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“It does not matter how slowly you go as long as you do not stop.”


Commentary & Analysis
China’s Currency Goes Lower, Maybe a Lot Lower

Chinese leaders made a big mistake. They trusted the forecasts of Western economists who assured them, at least implicitly, growth would rebound sharply after the 2007-2008 Credit Crunch as the big guns of monetary and fiscal policy were switched to auto-fire. So China got busy doing what it does very well—adding more manufacturing capacity and growing infrastructure and building cities on the expectation of grabbing increasing levels of global share from rivals as the world rebounded and capital flooded into the country. The world hasn’t rebounded to the degree needed to fill those factories and utilize all that capacity. And capital has been heading away from China lately, not towards it.

China (and most government economists) didn’t seem to realize, or wished to pretend otherwise, the New Abnormal was settling upon us (we described it early on after the crisis). So China continued on its investment spree forgoing the warnings of delaying its rebalancing or not moving fast enough.

We most recently wrote about the New Abnormal in Currency Currents back in January 2014:

I can just hear Rod Serling saying something such as: “…you are moving into a land of both central bank cluelessness and Federal government recklessness, you’ve just crossed over into “the new abnormal.”

You think this is a “normal” recovery? You think the Fed’s bond buying has worked? You think the banks are confidently lending and the interbank credit system is back to “normal”? I would suggest the chart below [from Hoisington Economic Research] should make you think again if you answered yes to any of the questions above:

Monetary velocity is still falling off the cliff. We’ve talked about this many times in Currency Currents, I won’t belabor the point. I will say it is an indication the demand for cash continues to rise—confidence in the future is low. In short, the animial spirits aren’t out “partying,” to phrase it in the venacular.

The money multiplier is now at a 100-year low. Though we confidently are told again and again: “Oh yes, the banking system is completely healed. Our credit system is functioning normally again thanks to the efforts of Ben “Blitzkrieg” Bernanke. Recovery is here and accelerating.” Hmm…if any of that were true, the money multiplier, which is a measure of how banks convert reserves into deposits, would not be at a 100-year low and trending lower.

These two indicators continue to provide support for the major global market structure framework we developed a couple of years ago.

Has anything really changed? Currencies values have moved substantially since January 2014, but global aggregate demand hasn’t improved much, which is why China’s leadership is, or should be, heading toward panic mode.

From Professor Michael Pettis’ blog July 31st 2015 [my emphasis]:

As the US recovery continues to be weakened by trade war, I continue to expect the trade environment to get worse. Three days ago the Financial Times published an alarming article about the falling volume of world trade in which it said “The problem has been getting worse for some time. Trade bounced back fairly well in 2010 after the global recession but it has disappointed ever since, growing by barely 3 percent in 2012 and 2013. Now it seems the world cannot manage even that.” I expect trade will be a major topic in the upcoming presidential elections and Americans will increasingly (and probably rightly) question the value of its openness to trade in a world in which every major economy is attempting to export its excess savings and its domestic demand deficiency onto the US.

Let’s go to the chart and see if the US is indeed absorbing global demand again:

The answer is yes, the US is absorbing “demand deficiency” from elsewhere, as the US Current Account Deficit widens as it has over the past three reported quarters.

Note where the US dollar bottomed in 2008 (March 17th) as indicated on the chart above; just over a year after the massive improvement in the US Current Account Deficit got started. Because the US dollar is the world reserve currency, by exclusion it is the most important in global funding. As US dollar credit shrinks, i.e. the US CA deficit declines, it has a feedback loop impact on the dollar’s value.

As dollar funding declines, driven by a decline in real aggregate demand, dollar-based loans are paid back leading to more decline in dollars outstanding, i.e. a smaller supply of dollars, etc. Much of the dollar loans were tied to countries needing XX amount of dollar reserves to buy oil (priced in the world reserve currency); as oil prices fell because of falling demand (and increasing supply), these loans based on oil funding needs also fell—self-feeding and supporting the dollar. This is likely why we see such a tight correlation between oil prices and the US dollar.

Now keep in mind, that up until yesterday the Chinese kept the value of their currency very much in line with the US currency—so the US and China effectively took the brunt of the depreciation in terms of trade competitiveness against other players in the world. Japan, among the majors, is the most egregious if one can assume the yen fell directly as a result of BOJ policies. Not a stretch given the level of reserves thrown onto the market. The yen has depreciated tremendously against both the US dollar and Chinese yuan.

Chinese yuan vs. Japanese Yen: A whopping 73% appreciation since 2011—it was a period when global trade volumes already started slowing again… is that a five-wave rally in CNY/JPY?

And it seems the Japanese currency depreciation has helped its trade balance (see below). The chart below shows the Japanese Current Account, USD/JPY, and CNY/JPY. It shows a massive improvement in the current account in line with a weakening Japanese yen.

So after taking the brunt of Japan’s depreciation, and sitting on a consensus view of an overvalued currency, why shouldn’t China want to get into the game again?

The game of using a devaluation to extract demand from its Asian neighbors and likely restrict the flow of international goods explicitly, and implicitly, as global purchasing power of the Chinese consumer falls along with the value of the currency. It is in China’s interest to devalue a lot more considering the seeming success of its neighbor Japan.

