Fears of further monetary tightening in China have recently been weighing on the Chinese stock market. Of all the bourses, the Shanghai Composite Index (3,046 at the time of writing) is the only one trading below its 200-day moving average …

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In the long run, economic development and — especially — corporate earnings are the main drivers of stock market performance. But this relationship is very loose. It becomes tight only if your time horizon is measured in decades.

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Zero Hedge

The next time we get a serious dip in the stock market, there is one sector that I am going to jump into with both of my size 14 boots: technology stocks. 

After the dotcom bust of 2000, these bad boys spent nearly a decade in the penalty box, shunned by the investing world as the poster boys for wild excess. Think Robert Downey, Jr. on steroids. During this time, cash balances doubled, free cash flows soared, outstanding shares shrank, and multiples fell to a tenth of their bubblicious peaks.

 I started recommending this group at the absolute bottom of the market last March (click here for the call at http://www.madhedgefundtrader.com/March_2__2009.html ), and it was no surprise to me when they outperformed almost every sector on the upside. With 60%-80% of their earnings coming from abroad, primarily Asia, I saw them really as foreign stocks wearing cowboy hats, pearl snap buttoned shirts, and Ray Ban aviator sunglasses.

They were great weak dollar plays. They did not need banks, as they are almost entirely self financed. They avoided many of the management errors that torpedoed so many other US firms, like derivatives books  and leveraged real estate exposure. While their American customers were getting poorer, hundreds of millions more overseas were getting richer.

The industry represents the last, best hope that America has for competing globally, as it is our only means of staying on top of the international value added chain. It seems that in addition to bulk commodities like corn, wheat, soybeans, coal and timber, aircraft, weapons, and movies, tech companies are among the few that make things foreigners want to buy.

The lessons of the bubble made them ultra conservative in their capital spending which will lead to product shortages and much higher prices in any recovery. Memory, for example, has seen no capex at all for three years. They are surfing the wave of innovation, and will cash in big time from the mobile computing revolution, cloud computing, and the virtualization of data centers.

During the last tech bubble, the industry did not have the global market that it does today. Now, demand from the rising emerging market middle class is kicking in, as it is for commodities. The nine month tech rally we saw in 2009 could  just be the down payment of a decade long bull market in these stocks, which will end with another bubble.

When John Chambers, a first class manager, discussed Cisco’s (CSCO) outlook after announcing blowout Q4 earnings, he was so effusive he sounded like he was on ecstasy. Take a look at Juniper Networks (JNPR), JDS Uniphase, (JDSU), Sandisk (SNDK), Micron Technology (MU), and lithography toolmaker (ASML). Long dated call spreads in all of these make sense on a decent dip.

For more iconoclastic and out of consensus analysis, you can always visit me at www.madhedgefundtrader.com , where the conventional wisdom is mercilessly flailed and tortured daily, or listen to me on Hedge Fund Radio at http://www.madhedgefundtrader.biz/ .

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The Daily Reckoning

Financial Times: US Household Debt Falls for First Time Since WWII

Yes, dear reader, we have been a voice howling in the wilderness. First the wilderness around the Café des Dames in Paris’s 19th arrondissement…recently the wilderness of Bethesda, Maryland…and lately the wilderness near the Taj Mahal Hotel in old Bombay.

Reading the TIMES of India is a delight. We see that a politician has been given a colorful, over-the-table bribe…a garland made up of 50,000 thousand-rupee notes (about $1 million)…

..a headless body has been found in Kandivli…26 people were killed when their bus fell off a bridge…

..and that more than half the population defecates in public.

In fact, India is Number One in outdoor Number Two, if our dear, delicate readers know what we mean. It has 10 times as many people defecating in public as the runner up, Indonesia. The US didn’t even make the top ten.

The poor Indians. They can’t handle alcohol. Research shows that Indians suffer higher rates of heart disease if they drink. Even light drinkers face a 40% higher risk of heart trouble, according to the study. Heavy drinkers’ risk of heart problems is twice that of non- drinkers…still, well worth it, in our humble opinion…

“110,000 killed on India’s roads and railways,” says another news item.

“Is that all,” we asked a colleague. Every time we cross a road we narrowly escape death. And we’re being careful. Other pedestrians seem to ambulate in the middle of highways…beg between lanes of busy rush- hour traffic…and make daredevil dashes across chaotic intersections. It’s amazing more aren’t killed.

There’s also an item that shows how India’s civil justice system works. A landlord has finally won an eviction – thirty-three years after he went to court! The unauthorized tenant lived in the apartment for an entire generation before finally being booted out.

But wait…our beat is money. So back to the big money story…

Mainstream economists and mainstream financial media tell us that the worst is over…that the ‘recession’ has passed…and that things are getting back to normal.

Nope, we reply. Not a chance. The old economy that existed since the end of WWII is dead. No way could it recover; you can’t revive a corpse.

It was beginning to look as though we would have to eat our words: the cadaver was sitting up in bed and watching TV.

Everything was beginning to look eerily normal, after all. A year after the stock market hit bottom, it still has not resumed its downward slope. Businesses that should have gone bust are still in business. Politicians who should have been run out of town on a rail are still putting their earmarks on everything. Bankers who should now be parking cars are still making loans.

