Yuan€phantSS

by Tickerville Moderator: QuasiD

As we turn the page into 2011, trading has devolved into the finding the hottest exotic mining company with operations in Xinjiang province, which leaves me a little free time to muse about the three main “big picture” themes that stand out in the macroeconomic backdrop for the New Year.   The title to this article, “Yuan€phantSS” provides a handy acronym for the three major “static imbalances” which investors and citizens of the United States and world at large will be hearing much about in 2011, and which stand a decent chance of impacting your portfolios, if not your lives.    All three involve massive imbalances, and to date, the major players in each area have shown little capacity or interest in taking the tough medicine necessary to correct them.   I will address all three in a series of Tickerville articles over the first week of the New Year.

The first of our trifecta of imbalances is the Yuan, which most know as the unit currency of Communist China, and which is also referred to as the “renminbi” (the physical currency itself).   The relative valuation of the Yuan versus the United States Dollar represents, in this author’s opinion, the root cause of the global system of static current and capital account imbalances that were at the heart of the housing and financial collapse in the United States (via the transmission mechanism of interest rates and misallocated global savings), and which imbalance persists in its base form today.    Quite simply, the outsized creditor status of China as a neo-mercantilist exporter is protected via holding the Yuan as cheaply as possible via a peg to the US Dollar, while the excess current account dollars are re-circulated back to the primary debtor United States largely through the purchase of US Treasury Bonds and Notes.    This static imbalance has remained in place throughout the financial crisis as the cheap Yuan persists largely through China’s interventionist currency policies which remain a central policy directive.

To make the undervaluation more accessible to non-economists or finance professors, the Economist magazine publishes a quarterly survey titled the “Big Mac Index”.   In it, the magazine measures the purchasing power parity of a currency versus the US Dollar through a study of the relative cost of a familiar and fungible consumer item, the McDonalds Big Mac sandwich.   At last printing in October of 2010, the Yuan stood out as the most undervalued currency versus the US Dollar at roughly 40% undervalued.   A statistic that you can literally sink your teeth into.

Since this imbalance continues to exist in a relatively “static” state, its danger to the investing public is rarely on the front lines of discussion.   However, the potential fault lines that exist in the Yuan/USD relationship stand out as the San Andreas of global macroeconomic dangers.    The main problem that the continued undervaluation of the Yuan causes is the misallocation of global capital.   It feeds the engine of Chinese exports and stuffs the gills of US consumers with affordable items, but it stunts the growth of purchasing power and services in China and facilitates the terminal debtor culture of the American government by facilitating its finance at less than rational interest rates.   The excess capital and low rates in the US also distort investment decisions throughout the economy by discouraging lending as banks get risk-free funding and a free ride on the margin in government bonds, distorting the cost of capital analysis in project funding, discouraging prudent savings by US investors (who owns a CD anymore?), and by extension fuelling undue risk exposure by investors by the de facto removal of most fixed income alternatives.   Finally, on the US side of the ledger, as the current unemployment situation becomes increasingly intolerable to the US populace, the political pressure steadily mounts for a

potentially debilitating protectionist response from the United States in its own neo-mercantilist gambit.

In China, the situation has also reached a critical mass that will be difficult if not impossible to rectify.   it is the old story that reads, “when you owe the bank $1 million, the bank owns you, but when you owe the bank $1 billion, then you own the bank”.   A key question becomes, does China own so much US government debt that it in essence cannot stomach a dollar devaluation versus the Yuan?  Such a devaluation would cut the value of its US holdings from between the 25-50% as a consequence of creating currency purchasing power equilibrium and the removal of the static imbalance existing in the global financial system.   A tough pill to swallow for any government, even one sheltered from direct political election.   Further, will China also stomach concurrent the hit to its exporters that such a devaluation would likely mean?   The answer here may hinge on the judgments that China’s rulers make on the state of rural migration labor absorption as its demographics stabilize.  China to date has clearly resisted all calls to meaningfully address this primary static imbalance, and has repeatedly made it clear that any adjustment, if one is to occur, will be on “it’s own terms”.

So there we have it, on one side a chronic debtor nation with historic unemployment, misallocated capital and interest rate markets, and declining relative economic strength, on the other, a prickly and myopic neo-mercantilist exporter with an artificially manipulated currency that becomes increasingly captive to the value of its growing horde of dollar denominated debt holdings, and social workforce tensions.   Thus sit the two main players in today’s global static macroeconomic imbalance.   The first of the Yuan€phantSS in the room for 2011 will mean watching for rumblings across the Yuan/Dollar fault lines, as a rupture here would have dynamic and unpredictable consequences for a wide range of global asset classes.