Latent Chinese Demand, a Potential Cure-All

With the People's Bank of China starting to pull back liquidity, and talk of even higher RMB interest rates on the horizon, we may be at a turning point in world trade where a latent and underestimated potential source of global aggregate demand is activated.

Simply summarized, the past policy of the Chinese government has been to subsidize its exporters by devaluing its own currency. It does this by buying US dollars on foreign exchange with newly printed RMB to keep the currency rate generally pegged. Doing this aggressively over the past decade, it has built enormous world capacity and stimulated world demand for the goods it produces.

By China saying it wants to decrease the rate of money supply increase (by restricting loans and raising interest rates), it is communicating to the world an end of this RMB devaluation policy, necessary to maintain their US dollar foreign exchange peg. The Chinese central bank can't have lower RMB money supply and a maintained US dollar peg, unless of course they make an agreement with the Fed to also reduce its money supply simultaneously. In this political and economic environment, this is an impossibility.

The People's Bank of China has two policy choices. The first is they can keep up the status quo, printing RMB to buy US treasuries in order to continue to subsidize exporters, with the unwanted side effect of continued local price inflation and asset bubbles (real estate in particular). The alternative is that they raise interest rates and impose higher reserve requirements, reducing the rate of money growth. They have already embarked on this path, so there should be very little to guess (especially in the longer run) on where the RMB goes from here.

A stronger RMB means the US and Euro zone (China's largest trade partners) import less from China, while China imports more from the US and Euro zone. Such a change signifies a reversal of what many view a predatorial trade policy on the part of the Chinese. It also means the $2.4 trillion US dollars of accumulated reserves will have less buying power going forward.

In such a change, China's trade partners will have to deal with higher import prices, and will thus have lower GDP as a response. In the long run, their economies restructure and their exports increase (GDP rises). This reflects the J-curve model in international trade economics.

With China already the number one consumer of autos in the world, the Chinese consumer with the benefit of a strong currency would spell a voracious appetite for potential consumption. Certainly, with Chinese demand for transports growing at an exponential rate and global crude oil demand once again increasing, Chinese policymakers now have all the incentive in the world to let the RMB strengthen, keeping input and fuel costs under control, as global supplies of key commodities dwindle.

In the long run, a strong RMB means strong Chinese consumer demand, less price inflation in China, and increased exports (and thus economic growth) from the OECD. It also signifies a trend reversion of trade account deficits to possibly surplus, especially within the US. In a most extreme case where the Chinese government decided to sell off its stash of US dollar assets and then spend those dollars, a significant amount of latent aggregate demand is represented here. Contrary to Robert Samuelson's suggestion in Newsweek that "The massive disgorging of dollars could trigger another global economic collapse," it could in fact trigger quite the opposite, in the form of spending stimulus the US has never seen before. $2.4 Trillion US dollars represent an enormous amount of real economic activity, and any near term economic risk a short term rise in interest rates would more than be offset by the increase in US GDP, employment rates, and correlating rising government tax revenues.

Inevitably, there are many undealt with moving parts here, resulting in more questions. Post-RMB revaluation, will the new strong Chinese consumer offset the losses the former Chinese exporter suffers? Will the surge in Chinese consumer demand be a one-off event, as their exporters languish? Will the US and Eurozone, with now weaker currencies, be able to be competitive exporters with the side effect of increased commodity costs? How long will it take for the US economy to restructure back into increased manufacturing and other industries clearly destroyed by Chinese predatorial trade subsidies? With a future US having increased real GDP activity and better government fiscal status resulting from corresponding increased tax revenues, a stronger US dollar may be a long run effect, contrary to any near term movement against the RMB.

The only near term certainty is that such a significant policy change will create volatility and result in enormous real economic change. An overshoot weakening of the US dollar would be likely. As well, gold may do well and US treasuries may suffer (as a significant buyer disappears from the market). Furthermore, since significant structural changes would need to occur in the US economy to adjust to a strong RMB, it may take a long time for exporters to adjust. This points to a lag in increased tax revenues. Short term, with a dollar devaluation, notional value of imports would increase, putting negative pressure on US GDP and making the US fiscal condition look all the more dire.

Inevitably, policymakers might invoke accelerated money printing and fiscal stimulus to ease the pain. Uncertainty may drive up inflation expectations as well, increasing the likelyhood of higher long run interest rates. Such an inflationary move in the US may be just what the doctor ordered, as nominal wages rise and accumulated debts currently stifling lending (reflecting bank insolvency) would be rendered non-issue.

My three favorite instruments

Gold, Japanese Yen (particularly against the dollar), and Treasuries.

I'm endlessly fascinated with this trio, and here are some latest thoughts after much belation. Today with a worse than expected jobs report, confirming a job market still in contraction after 2 years, the most notable market reaction is not in the treasury market, but the gold market. I can personally testify to the looseness of the job market here, being a somewhat discouraged job hunter right now (hint to all portfolio managers in San Diego).

Right now up about $15 off intraday lows, gold strength now reflects the general diagnosis that policy makers will resort to money printing and continuation of low Fed Funds in order to architect a meaningful and convincing recovery. I might even go out on a reach and say it is turning into a negative beta or at least low correlation asset to the S&P (S&P down, gold up), making it more desirable to portfolio managers even at these high levels. Will post updated model to confirm or deny this.

I've suspected for awhile that immediate substantial pressure on gold stocks (down 20%+ versus gold down 8%) versus outright gold bullion came from portfolio managers wanting as neutral a position as possible, going short the high beta gold stocks in combination with long lower beta gold, pricing the market out of their gold exposure. Of course, there is enormous operating leverage in gold stocks, and this neutral positioning may not do well in the case gold moves substantially. A model I've prepared shows Barrick gold price quadrupling if the price of gold rose 77%, holding input costs constant. This is just as if not more likely to explain the falloff. But it does not explain the relative longer term underperformance of the entire gold patch. More on these thoughts in another post.

Then the Japanese yen against the dollar, really my favorite position as of late. This bottomed recently around 85 yen to the dollar, and has shown continued strength ever since the Bank of Japan announced their easing program. Yesterday flying through the 93.10 mark on new Finance minister remarks attempting to talk up the dollar, it appeared this is a trend worth being a part of. My reasons for interest in being long the dollar against the yen have more to do with a belief that much like the US, the Japanese will have to increasingly resort to debt monetization to offset government deficits catalyzed by a lagging economy, correlated lower tax revenues, and most importantly a population demographic change leaving a shortage of demand for Japanese debt at absurdly low levels. Not an original idea, I envision trade against the Yen and even short the Japanese government debt will be an immense opportunity, and a giant macro game-changer as far as world trade is concerned. Imagine the changes to global trade implied by a 200 yen to the dollar exchange rate. Perhaps the best long term position idea is short yen versus gold or silver.

Onto US treasuries. Some $2T of debt will come to the market this year, and the duration of new issuance will likely increase. This means higher interest rates assuming the lending picture does not change considerably. If lending ramps up, that means more bank created money supply to finance the purchase of some of this debt. It's difficult to reconcile any dramatic movement either way, but those supply numbers are scary. Until issuance numbers start dropping off, treasuries will be under pressure unless yields move up. Today's interesting movement is the continued muted reaction (dead) in the long end, with increased inflation expectations trumping fear of outright economic collapse. Thus, gold doing better than bonds (from pre-report levels). Of notice is the strong dollar selloff today in contrast to a half a point upward movement in the 20 year future. In real terms, treasuries are stationary or even down on this news.