Returning Dollars Roundup

In a follow-up to yesterday's discussion about the many hundreds of billions of boomerang U.S. dollars that leave these shores in exchange for cars, clothing, and electronics, only to come quickly back in exchange for U.S. Treasuries and mortgage backed securities, we take a look at a few recent news articles.

Treasuries Rise; Government Begins Selling $44 Billion of Debt

U.S. Treasuries rose a second day as yields near the highest of the year lured investors to the first of three government debt auctions this week totaling $44 billion.

Treasuries also received a boost on signs the housing market, which has supported the economy by allowing homeowners to convert equity to cash, is cooling. Toll Brothers Inc., the largest U.S. builder of luxury houses, today cut its fiscal 2006 forecast for home sales, saying there has been "some softening of demand in a number of markets.''

Forty four billion here, forty four billion there, before you know it you're talking about real money. The treasury auctions should get even more interesting in the coming months as borrowing needs increase.

Bush Says China Should Continue Currency Flexibility

China's decision to let the yuan strengthen 2.1 percent against the U.S. dollar on July 21 "was a strong step forward,'' Bush said in an interview with reporters from Asian countries to preview his trip to the region next week.

"They should continue to advance toward a market-based valuation of their currency for the sake of the world, not just for the sake of bilateral relations,'' Bush said.

No, it wasn't really a strong step forward - it was only 2 percent. As you'll see in a minute, those guys are engineers who don't have to run for re-election - they think differently than American politicians.

The Nine Men Who Run China

The nine-member Politburo Standing Committee (PSC) is generally considered the pinnacle of power in the PRC. (One could argue, however, that the Central Military Commission, which controls the PLA, is nearly as important). So who are the current members of the Politburo Standing Committee?

Look at all the engineers - pretty interesting actually. The U.S. government is full of lawyers, theirs is full of guys who are good at math.

U.S., China reach deal on textiles

The United States and China reached agreement on Tuesday on reining in China's booming clothing and textile shipments to the United States.
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China's exports of clothing and textile products to the United States jumped more than 50 percent in the first eight months of 2005 to nearly $17.7 billion following the end of a global quota system on January 1.

The more you think about the U.S. - China relationship, the weirder it gets. One could reasonably argue that U.S. politicians are equally concerned about the appearance of something like this as they are the actual outcome, because they have to run for re-election - the motivation is completely different on the other side of the negotiating table.

The Price of Asia's Growth

China already gets 14% of its oil from Iran and last year made a long-term energy deal with the Islamic Republic worth tens of billions of dollars. Beijing has threatened to use its U.N. Security Council veto if necessary to protect Iran against U.S. efforts to impose sanctions.

Although Tehran can't afford to ignore the West, "it has significant pulls to the East," noted a diplomat close to the Vienna talks who spoke on condition of anonymity.

Iran is hardly an isolated case.

In Kazakhstan and elsewhere in Central Asia, U.S. efforts to promote democratic reform have been blunted in part by the reality that America is no longer the only major buffer against Russia.

Look for this to continue - China already has big deals with Australia, New Zealand, Canada, and countries in South America. They seem to have a much more pragmatic approach than the Japanese did in the 1980s - of course, they are investing in their military as well, perhaps the biggest difference between Japan in the 1980s and China in the 2000s.

Global: China and the Worldview

There’s nothing like an 11-day spin around the world -- a brief touchdown in London, followed by lengthier stops in India and Australia -- to set the global prognosis in context.
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There was one group I encountered on this trip that got it -- the Chinese ... Mindful of the unbalanced structure of their own economy, they were quick to grasp the significance of a potential slowing of the American consumer. With support from internal Chinese consumption in an embryonic stage at best, they did not rule out a slowdown in China’s overall GDP growth.
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There’s always the possibility that China could develop a self-sustaining internal consumption dynamic that would shield it from an externally-driven slowing in the US. Alternatively, other sources of global consumption -- such as Japan and Europe -- could fill the void. But in my view, these are all long-tailed developments, at best -- unlikely to temper the potentially imminent mismatch between the overextended US consumer and an externally-dependent Chinese producer. If such a mismatch comes to pass, global equities could quickly come under pressure and bond markets could be given another boost.

In a trip to China not more than a few months ago, Roach commented that the people he talked to in China were completely unprepared for a consumption slow down in America. They seem to be fast learners.

