks commercial real estate may pose to the financial system and the public.

                                                       --Congressional Oversight Panel, Feb. 2010

Is the Federal chairman worshipping a false religion?  Was Milton Friedman right in arguing that the quantity of (broad) money is what matters most, not the credit mechanism?

Upon this abstruse doctrinal point will depend whether the Atlantic economies rise above stall speed or lurch in a double-dip recession.

                                                            --Ambrose Evans-Pritchard[11]

Bonds, real estate, and pension funds, ultimately, are all collateral – the primary engine of liquidity. Over the long-term, the only way to stabilize the value of collateral is to establish a sustainable positive cash flow.

                                                                --Edward Ring, CIV FI

So how bad will it be? 

To put this in a global context, many regions around the world are already dealing with commercial vacancies of 15-20%.  The US is not alone. 

And there was not the predatory lending or insane “CDO squared” dicing that complicated the residential loan market.  This market is mostly whole loans and some overpriced paper, so the bank wounds will be “clean cuts.”  But they will be deep and they will be inflicted on the smaller players.

According to Real Capital Analytics, there are already 10,100 troubled commercial properties worth more than $205 billion in the US.  That number will obviously rise as we hit the “refinancing” period of 2011 – 2014.  Over the next few years, their report states, the banks alone could experiences losses nearing $300 billion.[12]

In this scenario, hundreds more community and mid-sized banks will face insolvency. These banks play a vital role in financing the small businesses that provide the majority of new job creation in the US.  Their widespread failure will further winnow local communities, undermine a sustainable recovery, and pressure the economy into a second recession a few years from now.

In a recent speech, Atlanta Federal Reserve President Dennis Lockhart spoke of the “potential of a self-reinforcing negative feedback loop” involving bank lending small business employment, and commercial real estate values.   No lending means that the small businesses dependent on that source of credit will be forced to shut their doors. This pushes up commercial vacancy rates in the local region, which pushes down on real estate prices. Those falling prices in turn will lead to additional write-downs in the bank's CRE portfolio.[13]

Worst case, this vicious cycle starts to hurt the local economies just as the municipal bond defaults start to occur, leaving no room for Keynesian responses.  Worse case, the real estate industry in China goes bad and the two downturns hit the global economy over the same time frame.  Worse case, today’s apparent bottom in property prices is a temporary respite, with a further fall mid-decade.

As has often been the case in history, the lag time between the CRE loan and the finished “shiny building” is the time delay between boom and bust.  What is truly unique today is that fifteen years of financial globalization had instituted an astonishing “simultaneity” to world growth patterns.  From Atlanta to Astana, from Barcelona to Beijing, from the OC to Hungary, speculative real estate was built.

The emerging economies saw real gains in purchasing power and industrial capacity. And decades of excessive monetary policy and credit expansion hid real wage declines in the developed economies. The world boomed in unity, but it may not recover in unity. 

With no likelihood of higher US wages or pronounced demographic growth, the nation’s commercial real estate market will likely endure capacity overhang for years.  This will continue to burden our smaller banks.  

As the following graph of “real peaks” suggests,[14] it is unclear whether the US will escape the kind of period of deflationary pressure Japan experienced on the long road down:

 “I have no doubt that a revaluation will happen over the next two years.  The timing, ironically, gets delayed by external pressure.”

                                             --Mohamed El-Erian, Barron’s (March 20, 2010)

The effects of Copenhagen are still being felt.  In December, during the global forum, a minor Chinese policy official publicly berated Barack Obama, hectoring him in a manner extremely strange for Chinese government emissaries who usually emphasize quiet decorum at such events.

China’s intransigence and its aggressive theatrics doomed the global climate forum and stunned European policy makers in particular. It showed the limits of the existing international framework despite their best aspirations.   More to the topic, it precipitated a new “realist” appraisal of China on the part of the American Left.  There was suddenly recognition that the emerging power might not simply need a dignified “place at the table” and then always be a progressive player on global agendas.     In fact, it might be more like the US –a hungry solipsistic nation, driven by unilateralist tendencies and obsessed with its own big domestic needs.  

The December detonation at Copenhagen struck deeply at the sunny multilateralism espoused by Democrats in the US.     A few weeks later, in a standard New Year’s forecasting article, progressive-in-chief Paul Krugman stated that he believed that 2010 would be the year we "call out" China.[1]

Two months later, the arm-chair forecaster became the agent provocateur, precipitating the fulfillment of his own prophesies.   In his March 15, 2010 column in The New York Times, Krugman recommended that the US impose a 25% tariff on Chinese imports unless the Chinese appreciate the renminbi.  The piece set off a cascade of official declarations from the highest level of the US and Chinese governments.

President Obama’s remarks three days later embraced the logic of the article and were measured and diplomatic.   Wen’s reply the following Sunday and the next-day resolution by 130 congressmen to look into the peg were far more inflammatory and suggest just how quickly the tinder of a long-un-countenanced issue can burst into crisis.  Just as the stock market rolled up a strangely sleepy but statistically aberrant eight day uptrend, there was suddenly talk of “trade war.”  