The government is still misleading… Economists are still mis- interpreting… Investors are still mis-understanding…

..it sure seems like things are back to normal!

But something important has changed. And here comes the proof from the good ol’ FT.

The FT, by the way, has the same dim economists as everyone else. While we wouldn’t trust a government employee to manage a coffee shop, the FT’s leading economist, Martin Wolf, thinks they can manage the whole world’s economy. It’s just a matter of getting the balance right, he thinks.

But beneath the surface of the flow of silly opinions and distracting noise, there is a powerful tide…an undertow that is sweeping everything out to sea. For the first time since 1946, household debt in the US is actually going down.

This is what de-leveraging is all about. The credit expansion is over. The tide has turned. Credit flowed for 61 years. Now it ebbs. No more increases in household credit. No more increases in consumer spending, over and above wage gains. No more extra sales. No more ‘growth’ at the expense of private sector debt.

It’s over.

Regards,

Bill Bonner
for The Daily Reckoning Australia

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In testimony today before Congress, Fed Chair Ben Bernanke outlined his reasons why the Federal Reserve is uniquely suited to be the regulatory supervisor for U.S. banks.

Bernanke offered two reasons why the Fed is the natural agency for financial supervision. First,
he suggested that some supervisory responsibilities are essential in order for the Fed to carry out its primary monetary policy functions:

[The Fed's] involvement in supervising banks of all sizes across the country significantly improves the Federal Reserve’s ability to effectively carry out its central-bank responsibilities. Perhaps most important, as this crisis has once again demonstrated, the Federal Reserve’s ability to identify and address diverse and hard-to-predict threats to financial stability depends critically on the information, expertise, and powers that it has as both a bank supervisor and a central bank. Not only in this crisis, but also in episodes such as the 1987 stock market crash and the terrorist attacks of September 11, 2001, the Federal Reserve’s supervisory role was essential for it to contain threats to financial stability.

Insofar as the Fed is expected to fulfill its function as a lender of last resort through the discount window, surely it needs detailed knowledge of the borrower’s financial situation. And actionable information on the financial system’s health and stability is just as surely essential for knowing when and how fast to change interest rates.

Second, Bernanke observed that no other agency has the Fed’s breadth and depth of relevant expertise:

Federal Reserve staff members have expertise in macroeconomic forecasting for the making of monetary policy, which is important for helping to identify economic risks to institutions and markets. In addition, they acquire in-depth market knowledge through daily participation in financial markets to implement monetary policy and to execute financial transactions on behalf of the U.S. Treasury. Similarly, the Federal Reserve’s extensive knowledge of payment and settlement systems has been developed through its operation of some of the world’s largest such systems, its supervision of key providers of payment and settlement services, and its long-standing leadership in the international Committee on Payment and Settlement Systems.

The Fed employs hundreds of extremely bright and very well-informed economists. On my visits to the Federal Reserve, I’ve been amazed at how well the staff work together to assimilate information and perspectives. In my experience, you can ask any one of them a question about pretty much anything, and although the person you’re talking with may not know the answer, he or she will know the name of the person within the Fed who does know. I’ve interacted with lots of different institutions over the years, and have never seen another one that functions so effectively as a single, cohesive neural processor. Certainly the objective record of Federal Reserve forecasts is pretty impressive; see for example the assessments by Christina and David Romer and Faust and Wright.

Doubtless others will be skeptical, trotting out the Fed’s spectacular underestimation of financial problems during 2005-2007. That criticism is of course well taken, and both the Fed and the economics profession as a whole have much more work to do in terms of recognizing exactly what should have been done differently. But let’s be practical. What other institution did a better job? Where in Washington today do you see an agency with the intellectual resources to get this right? Simply squawking that we need a change is not constructive leadership; it’s political finger-pointing and CYA.

Indeed, it’s striking that many of those who were instrumental in relaxing the oversight on Fannie Mae and Freddie Mac now believe that a regulatory body more directly under their political control could do a better job than the Fed. In the mean time, the FHA continues even today to dig us into a deeper hole.

Notwithstanding, the debacles of Fannie and Freddie and the perhaps soon-to-come trainwreck from the FHA also illustrate the primary concern I have about giving the Fed more supervisory authority. The more power the Fed is given in such matters, the greater the political pressures will be from the outside to satisfy certain constituencies, and the less the Federal Reserve will resemble the remarkable institution that Bernanke and I described above.

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In our previous essay we mentioned that although it was not clearly visible in the past weeks, looking at the charts with the RSI and stochastic readings in mind, silver’s historical cyclical tendencies point to a downturn. This decline could be easily triggered by a downturn on the general stock market.

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Over the course of the last 12 months, many analysts and newsletter writers have been discussing goldmoney.com?gmrefcode=bearmarket43″target=”_blank”rel=”external”title=”precious metals” >precious metals stocks as an alternative to fiat currencies. What opportunities remain—new and old—in Mexico, Colombia and elsewhere for investors? In this exclusive interview with The Gold Report, Mike Kachanovsky, aka ‘Mexico Mike’, (Investor’s Digest of Canada), discusses why he believes the market is better than ever for precious metals, as well as the abating political risk for mining companies in countries such as Mexico, Colombia and Vietnam.

