The Next Black Swan- A Yuan Devaluation

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China's bubble
In 11 big surprises for the next decade we wrote:

China Bluff Exposed, Regime Overthrown- China's communist regime continued to print money, lending it to everybody that wanted and didn't want it. The giant housing, infrastructure, and manufacturing bubble came to a violent crash when the debts where not paid and inflation forced the authorities to tighten despite massive unemployment. The combination of high inflation and high unemployment in the urban centers took the people to the streets. The Chinese citizens refused to accept state intervention in the economy and their personal life demanding more personal and economic freedom resulting in prolonged civil unrest which almost reached a full scaled civil war. The collapse of the Chinese regime and economy resulted in a colossal bust for commodity prices, albeit temporarily and caused a severe recession in Australia, Brazil, Russia, Argentina, and the Gulf States.

Well we predict that one of the next big shocks to the global financial system, happening probably as early as 2011 is not a Yuan revaluation as many expect but a Yuan devaluation!


China has a trade deficit

One of the big changes that emerged in the global financial scene in 2010 has been the emergence of a trade deficit in China. And if China’s trade deficit persists, There is a very high risk of yuan devaluation. This of course contrasts with forecasts this year from economists and investors including Goldman Sachs Group Inc.’s Jim O’Neill and Stephen Jen of BlueGold Capital Management LLP that the yuan will strengthen.

China has kept the yuan at 6.83 per dollar since mid-2008 to shield exporters from the global recession and a contraction in world trade. The U.S Treasury Department said in an April 15 report that is “seriously considering” labeling China a currency manipulator, according to U.S. Senator Charles Schumer.

China reported a trade deficit of almost $8 billion in March, compared with a $24 billion surplus in October, as imports grew faster than exports. China’s trade deficit in March, of $7.2 billion, was the first monthly deficit since 2004. It couldn't come at a more auspicious time, for China that is. Beijing is in the middle of a tug-of-war with Washington over the value of its currency, and the deficit takes the steam out of the American position that the yuan is grossly undervalued. Politicians in Washington (and many economists) have insisted that China purposely keeps the yuan (also known as the renminbi) at an artificially cheap level, giving its exports an unfair cost advantage in global markets and fueling China's persistent trade surpluses. If those surpluses have vanish, so does the American argument.


Still, economists are not changing their view that China will need to allow the yuan to appreciate to fight inflationary pressures and slow down a potentially overheating economy. Here's what Jun Ma, chief China economist at Deutsche Bank, had to say on the matter in a note to investors:


Many people wonder whether (the March deficit) would become a meaningful argument for China to avoid or delay its exchange rate reform. Our answer is no, as this monthly deficit is a symptom of economic overheating and a few other one-off factors and is thus tentative in nature. We expect China's trade balance to return to surplus a few months later, and the outlook for the RMB to resume flexibility should not be affected.


Yet there's another way of looking at this picture. The March deficit points to a much larger historical trend – China's surpluses have been decreasing, and now have vanished. It is true that the trade deficit is a result of the giant stimules mesaures taken by the Chinesse authorties and of the gorwth in credit and money supply in the country but that is the exact point. With China’s exports not recovring, since western consumes simply can’t add up more debt, with those further stimules china will suffer massive unempolyment which will threat it’s regime. But, since the trade surplus is now gone, further stimules will cause the trade deficit to rise and the Yuan to collapse.


China's trade and current account surplus has already been falling at a rapid pace since 2007…China's trade surplus to GDP ratio had reached a historical peak of 7.5% in 2007, then it dropped to 6.5% in 2008 and further to only 4% in 2009. Meanwhile, China's current account surplus to GDP ratio had almost halved to 5.9% in 2009 from the spike of 10.6% in 2007. We expect this trend to continue with the trade surplus to GDP ratio and the current account surplus going to negative terriotary by 2011. This is mainly because growth in China's imports is a direct result of infrastrucure building that is neccasry to keep the Chinesee empolyed.


Whatever the value of the yuan should or should not be, the March figures from China are also symbolic of another major trend taking place in the world economythe increasing importance of China and emerging markets as the last engines of bubble making.


