Tuesday May 3, 2005 - 11:09:59 GMT
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Black Swan Capital - www.blackswantrading.com
China problem--Aussie pain
"If you are going to use probability to model a financial market, they you had better use the right kind of probability. Real markets are wild. Their price fluctuations can be hair-raising—far greater and more damaging than the mild variations of orthodox finance.”
Benoit Mandelbrot, The Misbehavior of Markets
A friend of mine is a true believer in the Chinese economic miracle. He is extremely bullish on commodities because he believes China is very close to world financial dominance (maybe I overstated that) and Chinese demand will continue as far as the eye can see. He is not alone in this belief.
However, the fact is warnings on China are starting to leak out more frequently than either the communists or capitalists would like. And as I said yesterday, I think the concern on commodities is more than just the soft-patch—it’s China.
And if commodities continue to breakdown, we would expect one of the darlings of the carry trade—the Australian dollar, to break down in a big way. Already we are seeing a decent divergence between the Aussie, and gold (the darling of the US $ bear crowd)!
CHART: Aussie vs Gold
A couple of economists who know a lot about China’s economy believe there is real structural trouble brewing in China.
From Nouriel Roubini, Stern School of Business, and Brad Sester, University College:
“Credit is too cheap in China. Nominal interest rates are very low for a fast growing economy. Real interest rates are negative for many firms, as the nominal rate is lower than in the increase in producer prices. This has led to the substitution of capital for labor, even in the face of China’s enormous reservoir of underused labor (labor that can be drawn in from the country side as well as employees in some state firms). Work by some Chinese economists suggests a sharp fall off in the marginal productivity of capital, and total factor productivity. Labor productivity has been growing in large part because each unit of labor is now combined with more capital. The cheap price of capital is one reason why investment has soared in relation to GDP.
“In this dimension China looks like the “Asian Miracle” that went bust in the 1990s: high growth driven more by growth in factor inputs (notably the rapid accumulation of capital) than by growth in total factor productivity in economies with very high (excessive) rates of investment. Demand for credit at current interest rates remains strong, and, to date, low returns on bank savings has not impeded the growth of bank deposits. Indeed, with demand for credit, at current rates, well in excess of available credit, which is currently constrained by administrative controls, there are strong incentives for corruption. The long-term risk is clear: cheap credit will fuel an investment boom that eventually leads to an investment bust.”
From Andy Xie of Morgan Stanley:
“China’s currency peg to the dollar reflects its two weaknesses. First, its financial system is not market-based and accumulates bad debts. Without the peg, China could become a poor version of Japan, with a strong currency, deflation, and low growth. With a massive overhang of surplus labor, China could get trapped in a deflationary equilibrium.
“Second, China’s economic system does not create globally competitive companies and relies on export processing for growth. Hence, the export-processing companies have a major voice in China’s currency policy. Because the US is their major market, they prefer a dollar peg.
“Between the two, the financial sector is a bigger problem. Because the financial system overfunds fixed investment, the returns on capital are low. Hence, China’s investment boom needs a bubble to keep going. In the current case, the property bubble keeps up the profit expectation, and the expectation of an Rmb revaluation keeps liquidity plentiful. Because China’s investment boom is based on unrealistic profit expectations, if the currency is revalued substantially, it could, I believe, cause liquidity to dry up and the economy to have a hard landing.”
China is in a bit of a box of its own making because it has not freed its financial system nor developed a viable domestic economy based on consumer demand. This is a catch-22. If China raises interest rates to help stem overinvestment and the property bubble, it risks more funds flowing into the country—for yield and yuan revaluation speculation. If China doesn’t hike rates, it continues to fuel fixed investment—because of the negative real cost of money—into sectors already saturated and overheated—exacerbating a financial bubble stretched into the danger zone.
Can China avoid sparking another Asian meltdown? Yes! But even if they do, there could be some major bumps along the way. And we think the world’s major commodity currency—the Australian dollar—could feel much pain in the process.
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