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By Michael Pettis, China Financial Markets

The Chinese new year has only just started, and already trade tensions are ratcheting up. This is perhaps appropriate — astrologers tell us that the year of the Tiger is often a year of instability and conflict — and I suspect things will almost certainly get worse. The timing of various domestic political events in the US, China and Europe will make it harder than ever for any of these countries to back down before 2012 (by which time, presumably, the world will have ended anyway).

Last Thursday President Obama made a fairly strong speech in which he urged China to adopt a “more market-oriented exchange rate”. The timing of the speech was important. On April 15 the US Treasury department will release its report stating whether or not China is a “currency manipulator”, and it is hard to believe that the Treasury department is not facing some pretty stiff pressure.

China’s response to Obama’s speech was pretty rapid and pretty angry. According to an article in the Saturday issue of the Financial Times

What it means to “politicise” the currency policy wasn’t made clear, but on Sunday Premier Wen also jumped into the fray. He denied that the RMB was undervalued and, in the words of an article in Monday’s Wall Street Journal, added the following:

Wen is absolutely right. Undervaluing or depreciating a currency certainly is a form of trade protectionism, but that, I think, is exactly the point. In a world of sluggish growth and rising unemployment, everyone’s currency policies are legitimately going to be scrutinized over whether they constitute trade protection.

An article in the People’s Daily has Wen also warning that “China opposes accusations and even forceful measures that press for yuan appreciation, which will not benefit the exchange rate reform.” The claim that external pressure will never advance reforms in China is now much debated in Europe and the US, and may be less widely believed abroad than it has been in recent years.  We’ll see.

These are murky political waters into which I do not want to dip, but it is hard to escape the politics of the debate.  The same issue of the People’s Daily had another article pointing out that US debate on the currency was driven mainly by domestic considerations and that the only reason Obama brought up the subject of the RMB was to address domestic polls.

There is, as always, a certain amount of nonsense in these articles. For example the exchange rate itself affects the ratio between savings and investment, so while the first part of Zhao’s statement is more or less right — although not as a “fundamental reason” but rather as part of an accounting identity — the second part is certainly wrong and probably meaningless.  More interestingly, it seems a little weird to argue that one of the benefits that China has provided the world with its undervalued exchange rate is low consumer prices that allow countries like the US “to consume excessively”. Aside from the fact that this pretty explicitly acknowledges that the currency is undervalued, since excess consumption is exactly the problem in the US, and since Chinese per capita consumption is much less than 10% of that of the US, it seems that China should be more approving of US attempts to return the favor and allow Chinese consumers the benefit of subsidized US prices.

Everything is politicized

Still, I do think the People Daily’s article is right to say that the RMB is becoming an important domestic issue for Obama, and that it is domestic US politics that is driving much of the recent noise and the rancor. Obama’s popularity has dropped considerably, and ahead of the upcoming elections he needs to show that he is addressing fundamental economic problems. And of course it is also always easy to get votes by bashing foreigners — this is one of the many attitudes that the US and China share.

But even though the People Daily’s criticism is correct, perhaps that doesn’t change anything meaningful. The concern over the effect of the RMB on US employment may still be a perfectly valid one, and the fact that Obama is under domestic pressure to address the currency is not an especially good reason to dismiss his concerns. On the contrary. Obama has little wiggle room, and as Paul Krugman pointed out in a fiery, and probably influential, speech last Sunday, the US may hold the stronger cards in any showdown. According to the relevant article in Business Week,

Krugman elaborated further Monday in the New York Times in an article, and then in a follow up article Wednesday, both of which are likely to be much quoted and widely read. Although Premier Wen noted again in his speech Sunday that China is “worried” about the value of its US dollar reserves, perhaps as a warning that China would counteract any US trade move by selling off USG bonds, Krugman doesn’t seem especially worried about this threat.

He may be right. Aside from the fact that it is not clear how China can dump Treasury bonds, he claims that it would only help the Fed in its quantitative easing, and would probably do far more damage to Europe (since China would presumably have to buy euros) than to the US.

The latter point is almost certainly correct. China’s Selling dollars and buying something else would allow the US to get even more bang for its protectionist buck, probably at poor Europe’s expense.  I would also add that the main long-term impact of dumping USG bonds might be no more than to cause a liquidation of Chinese assets at very low prices, and an equivalent transfer of wealth from China to the US (or to others likely at some point to buy cheap dollar assets).

Remember that at the beginning of WW1 something similar happened. In an urgent attempt to raise gold reserves to pay for the war, in the late summer of 1914 European belligerents dumped onto US markets what amounted to a far greater share of US assets than China currently holds. This caused about six months of havoc, and many sleepless nights in New York and Washington. But the US responded by putting into place temporary capital and stock market controls, and when the dust settled, the net effect was one of the most massive short-term transfers of wealth ever recorded from one group of countries, the European belligerents, to another, the US.  European dumping caused a collapse in prices, and US investors ultimately scooped up the assets up very cheaply.

That doesn’t mean that there will be no cost for the US if China dumps, but rather that the cost might be absorbed fairly comfortably over a reasonable time period. I suppose I will be very unpopular for pointing this out — especially with people in the US Treasury department and among Chinese cold warriors — but please don’t blame the messenger.  I am just trying to use the limited historical precedents to figure out what is likely to happen.  We have seen asset dumping before, and on an even larger scale, and the US capital market is deep enough that it might easily absorb it.