What is interesting is how quickly the US government reacted publicly to the 2% devaluation by China, while it remains relatively quiet about Japan’s devaluation by other means. Could this have anything to do with geo-politics, aka the Asian Pivot?

Granted, China has manipulated the global trading system to its advantage for many years now. But Japan has too, and so have others competing for Western demand. So from that perspective, maybe the US has a legitimate gripe. But make the gripe consistent if you want to remain credible.

Does China have good reason to worry the US may not be a fair arbiter at this point in a global economic cycle teetering on the edge of a deflationary abyss (maybe a bit dramatic, sorry)? You bet it does.

“History repeats itself, first as tragedy, second as farce.”

Karl Marx

Despite what we would like to believe when we [Americans] tuck ourselves in at night, US foreign policy is about US “interests” and not about gummy-bears and roses. This is taken from the book I am now reading, The China Mirage: The hidden history of American Disaster in Asia, by James Bradley:

The Panama Canal had not been built yet, but it would complete the long-sought route that would stream China’s riches to ports on America’s East Coast. The United States then fomented the Spanish-American war and took over the Philippines, Guam, Hawaii, Cuba, and Puerto Rico to establish an American sea lane from China.

By the time Theodore Roosevelt became president in 1901 China was being squeezed between the Anglo American and Russian empires. Roosevelt realized that the Russian extension of the trans-Siberian Railway meant that China’s riches would flow overland to Europe rather than across the Pacific to the United States. Like the Japanese, Roosevelt grasped that Russian control of warm water anchorage at Port Arthur on the China Sea would enable the czar to base part of his Navy there and dominate the region. Prof. Franklin Giddings of Columbia University warned, ‘the great question of the 20th century is whether the Anglo-Saxon or the Slav of is to impress the civilization to the world. Passenger guidebooks found on the trans-Siberian Railroad solve the battle as won, proclaiming, ‘The honor of having planted the flag of Christianity and civilization in Asia is due to Russia.’

.. Roosevelt divided the world into what he called civilized and uncivilized nations. The civilized were mostly white industrialized nations, the citizens of which use the natural resources of the uncivilized nonwhites, who in turn purchase the industrial products of the civilized. To Roosevelt, it was the duty of the civilized to police the uncivilized, as Britain did in Africa and India.

In 1821 Pres. James Monroe had announced to the European powers that they must not meddle in South America. Now Teddy upped the ante with his Roosevelt corollary to the Monroe doctrine, declared to Congress that the US had ‘international police’ power in the Caribbean, Central America, and South America, as well as in China, to enforce the Open Door policy.

Looking toward Asia, Roosevelt saw Japan as an America–admiring civilized power that could guide uncivilized China. Roosevelt appreciated Japan as a counterweight to the czar’s ambit ions; Japan’s fierce army could, he felt, stymie the Russian advance. He also believed that Japan –so accepting of wise Yankee ways –would help the United States Americanize the rest of Asia.

It’s in the interest of China to keep the lights on. A weaker currency in a world where global demand is growing slowly and has a possibility of reversing is part and parcel to keep the lights on inside China. Will these interests clash with those of the United States and a newly militarized Japan? We better hope not or this era is looking more and more like pre-WWII triggered in large part by the Great Depression, save the hideous Treaty of Versailles (maybe being played out in reverse, in micro-format, on Greece at the moment.) Stay tuned.

P.S. This comment regarding the BRICS and the decoupling fantasy which was once as popular as Peak Oil was made by Professor Michael Pettis back in 2011—he nailed it and you can find more prescient stuff on his most recent blog post. One takeaway is this isn’t over and may only be near mid-game as it relates to damage to the emerging markets.

“There has been no decoupling of developing economies, or more narrowly the BRICs, from the developed world. All that has happened is that the transmission from one to the other has been delayed.

“Since most global consumption comes from the U.S., Europe and Japan, the collapse in their demand will ultimately be very painful for the BRICs and the rest of the developing world. The latter have postponed the impact of contracting consumption by increasing domestic investment, in some cases very sharply, but the purpose of higher current investment is to serve higher future consumption. In many countries, most notably China, the higher investment will itself limit future consumption growth, and so with weak consumption growth in the developed world, and no relief from the developing world, today’s higher investment will actually exacerbate the impact of the current contraction in consumption.

“This delayed transmission, by the way, is not new. It also happened in the mid-1970s with the petrodollar recycling. Economic contraction in the U.S. and Europe in the early and mid 1970s did not lead immediately to economic contraction in what were then known as LDCs, largely because the massive recycling of petrodollar surpluses into the developing world fueled an investment boom (and also fueled talk about how for the first time in history the LDCs were immune from rich-country recessions). When the investment boom ran out in 1980-81, driven by the debt fatigue that seems to end all major investment booms, LDCs suffered the “Lost Decade” of the 1980s, especially those who suffered least in the 1970s by running up the most debt.

“This time around a huge recycling of liquidity, combined with out-of-control Chinese fiscal expansion (through the banking system), has caused a surge in asset and commodity prices that will have temporarily masked the impact of global demand contraction for BRICs. But it won’t last. By the middle of this decade the whole concept of BRIC decoupling will seem faintly ridiculous.”