Trade Ideas, China, Inflation

April 2008 - Update March 2009

The Yuan vs Dollar exchange rate is fixed and controlled by the Chinese Government. When foreigners buy Chinese goods the Central Bank takes the foreign dollars and in return gives the local manufacturers Yuan. Because foreigners buy far more from China than China buys from them, the Chinese Central Bank has built up an enormous pile of dollars. These huge foreign currency reserves, well over a trillions dollars today and rising ever faster, are not a sign of strength, in fact, as we will see, they are a huge threat to stability.

The Central Bank can not simply take the dollars and print Yuan because that would be the equivalent of printing cash - which of course creates inflation. Instead the central bank employs a "sterilization" policy. On the one side the Central Bank invests the dollars it receives mostly in US government bonds, and on the other it borrows an equal sum from Chinese banks in short term Yuan loans.

The problem with exiting the peg is that is as the Chinese government's yuan-dollar position gets larger it becomes increasingly costly to exit the strategy by readjusting the yuan-dollar rate. With a trillion dollar position a 10% move inflicts a 100 billion dollar loss on the Chinese government which it must recover either by tax revenue or by money printing. Ok, China can absorb a 100 billion dollar loss easily enough without printing money, that's about 2% of its GDP. But how big are China's reserves going to get and how much is the yuan going to move in the long term? There is another problem with exiting the peg, such an enormous position could takes years to unwind without market impact.

The problem with maintaining the peg is that Chinese interest rates need to be fixed at US levels. If an exchange rate is fixed against another and the interest rates differ one could borrow money in the country with lower rates, invest it in the other, and after a time convert the money back again making a risk free profit. Even if China can use technical measures to prevent speculators doing this, if its assets in the US pay a lower rate of interest than its borrowing in Yuan it looses money on the huge dollar-yuan position. In February 2008 Goldman Sach's China economist estimated that Beijing is losing approximately $4 billion each month because of its foreign currency sterilization policy, even on the small interest rate differentials of today.

With China's inflation rate now hitting 9%, and its interest rates at 2.5%, the real rate of interest (nominal-inflation) is hugely negative. Negative real rates are relatively rare in financial history and generally lead to massive asset-price appreciation, inevitably followed, one day, by bust, especially in the housing market. China uses bank reserves to manage inflation in the same way that normal countries use interest rates. But can it really fight against absurdly inappropriate interest rates? China is a nation of savers who keep their money in cash to pay for health care etc, wiping them out with negative rates and inflation is a hugely difficult political choice. The peg benefits borrowers and hurts savers, and in China that probably means exacerbating the gap between the poor and the rich.

So China is stuck with a peg which is damaging to maintain and disastrous to exit. This damage comes in the form of inflation, one way bet problems, and tax payer losses. Personally I think this complex can of worms gets too little attention. I think China's imbalances and currency peg are critical to the future. Trying to understand outcome is very difficult, but here are two ideas:

First, it spells inflation for China and probably the world. There are 1.3 billion people in China and it's growing up as fast as Japan. On top of all that it is on a negative rate splurge. Wages in China are starting to rise. Billions of new consumers are coming online. How will this feed back to the rest of the world? It's not just China, other emerging markets are growing too. Commodity prices are going higher. We are in the process of the worlds largest growth boom - like nothing else that ever happened in history.

So while economists across the world first started talking about the death of inflation in the late 1990s, I guess that this process must now be coming to an end. In the 1970s inflation ended in a car crash as policy makers finally manned up to the problem, but manliness is very much out of fashion and they will be far behind the inflation curve for the next few years.

Second, the Chinese need to exit these US bond positions and invest more sensibly. A vast position in thirty year US government debt against short term yuan loans is literally a traders nightmare. In fact it is pure insanity, the most absurd position the financial markets has ever seen. Politicians in China and America think it suits them, but complacent irrationality never works in the long term. Not only do the Chinese stand to loose a fortune, they are at the mercy of US politics. The Chinese need to unwind this position. They should be investing in index tracking equities, real estate or commodities. They need investments with long term insensitivity to the level of the dollar. 

Another theme, unrelated to the peg, but vital to think about seems to me the increasing insolvency of Western governments. Even with world growth booming the West will not be able to maintain the standard of living it has come accustomed to. China is a greater challenge to the West than Japan was in the 1970s. We already see the Western rich pulling away from the rest of society, this process is likely to get much worse. As in Ancient Rome's expansion, it will be the poor that suffer. They simply will not be able to compete, and governments will not be able to pay the social security and heath bills. Western stock markets will continue to power ahead, but the government will not be able to raise taxes given the mobility of corporate entities and wealthy citizens. Eventually this process will probably end in some kind of nationalization of real estate - but I am talking in many years time.