Where I disagree with Krugman is with his claim that the chance of triggering a trade war is small. In fact, the day Krugman published his article, 130 US Congressmen sent an open letter to secretaries Timothy Geithner (Treasury) and Gary Locke (Commerce) demanding that China be designated a currency manipulator.  They called for duties to be imposed on Chinese imports to counter the effect of the undervalued RMB.  This raises pressure significantly, and I am sure in the next week or two there will be a lot more.  There are also strong rumors of some high-powered and relevant Congressional session next week.  Stay tuned.

Of course regular readers of my blog won’t be surprised by any of this.  The logic behind a prediction of trade war is almost unchallengeable, and the two countries are simply the two most visible in a world in which trade tensions must inexorably rise.  Just ask the Germans and their European partners.  Trade relationships will continue to get much worse, largely because the cost of trade war for high-deficit countries is so much lower than for high-surplus countries, and there seems to be no real attempt on either side to tone down aggressive actions or rhetoric. We seem to be caught in a downward spiral, and the longer it goes on the harder it is for anyone not to participate.

But while I think the economic effect of a tariff war on the US is likely to be smaller than many expect (and much smaller than that indicated by some of the outraged yelping I saw on a CNBC show dedicated to the subject today), and maybe even employment-positive in the short term, I do not think it is in the longer term interest of the US.  I think trade war would be very painful for China, and forcing them into such a difficult position will poison the relationship for many years.  This is likely to be the most important global relationship of the next few decades, and we really need a better way to resolve these very thorny issues, but that almost certainly isn’t going to happen.

To return to the People’s Daily article, I think many in China have argued that a revaluation of the RMB may have a significant effect on China’s trade surplus without having an equivalent effect on the US trade deficit. The same would be true of tariffs on Chinese goods.  In either case, say many in Beijing, China loses, but the US doesn’t gain, so why is the US so determined to force this outcome?

I think this claim is probably correct. An RMB revaluation in itself might not have as big an impact on the US deficit as many think. To see why, I thought I would try to outline what the impact of an RMB revaluation would be for China and the world by asking a few basic questions and coming up with my best possible answers. Here goes:

What will the balance sheet effect of an RMB revaluation be on China?

There are broadly speaking two different classes of revaluation effects, the economic effect and the balance sheet effect. By the former I just mean the impact a revaluation will have on the future development of China’s economy, and by the latter I mean the immediate balance sheet losses and gains for China. Obviously these two are related.

Let me begin with balance sheet impacts. Two weeks ago I posted a rather long entry on that very subject. For those who can’t bear reading or re-reading such a long post, the quick answer is that, contrary to common perception, a revaluation of the RMB is likely to have a very small, and probably positive, overall balance sheet impact on total Chinese wealth.

That is, however, not the end of the story. There is a significant transfer within China of wealth, which will create clear winners and losers. Basically any economic entity that is explicitly or implicitly long dollars (by which I mean any foreign currency not pegged to the RMB) and short RMB, will lose in a revaluation. Conversely, any entity that is explicitly or implicitly long RMB, and short dollars, will win. In my earlier entry I pointed out that the PBoC is the single biggest loser. It is long, if correctly counted, roughly $3 trillion in dollars, against which it is short an equivalent amount of RMB.

Exporters and manufacturers in the tradable goods sector will also lose. Their expected revenues (which can be conceptually capitalized as an asset) are mainly in dollars whereas their expected costs are partly or mainly in RMB. This means that the value of future revenues will drop relative to the value of future expenses, and so they will take a loss.

Finally in that entry I pointed out that any wealthy Chinese individual with a substantial amount of honest or ill-gotten gains stuffed in bank accounts abroad will also lose. But I forgot to mention another big group of losers — anyone in China who has stockpiled inventories of goods or commodities whose prices are set in international markets. Those prices will immediately drop in RMB terms upon a revaluation, and if the asset purchases were financed by RMB borrowing or assets, there will be a loss. So to the extent that companies or individuals are stockpiling iron, copper, chemicals, or anything similar, they will also take an immediate loss.

So who wins in a revaluation? Nearly everyone in China who has at least part of his consumption basket consisting of imported goods, which basically means every one in China except pure subsistence farmers. Because the rise in the value of the RMB causes the price of all imports automatically to fall, a revaluation increases the wealth of Chinese households by increasing the real value of their current and future assets and income.

This is the key point. A revaluation shifts wealth from the Chinese government and the manufacturing sectors (and some wealthy Chinese) to Chinese households — which, by the way, is pretty much what is meant by “rebalancing” in the Chinese context. There are many other ways besides revaluation to shift income this way. The PBoC can raise deposit rates, wages can rise faster than productivity, companies can be privatized by giving away shares to the pubic, and so on. They all have the same effect. They shift resources to households and away from producers, infrastructure investment, and real estate developers. This allows household income to grow relative to national income, which ultimately increases the consumption share of GDP.

What will the economic effect of an RMB revaluation be on China?

So as things stand currently, the reason an undervalued RMB distorts international trade is because it transfers income from Chinese households (they have to pay more for imports) and subsidizes Chinese manufacturers in the tradable goods sector. This is one of the many mechanisms by which households are forced to subsidize production and investment.

