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Wednesday August 8, 2007 - 10:25:14 GMT
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Cheers to roaring Chinese inflation instead of MAD

Key News


·         The Chinese government has begun a concerted campaign of economic threats against the United States, hinting that it may liquidate its vast holding of US treasuries if Washington imposes trade sanctions to force a yuan revaluation.  (Telegraph)

Key Reports Due (WSJ):

7:00a.m. MBA Mortgage Application Survey. Previous: +1.8%.

10:00a.m. June Wholesale Trade. Expected: +0.4%. Previous: +0.5%.




“All political thinking for years past has been vitiated in the same way. People can foresee the future only when it coincides with their own wishes, and the most grossly obvious facts can be ignored when they are unwelcome.”


                                                George Orwell


FX Trading –  Cheers to roaring Chinese inflation instead of MAD


There is a lot of buzz about the top story we posted this morning—China retaliation if the US imposes trade sanctions.  A reader of CC asked me if the Bush administration could do anything to stop this—the short answer is no! 


I have been speaking about this situation for some time—the slides below are from the last time I spoke on this topic.  The first slide is titled, “MAD,” that stands for Mutually Assured Destruction:


Slide: MAD


What has kept the US-China relationship in tact is the fact that benefits have flowed both ways.  The US has been receiving good quality products at low prices from China (besides allowing platform companies to record massive profits)—which supports overall domestic purchasing power and helps keep imported inflation pressures at bay. 


China has exported as fast as it can to the worlds best customer and creates jobs for it many hundreds of millions who need them.  All these exports have allowed China to stockpile a massive reserve base and liquefied its economy.  It liquefies by pumping huge amounts of new money into its economy; the process by which it exchanges yuan for the dollars its exporters bring home—this is how China controls its currency.  Most of these reserves have been recycled back into US Treasuries, agency, and corporate paper.  Two reasons for this: 1) No other capital market is deep enough to efficiently handle such large amounts, and 2) It pushes US interest rates lower (bond prices higher) than they otherwise would be, effectively subsidizing the borrowing needs of its best customer and allowing them to “buy more.”



Slides: China FX Policy & US Benefits



The core of the issue is growing angst among wage earners in US (and other Western nations); they’re earning potential has stagnated—politicians are simply reflecting this real concern. 


“Over the last several years, a striking new feature of the US economy has emerged: real income growth has been extremely skewed, with relatively few high earners doing well while incomes for most workers have stagnated or, in many cases, fallen.  Just what mix of forces is behind this trend is not yet clear, but regardless, the numbers are stark.  Less than four percent of workers were in educational groups that enjoyed increases in mean real money earnings from 2000 to 2005; mean real money earnings rose for workers with doctorates and professional graduate degrees and fell for all others.  In contrast to earlier decades, today it is not just those at the bottom of the skill ladder who are hurting.  Even college graduates and workers with nonprofessional master’s degrees saw their mean real money earnings decline.  By some measures, inequality in the United States is greater today than at any time since the 1920’s.”


                                    Kenneth Scheve and Matthew Slaughter, Foreign Affairs July/August 2007


If true, this validates the view that US and Western workers not in the upper echelon income categories are bearing the brunt of enriching poor Asians.  And the benefits of this are flowing disproportionately to the upper echelon earners. (Read higher income taxes are on the way as class warfare takes center stage again as a powerful political wedge.)


So, the threat of MAD becoming reality is real—driven by real factors and fears.  Rational individuals would avoid such a path.  But the tug of events and circumstances sometimes takes nations where they really don’t wish to go.


Let us not lose hope.  There are solutions. First and foremost rising inflation in China may be one.  If China realizes an appreciating currency will do more to stem rising inflation and the social unrest it’s causing (a higher currency would reduce Chinese import costs and domestic money supply because China would not have to reissue so many yuan to buy back dollars); they will allow the yuan to appreciate much faster than it previously has.  And then Mr. Paulson (the good cop), could use this to head off trade sanction legislation in congress (the bad cop). 


[Notice the comment on slide number 2 above, “They fight external pressure thanks to Japan’s history.”  China remembers when the Western nations forced the yen to appreciate back in 1985 by means of the Plaza Accord.  The Japanese yen soared in value over the next couple of years.  China believes this is why Japan was pushed into deflation for 15 or so years, beginning in 1990.  They are extremely concerned about that potential.]


So, let’s all hope for continued roaring inflation in China; it could create its own set of problems, but not near as many as MAD.   



Jack Crooks

Black Swan Capital


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