Emerging markets have not only helped to drive the rebound in global trade in growth terms, but have also contributed towards bringing back world imports to 2007 levels in U.S. dollar terms. World imports have recovered almost 50% of its fall during crisis…Looking over a longer period, the gain in EM (emerging market) imports since June 2007 is more than the loss in DM (developed markets) imports over the same period, indicating that EM are the last fourntiar standing between the world economy and the second great depression. In particular, the gain in China imports is more than the loss in the U.S. imports during crisis… The share of EM in world imports has risen significantly from 30% in the late 1990s to 45% towards the end of 2009. In particular, China's share of world imports has more than doubled in the past decade.




China has a giant housing bubble ready to pop

The rise in China’s imports is to a large extent a result of its giant housing bubble.
After sagging in the global financial meltdown of 2008, property values in China's urban centers skyrocketed in 2009. Shanghai's Pudong district, for example, experienced a 57% rise in a matter of months. The new real estate bubble in China is even more precarious than the one which imploded in the U.S in 2008. The popping of China's current housing bubble -- considered inevitable by regional experts such as Andy Xie -- could have widespread consequences. If housing turns down in China, China's growth could slow or even decline. And since the entire world is looking to China to lead global growth, then that could spell major trouble for the "global economy is recovering" story.





China's Stimulus Dwarfs America's


The reflation of China's real estate bubble has a number of causes, and the most obvious one is that nation's stupendous $586 billion stimulus, which was packaged with efforts to promote real estate lending and development to boost growth. According to China's central bank, new home mortgages in the first nine months were quadruple the amount borrowed a year earlier.

In terms of GDP -- China's GDP is $3.3 trillion compared to $13.8 trillion for the U.S .-- China's $586 billion stimulus is three times as large as America's $787 billion stimulus. China's stimulus spending is a heart-pounding 17.8% of their GDP, as opposed to America's comparatively modest 5.7% of GDP.

Even if we use the CIA Factbook's estimate of China's GDP in terms of purchasing power parity (PPP), China's stimulus is still almost triple the U.S. government's stimulus (5.5% U.S. versus 14.4% China).

The tremendous rise in construction, lending and speculative buying and housing starts rose 194% in 2009 blew a bubble that could burst in 2010, taking down everyone who jumped into the game in 2009: homeowners, banks, developers, stock markets, and local governments.

Central government efforts to stimulate the property market included tax breaks, smaller down-payment requirements, lower loan rates for first-time buyers, and vastly increased bank lending. When they saw what they have done, In an effort to lower the boom on speculative flipping -- buying and selling of properties within a short time span -- China's State Council announced changes to tax breaks for home sales by individuals.





China still depends on exports and they are not coming back


Lost in the euphoric frenzy of China's real estate market is the glum macroeconomic backdrop. China's overall economy depends heavily on exports; from January to July 2009, China's exports dropped by 22 percent -- a major hit to the nation's income stream, and they have not recovered much since, despite the surge in world stock markets






Despite the surge in domestic construction and infrastructure projects resulting from the stimulus spending China's exports are still way bellow 2008 levels And too much money has flowed into new and unneeded factories which are now idling at low capacity.

The present housing boom also has some serious macroeconomic headwinds. A typical 1,000-square-foot apartment in Beijing now costs about 80 times the average annual income of the city's residents, wildly out of line with the historic levels of three or four times annual income.

This speculative fever has been fed by a number of factors which will sound eerily familiar to Americans bruised by the U.S. housing bubble's rise and fall: low interest rates, official promotion of bank lending, and tax break galore for new buyers.

Unlike in the U.S., local governments in China are major players in real estate development because they sell land leases to developers for hefty sums. According to Chinese economists, up to half of all local government revenue comes from selling state-owned land to private developers.





Perhaps most dangerous, about 90% of the new construction is aimed at the luxury market, which is unaffordable to the average Chinese household. (This should sound familiar to residents of New York and other major international cities.) As a result, thousands of new homes and condos are sitting empty, purchased as investments not as places to live.