A revaluation, then, is part of the rebalancing mechanism. It helps to reduce subsidies to manufacturers and returns the income to Chinese households, who can then increase their relative consumption. But there is a cost to this rebalancing. China’s current industrial policies sacrificed household income in order to spur manufacturing growth, and this had the obvious secondary effect of speeding up employment and, with it, household income. So in a way by repressing household income growth China was paradoxically able to achieve rapid growth in household income. Neat trick, eh?

But of course this growth wasn’t unencumbered. Much Chinese growth was based on concealing the true costs behind hidden subsidies, so that real economic growth was likely to be lower than recorded economic growth. More importantly, because everything in the world must balance, the imbalances within China required the opposite imbalances outside of China — which mostly meant in the US.  Just as this global system implicitly taxed Chinese household consumption to subsidize Chinese manufacturing and employment growth, it also implicitly taxed US manufacturers in order to subsidize US consumers. American consumers got cheaper (foreign) goods, American manufacturers had to compete against lower (foreign) prices.

So Americans over-consumed and Chinese over-saved. The system worked well for quite a while, until, as with Japan in the late 1980s, US debt levels and employment rose to economically and politically unacceptable levels.

For China and the US to adjust means both of them unwinding this trade-off. Beijing will have to enact policies that reduce the subsidies to manufacturers and return the income to Chinese households. But this automatically means depressing economic growth and, more importantly, depressing employment growth.

This shouldn’t be a serious problem if it happens slowly. As Chinese manufactures gradually lose their subsidies, they will rely more than ever on the consequent rising Chinese consumption, and so domestic consumption will replace subsidized foreign demand as the source of growth. Not only will China have a safer and more balanced economy, but it will be more innovative (consumption tends to drive innovation, not production) and much more efficient.

But China cannot adjust too quickly. If Beijing removes the implicit subsidies, including those caused by the undervalued exchange rate, too rapidly, that could force large-scale bankruptcies as Chinese manufacturers found themselves unable to compete globally or at home. If these bankruptcies forced up unemployment, then paradoxically even as the transfers from households to businesses are being reversed, household income would nonetheless decline as unemployment soared. In that case Chinese manufacturers would find themselves becoming uncompetitive in international markets just as domestic markets are collapsing.

The conclusion? A rebalancing is necessary for China, as nearly everyone in the leadership knows. This will involve, among other things, a significant revaluing of the currency. But rebalancing cannot happen too quickly without risking throwing the economy into a tailspin.  That cannot and should not be a part of the US or Chinese policy objective.  By the way if China is forced to revalue the currency too quickly, it will have to enact countervailing policies — lower interest rates, suppress wages, increase credit and subsidies — to protect the economy from falling apart, and these will exacerbate other imbalances that may be even worse than the currency misalignment.  Currency revaluation, then, should be part of a broader adjustment process.

So how can the global system adjust?

If we abstract for a moment, and call all trade-deficit countries the United States, and all trade-surplus countries China, there are broadly speaking two ways the system can adjust. Remember that each domestic imbalance requires the other, so that if China adjusts, the US must adjust too, and if the US adjusts, China must adjust too.  (For those more technically inclined, by the way, this is one of the points that Krugman makes in his second article, although using different terms: China’s exporting of capital must create capital imports somewhere else, and these capital imports are the obverse of the trade deficit.)

One way in which the system can adjust is for China to take the lead and reverse the policies that cause households to transfer resources to its manufacturers. As a consequence consumption will no longer be taxed to subsidize production. This will cause household consumption to rise as share of GDP — the good way by a surge in consumption, the bad way by a collapse in economic growth.

Either way, the rebalancing in China will force an equivalent rebalancing in the US. As the price of Chinese goods rise, the net impact will be to transfer resources from US consumers, who have to pay more for their imports, to US producers (US producers become more globally competitive). The rise in Chinese consumption relative to Chinese production would be necessarily matched by a rise in US production relative to US consumption. (Some readers will notice that I am ignoring the role of investment in economic growth, and of course changes in investment matter, but over the medium to long term the basic argument is unchanged.)

The second way in which the system adjusts is if the US drives it. The US can put into place policies that favor manufacturers at the expense of consumers. These include consumption taxes, manufacturing subsidies, penalties for consumer borrowing, subsidies for investment, or, more ominously, import tariffs. These can all have the same aggregate effect on the US trade account by shifting the relationship between how much Americans produce domestically and how much they consume. And of course as the US adjusts, China must also automatically adjust.  Tariffs just on Chinese goods, by the way, will have a minimal impact on the US adjustment since trade may very well just shift to other countries.

Note that in either case both countries will rebalance, but rebalancing says nothing about how rapid economic growth must be. I addressed this in a blog entry last week when I discussed Japan’s dismal post-1990 rebalancing. In this context rebalancing just means that in China economic growth will be less than consumption growth, and in the US consumption growth will be less than economic growth. The problem is that China will try to adjust by pushing the cost of the adjustment onto the US, and the US will try to adjust by pushing the cost onto China. Each country can strive towards the good outcome (rapid economic growth) or find itself facing the bad outcome (declining consumption). This is why policy coordination and gradualism is so important.

Will a revaluation cause China’s trade surplus to decline?