How can one profit from all this? Commodity prices have already moved a lot. Jim Rogers sure got this one right, what now? I think rising stocks and rising interest rates must be the key long term picture to bear in mind over the next several years. For investors, I think buying Hong Kong stocks or property looks good. Or a pan Asia Pacific stock index. Chinese stocks look good too, but the rise of Chinese State Owned Enterprise clouds the picture - will Chinese profit margins be squashed by idealistic SOEs? I don't like India much, it is not a well run country in the way China is. A China blow up is not on the horizon, so ride the global growth wave. Also, with inflation ticking up you need to be invested not in cash. Perhaps the big investment to avoid is Western property markets. The long term outlook for the West I think makes this a bad idea, unless you are buying high end properties in places the nouveau riche want to buy holiday homes.

However, for traders, right now I prefer the inflation bet to the stock bet. I recommend selling US 30 Year Bond Futures (selling the bond means betting that its yield will rise). Because we are still at the tail end of the deflationary years and have seen recent growth jitters, these bonds are at their lowest ever yields. The chart of the yield shows a strong bottom, the trend is flat and no longer declining.

Charts of US 30 Year Bond Yield Index (Index Price=10*Yield) - Bumping along a 4.25% bottom for last five years- and close to this bottom now.



The risk is of course that the recent growth jitters delay the inflation. As a result of the years of deflation governments around the world, especially in the US and the Eurozone cut real rates creating huge asset price booms, especially in housing. All booms end eventually in bust, and the mortgage crisis may be the beginning of that process. Nevertheless, I do not buy the idea of a big global growth slowdown. To believe in the inflation trade you have to believe, as I do, that growth in Asia will continue to boom and this will outweigh a certain degree of decline in the West. In the very long term both environmental problems, and a China inflation crash say bonds up, but at this time frame Western economic decline says bonds down more. Within the next few years US 30Y yields will probably be over 8% and anyone backing this trade will be very rich.

Update March 2009

In this article I predicted that TBond prices would fall and Asian equity markets would rise. Both of these predictions were completely wrong (at least in the relevant timescale). I talked about "growth jitters", what actually emerged was a crisis which had the potential to destroy America! Pretty embarrassing! US 30Y yields rose for a while, then the carry changed, making shorting the bonds costly, and the it went back to its lows. With the Lehman's bankruptcy (Sep 2008) US 30Y yields crashed to a low of 2.5% exacerbated by Fannie and Freddie gamma. I was thinking about a period of weak Western growth, after Lehman's fall we started looking at life in a whole new way.

The Chinese didn't use the rally in US bonds and the dollar to unwind their US assets. In fact Chinese newspapers have been printing articles about how much money China wasted buying Blackstone etc. I think the newspapers are wrong, switching out of US government bonds into less dollar and US rate sensitive assets is still absolutely vital. I feel like a fool, predicting 30 year US bonds would rise in yield and then they fall to 2.5%! But is not 100% me. Hank Paulson killed Lehmans instead of nationalizing it. And the Chinese let us down too. They could have used the crisis to exit their US positions, instead they sat on their hands. 

But the really interesting thing is how I got wrong the impact of the huge Chinese surpluses invested into US Bonds. I knew it was the key factor in the world economy, and I spend a long time pondering on the issue, but I came up with the wrong answer. In fact the huge surpluses, ie the huge lending to the US, pushed the US into an asset and credit price boom (the credit crisis), and the consequences were a bust in the US, not an inflationary boom in China.

Another thing I got wrong was trying to trade Western government incompetence by shorting US 30Y bonds. Looking back it is obvious that the first mover has to be in the Eurozone where governments can not devalue their way of difficulty. Greek sovereign bonds are the ones looking sick right now. Even in the US selling long municipal bonds is going to react before treasury bonds. I basically picked the last man to fall which was stupid. You pick the weakest man, you short him, when he drops you move onto the next etc.

The next big question is the shape of the world after this bust. I still see a period of weak Western growth more than offset by booming emerging markets. Ironically I think my original advice- short TBonds and buy Asian Stocks is doubly true - but for anyone following me it is too late as they have lost too much money and too much confidence!