To fully understand why China's housing market has ballooned into a new and increasingly risky bubble, we have to understand that it's not just government policies that have created a runaway speculative market; other financial and cultural issues are also at work.



1. There are no property taxes in China, so the costs of carrying speculative (empty) homes is very low in comparison to the U.S.
2. Property values have, with brief interruptions, risen for decades, so the average Chinese household considers real estate a much safer bet against inflation than the stock market.

3. Until recently, households had few investment alternatives to a simple low-yield savings account. The incredible boom and bust in the Chinese stock market in 2006-08 -- akin to the dot-com mania in NASDAQ stocks in 1998-2000 in the U.S. -- left many Chinese investors wary of the stock market. As a result, many view owning investment properties as akin to "money in a savings account," that is, a low-risk, long-term investment.

4. Though the central government is trying to suppress speculation, it is aiming at the wrong target. Flipping property is simply not common in China; the overall number of sales of existing homes is very low by U.S. standards. The speculation arises from the easing of lending by the central government and local government dependency on real estate development for revenues and economic growth. As a result, the planned tax on private re-sale transactions will do little to lower speculation.


From one point of view, China's Central government massive stimulus and easy-credit campaign have spurred a massive malinvestment in unneeded factories, marginal infrastructure projects and speculative luxury-market housing, much of which is sitting empty as "investment properties" held in lieu of other investments by Chinese households.


History does not provide many examples of governments successfully deflating a speculative credit or housing bubble. Speculative excesses tend to run out of steam quickly and end in a bust. Now that China's central government has already gone all-out to boost the economy, the world should wonder what's left in their expansionist tool belt should China's real estate suffer the hard landing in 2010 that many analysts expect.


And if China's real estate sector runs out of steam, so too does the entire China growth story -- and the global leadership many have been counting on.



Speculaters are betting the wrong way!!





Meanwhile, investors worldwide are making large bets that the Yuan will revalue and gain value versus the U.S dollar. Ironically, this intensifies the potential of a Yuan crash, since the presence of so much speculative funds is going to overweight China’s foreign exchange reserves. If China decides to let the Yuan float, it may go up initially but once foreign investors take the money out of the country once the revaluation has been done, the flow of capital will drain China holding of FX reserves since it will need to sell them in order to prevent a Yuan collapse.





Investors in Hong Kong are snapping up the Chinese yuan amid widespread expectations that Beijing will soon respond to growing calls to revalue its currency.



The financial center’s banks have seen a spike in currency transactions as speculation continued up until the crisis in Europe shocked the world markets, with HSBC saying trade in March alone almost doubled from the previous month. Dealers are rushed for the yuan as Beijing faces pressure to allow it to appreciate, with critics led by the United States saying it is being kept artificially weak to boost exports. Francesca McDonagh, head of personal banking services at HSBC Hong Kong, did not disclose the bank’s precise foreign-exchange trading figures, but said the surge up to April 2010 was “not a tiny amount.” Hang Seng Bank said yuan exchange transactions and yuan deposits recorded double-digit growth in the first quarter, a trend that slowed down since mid April.





For most of its history until the 1970s, the RMB was pegged to the U.S. dollar at 2.46 yuan per USD. During the 1970s, however, it was gradually appreciated until it reached 1.50 yuan per USD in 1980. When China's economy was opened during the 1980s, the RMB was devalued again to improve the competitiveness of Chinese exports. Thus, the official RMB/USD exchange rate declined from 1.50 yuan in 1980 to 8.62 yuan by 1994, fueling a giant export boom that lasted up until 2008.





The U.S should be careful what it wishes for





In March President Obama made a fairly strong speech in which he urged China to adopt a “more market-oriented exchange rate”. China’s response to Obama’s speech was pretty rapid and pretty angry. Su Ning, a deputy governor of the Chinese central bank, said the US should not “politicise” China’s currency policy…“We always refuse to politicise the yuan exchange rate issue and we never think that one country should ask another for help in solving its own problems,” Mr Su said on Friday.