Yes, all other things being equal, but of course all other things are not equal. Within China there are several things that will affect the trade surplus. Remember that the trade surplus exists because of the imbalance between Chinese domestic production and Chinese domestic consumption (technically the surplus is the difference between savings and investment), and so anything that affects the subsidies to manufacturers, or that affects household income, will also affect the trade surplus.

I have already argued that interest rates and wage growth that is lower than productivity growth can affect the trade surplus as much as the undervalued currency. In that case, if the RMB revalues, and at the same time real interest rates are forced down by a sufficient amount, or wage growth is restrained, the net result can easily be a rise, not a decline, in the trade surplus. It depends on the relative magnitude of the different factors.

The external environment also matters. If US interest rates decline for example, unlike in China where declining deposit rates is likely to spur savings, US consumption may rise even as the cost of Chinese imports rises because of a surge in the RMB.

Quite a lot of defenders of RMB stability have made the point that the rise of the yen after 1985 and the rise of the RMB after 2005 were most emphatically not associated with declining trade surpluses. According to their arguments, this clearly proves that the currency doesn’t matter.

This is nonsense, and even if it were true it seems more an argument in favor of revaluing than an argument in favor of not revaluing. But it isn’t true because in both cases there were countervailing changes.  Perhaps most importantly, local interest rates in Japan and China declined in real terms, thus reducing local consumption, and US interest rates also declined, spurring US consumption (I know, I know, this sounds strange, but the wealth effect of interest-rate changes in the US is the opposite of that in Japan and China because of the differing structures of household balance sheets). All that happened in both cases was that the rebalancing effect of the currency revaluation was swamped by the exacerbating effect of other factors. The only thing that Japan after 1985 and China after 2005 prove is that the currency is not the only thing that matters.

Will a decline in China’s trade surplus cause the US trade deficit to decline?

Not necessarily. Beijing has pointed out many times that a contraction in the Chinese trade surplus does not necessarily mean an equivalent contraction in the US trade deficit. All it requires is an equivalent contraction in the rest of the world’s net trade deficit. This could easily happen with an improvement in the trade balances of Vietnam, Mexico, Korea or anyone else, enough fully to absorb the reduction in China’s trade surplus. In that case, the US trade balance does not improve, and the US gets none of the employment benefit of the RMB revaluation. China will simply import fewer jobs from abroad and some other countries will import more, or export fewer, jobs.

Remember that if the RMB revalues, this is the same as if all the currencies of the rest of the world depreciate. This will cause a shift in the rest of the world so that households will see a small reduction in their real income, and non-Chinese producers in the tradable goods sector will see a small increase in their competitiveness vis a vis the rest of the world (largely because Chinese producers becomes less competitive). This will reduce non-Chinese consumption and increase non-Chinese production, and the distribution of these changes among different countries, including the US, will depend on a vast array of factors.

So Beijing is absolutely correct in arguing that an RMB revaluation might not have a major impact on the US trade balance, although there is one important caveat. A number of other developing countries, especially in Asia, are concerned about excessively loose domestic monetary policy and inflation, and would like to raise the values of their own currencies. They cannot do so, however, until China does. During the crisis China has expanded its share of global net demand at their expense. If an RMB revaluation causes revaluation in other countries with large trade surpluses, the net impact on the much smaller “rest of the world” will be much bigger, and so simply as a function of arithmetic the US is bound to benefit.

This fact again argues in favor of globally coordinated action rather than an excessive focus on RMB bashing. If China is forced to revalue the RMB, in order to gain the optimal global rebalancing it should be done as part of a general realignment of currencies (although of course cynics will point out that surest way to ensure that something doesn’t get done is to coordinate it globally).

Is it only China that must act?

China will rebalance, but it cannot do so quickly. If it does, as I discussed above, it may easily fall into a spiral of declining competitiveness leading to rising unemployment leading to declining domestic consumption leading to more unemployment. Clearly this is not in China’s interest.

There is another problem. There are several countries with structurally low consumption and high production — Germany, Japan and China being the most important (and I leave out the OPEC countries for obvious reasons). Simply forcing China to adjust, in that case, might cause damage to Chinese growth prospects without helping the US rebalancing effort.

For example, a sharp rise in the RMB, especially if accompanied by a rise in other Asian currencies, will take depreciation pressure off the dollar. Since currently most of that depreciation pressure is borne by the euro, a revaluation of the RMB could easily also result in a decline in the euro, whose economies will then see a sharp improvement in their net trade balance. This means that a significant part of the benefits of Chinese revaluation may accrue to Germany, a country that has yet to resolve its own internal imbalances.

So limiting the whole rebalancing discussion just to China and the RMB may end up not helping much. It is true that the US could force through a rapid domestic rebalancing of its own, including by raising import tariffs generally (and not just on Chinese goods), if it really wanted to, and the benefits to the US would be a surge in employment and manufacturing at probably little real long-term economic cost. But unilateral action on the part of the US risks creating at least some problems for the rest of the world, especially China, Japan, and parts of Europe.

So what must be done? Clearly there is a problem with the undervaluation of the RMB and with Chinese domestic imbalances. But just as clearly there are also problems with a number of other major over-consuming and over-producing countries. In addition Chinese producers have become so addicted to a wide variety of implicit subsidies, besides the currency, that they cannot possibly adjust very quickly. It will take years of continuous adjustment to wean them away from an undervalued currency, too-low interest rates, excessive credit aimed at SOEs, and sluggish wage growth.

