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“I hope you’re ‘milking’ the New Zealand dollar for everything it’s worth!”

… That’s what I wrote to Jack this morning.

What can I say — I play with words for a living!

Jack, on the other hand, plays with currency. And China plays with fire. (More on that in a moment …)

Jack recommended his Black Swan Forex subscribers add a short position in NZDUSD on Friday. (And as of this morning they could have been sitting on a better-than-$1,200 profit in this open trade, based on trading one standard-sized lot!)

What’s not funny like my puns, nor exciting like Jack’s profits, is the utterly unfortunate situation in New Zealand. From Reuters:

New Zealand’s Fonterra apologised on Monday for a milk powder contamination scare in China that has raised safety concerns that threaten New Zealand’s $9 billion annual dairy trade and Fonterra’s own business in a top market. 

It looks as though this development could taint the outlook for New Zealand’s economy, where China accounts for 90% of the country’s total milk powder exports which in turn account for 25% of New Zealand’s entire export market.

That’s what drove NZDUSD lower.

But China’s response to bacteria in the milk from New Zealand may be the least of the concern.

How China handles a souring foreign exchange dynamic has the potential to upset the stomachs of many more investors. 

I want to hand this over to William Pesek, a very thoughtful market and economic analyst with a focus on Asia, so he can explain part of China’s FX predicament:

We need to stop considering huge reserve holdings as a financial strength. They are a trap that is complicating economic policy making. It’s time Asia devised an escape.

China isn’t without leverage …

But that leverage is limited. Xi and Premier Li Keqiang are engaged in a risky rebalancing act, trying to wean the Chinese economy off exports without fanning social unrest. Another debt-limit tussle would fuel market volatility, strengthen the yuan as the dollar plunges, and result in the loss of tens of billions of dollars in China’s portfolio of U.S. Treasuries.

Pesek again:

The more Asia adds to its holdings of U.S. debt, the harder they become to unload. If traders got even the slightest whiff that China was selling large blocks of its $1.3 trillion in dollar holdings, markets would quake. The same goes for Japan’s $1.1 trillion stockpile. So central banks just keep adding to them. Pyramid scheme, anyone?

Never before has the world seen a greater misallocation of vast resources. Loading up on dollars helps Asia’s exporters by holding down local currencies, but it causes economic control problems. When central banks buy dollars, they need to sell local currency, increasing its availability and boosting the money supply and inflation. So they sell bonds to mop up excess money. It’s an imprecise science made even more complicated by the Federal Reserve’s quantitative-easing policies.

Certainly this is not a revolutionary discovery. And I’m sure Mr. Pesek has spent time writing on this concept before now.

But it is becoming pertinent again as China’s financial system breeds uncertainty, economic growth appears more fragile and Chinese officials’ scope for managing the economy narrows.

Pesek suggests the big risk for China is if the US dollar plunges in value due to some type of crisis in confidence when it comes to the US deficit and debt (soon to be making headlines again). 

And sure — US deficit talks are something to keep in mind. But there is another angle to consider. 

Despite the burdens cast upon the US dollar by fiscal and monetary policymakers, it is the best-positioned of the major currencies to strengthen in coming months.  

The US dollar is being driven by expectations of relative US outperformance right now.

A few weeks ago the IMF released its projections of economic growth for full-year 2013 and 2014. The biggest increase in the rate of growth is expected to occur in the US. As such, it has been and will continue to be a recipient of global capital flows.

I read these points in a Bloomberg article this morning:

[US] gross domestic product forecast to grow 2.7 percent in 2014, the fastest of any Group of 10 nation, surveys of economists by Bloomberg News show, while the budget deficit is the least since 2008.

[The US Dollar’s] share of global foreign-exchange reserves rose to 62 percent on March 31 from a low of 60 percent in June 2011, according to International Monetary Fund data.

Credit-default derivatives used to bet on creditworthiness and insure against default signal the U.S. is safer than its top-rated developed market counterparts. Swaps tied to the U.S. are priced at about 22 basis points, the lowest since 2009 and less than half the 55 basis points when S&P downgraded the nation, according to CMA data compiled by Bloomberg.

It seems pretty clear how investors have grown to view the US as a relatively attractive haven. And this expectation is likely to remain in play for a while. 

But wouldn’t an appreciating US dollar (depreciating yuan) be a good thing for China’s FX reserve portfolio, based on how Pesek laid out everything?

Not necessarily.

A weaker yuan may actually make Chinese exports less competitive as input costs would rise. China’s exports depend on intermediate goods and natural resources. Of the two, intermediate goods make up 55% of the final goods China exports. These intermediate goods mostly originate in Japan. And because Japanese policymakers are committed to reforming their economy, the Japanese yen is expected to continue depreciating. So, basically, Japan’s quantitative easing threatens China’s export competitiveness from all angles.

Mr. Pesek suggested the globe is in need of a currency summit. He thinks maybe the IMF or the G-20 can accomplish something to help Asia, namely China, deal with its accumulation of FX reserves.

It’s a tall task. And while his point is duly noted, we don’t share his optimism for a potential solution in an environment where the global community seems more likely to fracture than come together. As such, China needs to bite the bullet …

Jack has a very rough blueprint regarding such a solution:

If the decline in China’s reserves are used to boost more investment, that is a problem. But if it is to pass on wealth or a greater portion of economic goodies to households, that is good in the longer-term (even though it hits GDP in the near term.)

Social stability will be about rising incomes — lower GDP will not hurt social stability if incomes are on the rise.

Raise your hand if you think either China, the IMF or the G-20 can help to meaningfully re-allocate “vast resources” before the market notices this predicament?