Several thoughts come to mind on this crisis:

First, it’s a shame that a currency revaluation has to be such a political “event” --charged with bi-lateral rhetoric, lagging a build-up of problems, and filled with recriminations.    It has been a noticeable failure of the present currency regime since its inception in the early 70s.  Though it beats the gold standard on growth, the floating exchange rate system lacks inherent balancing mechanisms.  Arvind Subramanian’s proposal that “a multilateral rules-based solution” be set up in the WTO to deal with such issues sounds like an excellent long-term fix, though it will have no effect on the present issue.   As the Peterson Institute fellow stated in FT recently:

What is needed is a new rule in the WTO proscribing undervalued exchange rates.  The irony is that export subsidies and import tariffs are individually disciplined in the WTO but their lethal combination in an “undervalued exchange rate” is not.[2]

Second, the US might be jawboning a revaluation more for the developed markets in general, not just for itself.   It might be more an example of the hegemon operating on behalf of the system itself.  

US manufacturing exports to China are limited. China’s list of “approved products” actively avoids US manufacturers.   But China’s peg is severely hurting US trade partners in Europe and Asia.   It is forcing the adjustment process not so much on the US itself but on to almost every other country. Even Brazil has had to impose short-term capital controls.

The quick and supporting remarks from both Japan and Europe on a revaluation would suggest that.  "Germany welcomes the move," German Finance Minister Hans Eichel said in a statement.  And at a press conference last Monday, Yoshihiko Noda, a senior vice finance Minister, stated:  “I basically think that making the Yuan flexible would be positive, not only for the world’s economy, but also for China’s.  Many of China’s neighbors seem to have questions about the dollar peg.”     Indeed, Korea, Taiwan, and Malaysia have all been trying to cap their currency advances to compete with Chinese trade more effectively, more or less confirming the “depressing effect” that Krugman suggested in his article. 

This vocal support by other players suggests that there have been active “back channel efforts” on the issue for months.   China’s Ministry of Commerce has allegedly been doing impact studies of a Yuan rise on textile manufacturers since early this year.[3]   Exporters like Germany and Italy in particular need market share to perpetuate their economies and insure tax revenues.  The US cannot risk having them fall into the kind of problems Greece now faces. 

The Yuan-dollar peg has been in place since July 2008 and helped China weather the credit crisis.  China has been a bastion of stability due to the peg, its stimulus, and its proactive good governance.   But the world is moving into a new phase of recovery and a new course is required.

Whereas most of the developed markets are dealing with anemic deflationary conditions, China never technically went into recession.   China’s economy is actually overheating in certain areas, like coastal real estate.  In February, its CPI rose 2.7% from a year earlier, and nearly double the 1.5% in January.   Its economic growth lurched to 10.7% last quarter, and property prices in 70 cities rose nearly 11% year over year.   The IMF forecasts 10% growth this year and 9.7 % this year.   The low Yuan and massive stimulus combination are now generating an inflation unwanted in China, but perhaps desired globally.

Third, a modest revaluation of the Yuan is not only desirable but inevitable.   There will be near-term negatives for both China and the US, but if a trade war can be averted, they are overblown in comparison to the long-term rebalancing.  

The following list might best characterize the China’s fears:

1.      A revaluation will hurt exporters already operating at razor thin margins, and according to Shaun Rein, Managing Director of the China Market Research Group, may lead to –at worse--another 5 million job losses.

2.      This might create social unrest.

3.      The Yuan is no longer as undervalued.  A rise in the minimum wage and the new enforcement of medical benefits for employees has already affected profitability at firms.

4.     The Chinese government will have a smaller treasury to generate needed modernization projects.

In comparison, here is the list of near-term negatives to the US:

1.     It will hurt the purchasing power of the US consumer, with higher prices in  stores.

2.     Higher interest rates nationally

3.     US corporate profits will be hurt, as most of manufacturing costs from China are a tiny fraction of the retail cost.  This will only hurt US companies more.

4.      A Chinese sell-off of US treasuries.  No one will buy our debt and interest rates will soar.

Long term positives for China include:

1.     Chinese consumers get more purchasing power –a well-deserved measure -- as the government and exporters have essentially kept them poorer than necessary.  Mao kept them poor for 30 years for the sake of a “worker-peasant” utopia, a state prerogative.  Now the CCP keeps them poor for the sake of a nationalist project and its own self-preservation.    The era of “export-platform Asia” is ending; the Chinese need to become active consumers.

Near term positives for the rest of the world include:

1.     Low-margin factories might now be sent to Vietnam, Cambodia, Uganda or other parts of Africa –countries that need those jobs and are at a lower stage of economic development than China.   These countries will also be more likely to buy US goods.