That suggests that if we want to resolve the global imbalances in an optimal way that maximizes global growth and equity, we would need all the major problem countries to work out a program, perhaps over 8 to 10 years, in which China, Japan and Germany take concrete measures to shift subsidies away from manufacturers and return the income to households, and the US, the UK and other deficit countries shift income from households to investment.

Of course the cynic in me says getting a global solution will prove impossible. Each country that benefits in the short term from stonewalling on any aspect of the complex adjustment process will do so. So I guess that just leaves trade war. This is the year of the Tiger, after all.

More articles from China Financial Markets….

Zero Hedge

Via UBS Financial Markets

Currency Curse Continues Complicating Life For Commentators – Market pundits scrambled to fill up air time by attributing the market movement to this data or that comment. The market rally catalyst was quite singular however.
As rumors spread of a firmed up Greek rescue package, and the S&P suggested it was shifting Greece out of ICU, the Euro soared. It spiked 0.7% which is a significant move in the currency arena.

The result was immediately evident and dramatic. Gold spiked $20 and oil shot up over $2. Those moves came long before the FOMC statement. Those moves were not influenced by some piece of economic data. Those moves were not the result of some shift on the outlook for the President’s health plan. Those moves were the direct result of the jump in the Euro and the correspondent weakening of the dollar.

We believe that the Euro/Dollar move was also the primary catalyst in the stock market. Given the action in gold and oil, the stock market’s reaction was rather mute. With such a strong tailwind, you might have expected something like a 100/150 point move in the Dow. The real question on stocks was what was holding stocks back given the currency boost.

The restrained action in stocks was also noted by the WSJ (albeit from a slightly different direction). They discussed it in a story headlined – “For the Dow, the Quietest 6-Day Steak”.

Although the stock market was muted, it did move the ball. The S&P closed above 1159. It hadn’t closed at a level that high since early October 2008. The Dow moved up 44 points but failed to take out the high of 10725, which leaves the outside risk of a Dow Theory non-confirmation as a lingering possibility.

The bulls got the S&P clearly through 1150 but failed to close above the backup certification at 1160. It was a victory but not quite the rout they were hoping for. Crossing 1150 failed to inspire a sudden rush of short-covering, which many presumed would occur. Breaching a key target should not be accompanied by a yawn.

Takeaways From The FOMC Statement – As the pundits are noting this morning, the FOMC statement was not substantially different from the statement of January 27th.

Of note (to us) is the change in wording on the labor situation. In January’s note, they said “that the deterioration in the labor market is abating”. Yesterday, they said “that the labor market is stabilizing”

So, in January they saw the labor market worsening but at a slower pace. Yesterday, they suggested things were stabilizing – in essence – bottoming out.

Overall, the new statement seems to suggest that the Fed is clearly homing in on jobs. That may be their guideline for the timing of any policy change. They are also focused on the housing market. There was also a hint that business inventories had re-built to somewhat worrisome levels.

The Greek Problem Has Not Exactly Disappeared – While the S&P appears to have been mollified and front page headlines are fading, the concerns about Greece and the Euro continue. Here’s a bit from a piece on Bloomberg:

March 17 (Bloomberg) — Harvard University Professor Martin Feldstein, who warned almost two decades ago that the euro would prove an “economic liability,” said Greece’s austerity plan will fail and the country may quit the single currency to fix its fiscal crisis.

Under pressure from investors and fellow policy makers, Prime Minister George Papandreou’s government is striving to knock four percentage points off its budget gap this year from 12.7 percent of gross domestic product and has vowed to meet the EU’s 3 percent limit in 2012 for the first time since 2006.

“The idea that Greece can go from a 12 percent deficit now to a 3 percent deficit two years from now seems fantasy,” Feldstein, an adviser to U.S. presidents since Ronald Reagan, said in a March 13 interview in Geneva. “The alternatives are to default in some way or to leave, or both.”

His diagnosis clashes with that of European Central Bank President Jean-Claude Trichet, who calls Greece’s strategy “convincing” and rejects as “absurd” any speculation it might leave the euro zone. Investors nevertheless aren’t ruling out Feldstein’s analysis. Billionaire George Soros said last month that the euro “may not survive,” and credit default swaps indicate a 22 percent chance Greece will default within five years, up from 16 percent a year ago.

The judgment of Feldstein, 70, a former contender to chair the Federal Reserve, marks his latest broadside against the single currency five years after he said its rules generated a “very strong bias toward large chronic fiscal deficits” and more than a year since he first suggested the 16-nation bloc may splinter.

In addition to the Bloomberg story, today’s NYT has an article titled: “Ailing Euro Seen As A Signal of Deeper Woes on Continent”. It does not portray a rosy future for either the Euro or the European Union.

Further, in today’s FT, Martin Wolf analyzes the posture of Germany and China toward debtor nations. He believes that if their current attitudes are continued, global deflation could result. That could make “double dip” seem pleasant.

Cocktail Napkin Charting – Tuesday, we said that the napkins suggested resistance in the S&P looked like 1156/1160. Yesterday’s high was 1160. For today the napkins suggest resistance is likely 1166/1170. We’d love to see some sign of a breakout if that level is breached. Support looks like 1148/1151.

Today – Bernanke testimony could be a factor but continue to watch the dollar. Action in crude and gold will help you measure influence level.

