China, Inflation & Trade Idea

April 2008

The Yuan vs Dollar exchange rate is fixed and controlled by the Chinese Government. When foreigners buy Chinese goods the Central Bank takes their 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 build up enormous currency reserves which now exceed well over one trillion dollars. These huge reserves 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 in which it borrows Yuan in the local market. 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 in short term Yuan loans.

The Yuan vs Dollar exchange rate is fixed at what many believe is the the wrong rate. If the Yuan was stronger Chinese exports would become more expensive to foreigners and trade imbalances would moderate. Western Politicians increasingly threaten to impose sanctions on trade with China if it does not allow it's currency to appreciate. However, if the currency appreciates the central bank will suffer enormous losses on its dollar-yuan position.

Also, interest rates in Chia have to be kept 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 people 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 already losing approximately $4 billion each month because of its foreign currency "sterilization" policy. Any large move upward move in rates in China, or any large move in exchange rates would create enormous losses. If the losses were large enough the Chinese government would be unable to maintain the sterilisation policy and rampant inflation would be the result.

Faced with these losses the peg has to be maintained and interest rates in China have to be fixed at US levels. However, US rates are far too low for fast growing China. Indeed 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 they ultimately lead to massive asset-price appreciation, inevitably followed, one day, by bust.

In the 1970s the cost of simultaneously expanding social spending and funding the war in Vietnam came together to heat up inflationary pressures in the USA. US Real interest rates averaged -0.5% in the 1970. Farming and land prices boomed through the decade. By 1979, opinion was swinging toward the view that inflation was the primary economic concern and President Jimmy Carter was forced to nominate hardliner Paul Volker as chairman of the Federal Reserve. Volker took a couple of early shots at inflation and didn’t even faze it. Then he got serious and brought out the big gun of monetary targeting — basically squeezing the money supply until interest rates rose sharply above the rate of inflation. The result was that the speculators, farmers and builders who were riding the inflation got smashed against the windshield. Game over, reset the cycle.

China is trapped in an inflationary spiral which, along with its foreign exchange reserves, is getting larger all the time. Currently China fights inflation which technical measures on bank reserves and recently even price controls, but these tools can not hold back the tide. China is headed for runaway inflation and it will be several years before they burst the bubble.

Inflation in China and, given its importance, inflation across the world is the future. It's not just a China problem either, as emerging countries across the world have recently started to grow more quickly, commodities prices have been driven higher. After years of strong growth wage levels across the emerging world are rising. Billions of new consumers are coming online - we are in the process of the worlds largest growth boom. Economists across the world talked about the death of inflation during the 1990s, but this process has come to a dramatic end.

How can traders profit from all this? Probably the easiest trade is 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. Other reasons: US government debt levels, china moving out of bonds into stocks, positive carry, 30 year fixed rate debt suffering from risk aversion. For more advanced investors paying the 15 year Honk Kong swaps is another trade. For basic investors buying Hong Kong stocks or property looks good. One day the situation in China will fall to pieces, but in the meantime negative real rates make a massive boom very likely (remember Japanese stocks rose 100 times between 1955 and 1990).

Charts of US 30 Year Bond Yield Index (Index Price=10*Yield)

The risk is of course that the recent growth jitters delay the inflationary car crash. 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. Weak democratic governments failed to fight the housing booms by taking radical action to increase housing supply, the UK offers perhaps the worst example. Despite immigration and divorce pushing housing demand higher, grid locked planning permission forced home building in the UK under the Blair Government to fall to its lowest levels since the second world war. In 2007 quality homes in London became the most expensive in the world. What the UK should have done is to knock down vast swathes of poor quality housing and rebuild sky scrapers Shanghai / Hong Kong style.

All booms end eventually in bust, and the mortgage crisis may be the beginning of that process. Also, although wages are rising in the emerging world the average person in the developed world is suffering from competition. However, wealthy developed world investors have a stake in emerging market production and are doing very well. The S&P 500 is less about the average American than it is world growth. Continuing dollar weakness is S&P 500 positive.

Some argue that what I described as 'recent growth jitters' are much more serious. Serious growth problems damage the inflation trade - although the grid locked democratic government of Italy is an example of country that has had years of poor growth and high inflation (stagflation). Nevertheless, to really 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 rich West. I also believe, that the inability of many declining democratic governments to control spending will also help the inflation trade. In the very long term both Climate Change and a China Crash after an enormous inflationary boom darken the outlook - but long before then US 30Y yields should have passed 8% and anyone backing the trade will be very rich.