2.     Higher value-added manufactures from the US, Europe and Asia will be more competitive with China.  One example: China is developing a high speed rail industry that sets out to remove all components imported from Germany, France and Japan.  Three years ago, Chinese companies had no ability to make parts for their systems.  Now its state-funded industry threatens to displace companies such as Siemens (SI), Alstom (ALSM.Y), Bombardier, and Kawasaki (KWHI.Y) from any involvement in their domestic rails, and is competing on international projects with them.   A mercantilist country competing on this level should not be hiding behind a currency peg.

Long-term positives for the rest of the world include:

1.      The future of world growth now requires a greater consumption patterns within Asia.

2.     This is an appropriate re-balancing of the currency regime, similar to both the Plaza Accord and the Reverse Plaza Accord (which was initiated in 1996 to help the yen and strengthen the dollar).  Though it can be very disruptive and very post-factum in its response, it is necessary to rectify imbalances.   

Fourth, the US must defend the present currency regime.   It is a flawed system.   It is bubble-driven and lurching, and dangerous to small nations with low reserves.  But it is the only regime we have or will have for another twenty years.  It also is ultimately the most growth-oriented currency regime in history.   (The Euro’s recent weakness suggests that any future “Asian monetary unit” might have its share of problems)

The gold standard offered nice balancing mechanisms but it forced extreme restrictions on global growth.  Today’s “post-Bretton Woods” regime requires active negotiation between the major players but it is very expansionary in monetary terms.  Though often criticized, it is probably far more responsible for the vast Asian middle class and the global wealth that was created during the 1973-2008 period than anyone would want to admit. 

Indeed, to grow, most of Asia has followed an export-platform model of economic development directed specifically to the US market.  This was an important component to US geo-strategy during the Cold War period -- to stabilize those few island nations and peninsular enclaves along the Eurasian landmass that were not communist.  It was not designed for China, an adversary.

Since dropping the gold standard in 1971, the present currency regime has required a strange dance of re-calibration between the “major powers” from time to time.  If China wants to be a player in the international financial system, it will have to learn to dance this awkward dance.   In 1971, Nixon’s Treasury Secretary famously stated its “our currency, but your problem” and imposed a temporary 10% surcharge on imports.  The tax was removed a few months later after Germany, Japan, and others raised the dollar value of their currencies.   This may have been impolite, but the Warsaw Pact offered far worse indignities.

In 1985, the Plaza Accord forced Germany and Japan to again strengthen their currencies and the measure did help US manufacturing in the 1986 to 1995 period.   The Endaka created an asset bubble in Japan five year later, but other more structural factors were in play to cause the later Depression.

The Reverse Plaza Accord of 1995 suggests it’s not just a one-way street, but truly a range-bound negotiation. Though it hurt US manufacturing, Treasury Secretary Rubin thought that the Japanese economy needed a weaker Yen to ensure Japan’s economic strengthening.    The result of the stronger dollar was an asset bubble in the US that also burst five years later. 

China shouldn’t paint itself into a corner with nationalist rhetoric.  The US spent the 20^th century laying the groundwork for a liberal international order that China initially rejected.   From 1949 to 1980, the People’s Republic of China attempted a self-contained economic utopia that –through the Great Leap Forward and the Cultural Revolution, ultimately degraded its population and caused more human suffering than any other period in its history.   Its efforts in the 60s to export its “worker-peasant” / collectivist approach to parts of Africa and Asia failed in those societies as well.  

Embracing a relationship with the US and its non-communist allies in Asia in the mid 70s has helped more Chinese arrive at more fulfilling, affluent lives than ever in its long history.    No one in China would trade the “open” years of 1980 – 2010 for the ”closed”  years of 1950 – 1980.  Yes, the US is a hegemon, but it offers a far more benign hegemony than most in history.  

So will China dance the “Plaza Accord pas de deux”?  The existing currency regime requires it.    In the prior Accords, the negotiation was with Germany, Japan, France—strategic allies facing at the time a common external threat.   America’s geo-political relationship with China has not been resolved.  So this time is very different.

Wen Jiabao says that he opposes measures “to force countries to appreciate their currencies.”   Is he stating then that China will not work within the existing exchange rate system?  After all, as we have seen, the present fluctuating rate regime requires periodic adjustments among its primary actors to rebalance the system and keep unemployment from flowing too much into one nation in particular.   

But, as it did with Copenhagen’s emission targets, China sees the revaluation as some Washington-sponsored assassination plot, a crafty Endaka to cripple their ascent. 

As you’ll remember, in late 2003, when Zheng Bijian first used the term “peaceful rise” at the Boao Forum for Asia, he was discussing that, in the past, a rise of a new power often resulted in war or a concerted subversion of the international order.  He believed that this was because these powers "chose the road of aggression and expansion, which will ultimately fail."[4]

So, does China’s “peaceful rise” doctrine suggest it will embrace the existing international regime?[5]   Or is it a temporary mask for a strategic competitor fully intent on disrupting that order?   Though Japan and the West decided against active containment years ago, seeing a weak China as more destabilizing than a strong one, there remains great trepidation in the developed world over the PRC’s future role internationally.