At any rate, in honor of St. Patrick and at the risk of becoming the Salman Rushdie of the Hibernians, I will reveal to you a secret Irish prayer that St. Patrick gave the Irish in 452 A.D. For over 15 centuries it has been whispered in the ear of each Irish lad on the day before he receives his first corkscrew.

“For those who are with us
May God turn their fortunes bright
For those who are against us
May God turn their hearts toward us
And if God cannot turn their hearts
May He at least turn their ankles
So we may know them by their limp!”

Consensus: Up the rebel, up your spirits, up your glasses and let the market take care of itself.

Trivia Corner

Answer - The one word that fits in both blanks to make sense of the sentence is “reverse” as in” “Esrever is reverse in reverse.”

Today’s Question - Silly Rebus – If “CCCCCCC” is “Seven Seas”, then what are these: “JOANB” (A crime?); theTHE (Alpha & Omega); ATTE (the critical point).

History Trivia

On this day in the year of our Lord 389, there lived a foin broth of a lad who was…. dependin’ on the boyographer ye read: a Spanish peasant, a French herdschild, a Celt from Bannavem or a Gael from Dumbarton, Scotland. At any rate, at age 16 this lad was kidnapped by pirates and sold to one of the only 2,500 Irish kings that were reigning at the time. He served this King as a swineherd mucking out stys and such. For six years he labored in slavery, poorly fed; often beaten; surrounded by people who spoke a language he couldn’t understand. Then he discovered that six years of such treatment was equivalent to a parochial school education. So he became a Catholic and escaped to France to become a monk.

Upon becomin’ a bishop he mistakenly perceived the French to be a bunch of snail eatin’, grape juice drinkin’, truffle huntin’ toads. He longed for the emerald green fields of God’s own land and the special amber holy water found there.
He returned to Ireland which was still under the influence of a group of heathen English druids and a few nocturnal banshees. Nonetheless, he set about convertin’ and baptizin’.

Unfortunately Patrick was not an MBA and, therefore, did not know the law of diminishin’ returns. So he managed to baptize over 120,000 people, built over 300 churches, chased the snakes out of Ireland, developed the shamrock and established a factory to make pennants with the slogan “Go Notre Dame”.

To celebrate the life of this fabulous man, sing ye some sad songs, talk ye merrily of battles and take ye a wee nip of somethin’ till ye might be seein’ da little people.

It was not the little people that bothered markets yesterday. It wasn’t even the little changes in Fed language. What moved the markets was movement in the Euro – and that was not so little.

More articles from Zero Hedge….

By Karl Denninger, The Market Ticker

If you were wondering where the hidden taxes are in “Health Reform”, guess what – President Obama has just given you something to sit on.

The forced march to pass ObamaCare continues, and all that matters now is raw politics. But opponents should go down swinging, and that means exposing such policy debacles as President Obama’s 11th-hour decision to apply the 2.9% Medicare payroll tax to “unearned income.”

That’s what savings and investment income are called in Washington, and this destructive tax wasn’t in either the House or Senate bills, though it may now become law with almost no scrutiny.

This is unbelievably destructive to capital formation.

For the person who is “short-term trading” (e.g. daytrading, etc) this is a relatively small tax, an increase of about 7% in the tax (2.9% applied to the 39.6% maximum rate on “ordinary income”, which short-term capital gains are.)

But for the person who is INVESTING for the long haul, that is, who is holding stocks for more than one year, this takes the marginal rate from 15% to 17.9%, an increase of almost 20% in the tax owed.

This, of course, comes on the back of President Obama’s fraudulently engineered “rally”, which was created through Congressional intervention to permit – surprise surprise – legalized accounting fraud through “mark to model.”

So you got your stock market rally, and now President Obama and The Democrats are going to cram a 20% tax increase down your throat if you profited from it - and at this point, being 2010, there’s not a thing you can do about it.

It gets better.  Since ordinary investors can only write off $3,000 in capital losses, when you lose you don’t get a tax credit.  Oh yeah, you get to carry forward the loss to future years, but you paid the tax on the gains already – this is a putative future credit back.

Oh, and let’s not forget that there was already a huge tax increase coming this year - the long term capital gains rate goes to 20% at the end of this year anyway as the Bush tax cuts expire.

So in fact the rate goes from 15% to 22.9%, a fifty-three percent increase in the tax rate.

And oh, if your AGI goes over $200,000 by even a dollar you are subject to this tax from the first dollar of your investment income.

A fifty-three percent increase in taxes on long-term (that is, capital-forming, long-term investment) capital gains – exactly the sort of investment activity you want to form businesses and invest for the long haul in America’s future, not to mention generating jobs by forming those enterprises.

That’s slammed the door on any interest I might have in forming a new business as I did in the 1990s – ever – and I suspect I’m not alone.

When this goes into effect my capital, other than that which I can shelter from taxation, is no longer going to be put at risk in the markets. I’d rather live in a nice little cottage on the beach and simply expend what I have rather than contributing to capital formation in any way, shape or form under a punitive system like this.

Why?

Because if Congress demonstrates that it will put 53% on the capital gains rate once I’ve already committed my capital (thereby destroying my return) I will not take the risk of them doing it again and making the rate even more punitive.

More articles from the Market Ticker….