Reforms of China's banking system have not gone nearly far enough

China's political leaders have an iron commitment to bank reform—a commitment backed with cash. Since 1998, Beijing has injected more than $260 billion into its banks via straight handouts and by allowing the Big Four to shift dud loans into separate state-backed companies. This is about twice what South Korea spent to restructure its banks after the 1997-98 Asian crisis and about what America needed to bail out its savings & loans industry.
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It expects 30 billion yuan in new bad loans in 2005. And on October 14th having inspected 11 banks, the CBRC concluded that it is “common practice” for banks to ignore regulations and fail to monitor loans, and that bad-loan levels are “not accurately revealed”. Poor accounting means that the banks themselves are unsure of their bad loans. Others do not tell. Lai Xiaomin, head of the CBRC's Beijing office, admits that “when our banks disclose information, they don't always do so in a totally honest manner.”
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The banks simply do not understand how to price risk or spot a dodgy borrower. Neither flexible interest rates nor loan classifications can help if credit officers cannot tell good loans from bad. The current boom has led loan officers to believe the value of collateral always goes up.
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To reform its banks properly, China must allow foreign takeovers. And its banks must be allowed to merge and fail. Yet even if Beijing raises cumulative foreign-ownership limits above the current 25% next year, as the CBRC expects, it is unlikely to relinquish control of a major bank. Worryingly, the CBRC seems ambivalent about foreign participation. Mr Han says he doubts the wisdom of raising the ceiling on foreign investment “if we don't get something in return”. Yet as banks in Poland and the Czech Republic discovered, preventing foreign takeovers simply delays bank reform and means more costly bail-outs. A stockmarket listing cannot really help while the state remains in charge: minority investors can do little to change poor corporate governance or influence strategy.

Instead, China is gambling on going it alone. By rushing poorly reformed banks to market and sucking in a bit of money and know-how (not to mention greater scrutiny) from foreign investors, it hopes to improve them sufficiently and sufficiently rapidly before the economy runs into a headwind. The size of that gamble should not be underestimated.

This will be one of the crucial tests for China as an economic superpower - their banking system. From their point of view, if they look at all the derivatives and other exotic financial instruments in the U.S. banking system, they must think, "That thing is going to explode someday". But then, what they have right now seems to be so primitive, lacking very basic controls. Will the engineers be able to figure it out?

Asia the place to invest after a US financial crash

Should the day come when Asians have more confidence in their own economic bloc (which I think will happen in the next few years), we could see a massive shift of assets from the US to Asia, with Asian financial assets and Asian currencies rising very strongly relative to US financial assets and the dollar.
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But, while I am very positive about Asia from a number of points of view (the size of the economy, growth potential, low valuations, and low weighting within the MSCI Index), I also have to admit that near term I am far less optimistic. I simply feel very uncomfortable about the US economy and the entire financial system, and feel that the US stock market has at best entered a sharp correction phase or may at worst, experience a crash - if not now, then following another brief bout of strength.

And since the recent strength in the Asian markets has been driven largely by foreign buyers, a US stock market correction or, in the worst case, a crash would almost certainly spill over into Asia and lead to some pronounced weakness but not likely to new lows. It is for this reason that I have turned more cautious on Asia from a near term point of view.

Dr. Faber's Tomorrow's Gold is highly recommended - he and Jim Rogers have given the U.S. - China debate an entirely new perspective for those who take the time to read what it is they have to say. The confidence issue is key - much of Asia has vivid recollections of the late 1990s crises and probably want to proceed cautiously.

Are Foreign Investors and Central Banks Free-Riding on China?

China does not want a major devaluation of the dollar against the renminbi for two reasons. First, if US consumers bought fewer Chinese goods, economic growth and job creation in China’s export sector would stall, which would have worrying social and political ramifications for the Chinese government. Second, China’s foreign exchange reserves are massive (they could reach nearly 50% of GDP by the end of the year) and predominantly denominated in dollars (around $800 billion worth). A big dollar move to the downside would destroy much of the value of China’s foreign exchange reserves, and a portfolio loss equal to tens of percentage points of GDP would hurt.

On the one hand, other East Asian countries are likely to keep their exchange rates steady against the dollar so long as they think the People’s Bank of China is still showing up at Treasury auctions, in order to maintain the competitiveness of their export sectors. This, in turn, encourages the carry trade. Private investors are tempted to take advantage of the interest rate arbitrage available between US bonds (10 year Treasuries are currently yielding around 4.6%) and their domestic alternatives (10 year Japanese notes are yielding around 1.6% by contrast). But only so long as they believe exchange rates will remain steady. Dollar depreciation wipes out the gains available under the carry trade, so private investors are free riding against their central banks, which in turn are free riding against the PBOC.

The second implication is that it is likely that any defection from this arrangement will not originate in China. Instead, it could be, say, the South Korean central bank, or the Russian, or some Gulf State will decide to invoice its oil in Euros and Yen. In the end, China stands a fair chance of being left holding the bag.

This is some very interesting commentary. For whatever it's worth, there was a Federal Reserve report some time ago that looked at how much import prices would rise if the dollar fell. They concluded that a relatively small fraction (20-30 percent?) would actually pass through.

The Asian carry trade and the continuing conundrum is quite interesting - is bookish Ben Bernanke ready to deal with something like this?

International Capital Flows and U.S. Interest

Foreign flows have an economically large and statistically significant impact on long-term interest rates. Controlling for various macroeconomic factors we estimate that had there been no foreign flows into U.S. bonds over the past year, the 10-year Treasury yield would currently be 150 basis points higher; even a step-down to average inflows would imply an increase of 105 basis points. The impact of the headline-making foreign official flows—a relatively small subset of total foreign accumulation of U.S. bonds—is also significant but markedly smaller. Our results are robust to a number of alternative specifications.

This is an interesting Fed study - long term rates 1.5 percent higher without foreign buyers? Surely that doesn't count the psychological effect of foreign buyers withdrawing from the market on other bond holders and buyers.

China's Economic Success Is Uncertain, Letters Imply

Can China's economy continue to soar as long as it retains an authoritarian political system? That was the question raised by my Business column1 this week. And readers offered some very different answers.
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Michael Broudo argues, though, that the political system will change, as an inevitable result of China's economic liberalization:

"Throughout history, economic liberalization creates an emerging middle class/bourgeoisie that eventually gets wealthy enough to be able to challenge the ruling class (the aristocracy, or in China's case, the Communist Party) and demand political freedom. Contrary to this, fascism has typically thrived in cultures where no middle class was able to develop. In short, Gorbachev is correct; China's path toward democracy has already been set into motion."

William Evans, who has also spent time in China, disagrees.

"I rarely saw anyone who sought 'democracy and freedom.' Politics was usually last, if ever, on the minds of workers, managers, businessmen and farmers. Everyone pursued the good life -- material possessions, a home and car. Some older people who were slow to prosper even fondly remembered 'the old days' when everyone was equally poor.

"As long as China grows and prospers, I don't see any chance that the people will demand political change. If economic problems occur, there will be demands to fix the problems -- probably not demands for change to what we call 'freedom and democracy.'"

And Warren Hua says you don't have to travel far to see how an authoritarian regime can survive alongside economic freedom.

"My answer to your question 'Will China soon have to link economic and political openness?' is one word: 'Singapore,' a benevolent dictatorship with an economic miracle. I am answering with such confidence because I have been there for over four years and have a first-hand account of how political openness and economic openness do not have to go hand-in-hand necessarily."

Interesting question indeed - Communist government / free-market economy - what's going to happen? The last two comments seem to make the most sense - as long as people have an improving quality of life, they don't care about what the government does. The Chinese government probably understands this better than most Westerners could ever imagine - if there is a significant slowdown as a result of U.S. led export weakness, that will test this thinking.

China Is No Superpower

Many in Europe and some within the U.S. exaggerate China's rise as a stick to beat the Bush administration. Any rise with the potential to take President George W. Bush down a peg or two is inevitably maximized by those for whom Bush's America would not be their first choice as the world's sole superpower.

Amid all this hype, it's worth recalling a few important facts that are often forgotten. The American economy today is seven times the size of China's. Even the Japanese economy is three times the size of China's. Some even overlook the fact that China is a Leninist regime -- the kind that mostly went up in a puff of smoke 15 years ago.
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China's economy may continue to grow at its present rate. Or China may retain its Leninist party-state. But both can not happen. Either the economic or the political logic will soon gain the upper hand.
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In Beijing and Shanghai and Xian, I find less talk of China being near to eclipsing the U.S. than I do at Harvard and in the U.S. media. Overall, China may not be the new colossus it appears to its self-made foes or to distant lotus-eaters. A Leninist-ruled Chinese superpower eclipsing the U.S. is not on the horizon.

Notice the condescending tone and that purchasing power parity is absent from the discussion - Wall Street Journal editorials are like that.