What it means to “politicise” the currency policy wasn’t made clear, but on Sunday Premier Wen also jumped into the fray. He denied that the RMB was undervalued and, in the words of an article in The Wall Street Journal added the following:





“I can understand that some countries want to increase their share of exports,” Mr. Wen said, in an apparent reference to the Obama administration’s goal. “What I don’t understand is the practice of depreciating one’s own currency and attempting to press other countries to appreciate their own currencies solely for the purpose of increasing one’s own exports,” he added. “This kind of practice I think is a kind of trade protectionism.”





Wen is absolutely right. Undervaluing or depreciating a currency certainly is a form of trade protectionism. In a world of sluggish growth and rising unemployment, everyone’s currency policies are going to be scrutinized over whether they constitute trade protection.

An article in the People’s Daily has Wen also warning that “China opposes accusations and even forceful measures that press for yuan appreciation, which will not benefit the exchange rate reform.” The claim that external pressure will never advance reforms in China is now much debated in Europe and the US, and may be less widely believed abroad than it has been in recent years.

The same issue of the People’s Daily had another article pointing out that US debate on the currency was driven mainly by domestic considerations and that the only reason Obama brought up the subject of the RMB was to address domestic polls.


“The U.S. government wishes to eliminate trade deficit and ease its high unemployment rate by pushing yuan appreciation. That was only its wishful thinking,” said Yi Xianrong, an expert with Chinese Academy of Social Sciences (CASS).


…The saying that “undervalued yuan leads to global trade imbalance” cannot stand up to close scrutiny. Zhao Qingming, a researcher with China Construction Bank stressed that imbalance of an economy’s deposit and investment was the fundamental reason for trade surplus or deficit. Exchange rate has only minor influence.


Paul Krugman said China’s currency policy has a “depressing effect” on economic growth in the U.S., Europe and Japan, as measured by gross domestic product. If China’s currency, the yuan, were not undervalued, it would have a “significant” impact on the global recovery, he said. “If we could get some change in China’s currency policy, it would help the world,” Krugman said today at an Economic Policy Institute event in Washington.


Krugman said the world economy wouldn’t be hurt, and could benefit, if China were to sell off a large portion of its dollar-denominated assets. He said that if China were to sell all of its U.S. investments, it would help the economy by acting as a form of quantitative easing and fighting a “liquidity trap” that has recently been affecting the U.S. economy.


“We should not be afraid of what the Chinese might do if we pressure them to stop this currency manipulation,” Krugman said. At the end of 2009, China was the top foreign investor U.S. government debt, with holdings of $898.4 billion in Treasury securities. Krugman said the U.S. may need to get more aggressive in its negotiations with China, perhaps by treating the exchange- rate issue as a countervailing duty or other export subsidy. “Without a credible threat, we’re not going to get anywhere,” he said. “The chance that we would trigger a trade war is very small and it’s hard to see any alternative.”



Since Paul Krugman is allways wrong we can now try to understand what is really happening.

To stop massive unemployment China will let the Yuan fall

Beijing had allowed the yuan to appreciate in a narrow band against the greenback until the global financial crisis began in 2008, when it informally pegged it at around 6.8 yuan to a dollar. But the United States has called on China’s leaders to unshackle the currency amid bitter complaints in Congress that it was being manipulated.


A classic contrarian indicator, are the remarks of Fubon Bank that said it planned to roll out yuan-denominated insurance products.


“We know there is very hot demand for yuan-denominated products so we started offering them in the second quarter,” said Harrison Ho, Fubon’s head of insurance.



Despite the speculation China has so far held firm, saying it will not bow to pressure from the United States and describing its policy as a domestic matter.


Secretary Geithner’s recent visit to china re-opened some uncomfortable issues about increasing trade frictions in the context of a Chinese currency which most commentators believe to be hugely undervalued and the US authorities believe to be manipulated.



As the 2010 synchronized global downturn intensifies, trade barriers will begin to be erected. Aggressive competitive devaluation and a proliferation of trade barriers would become an increasing prospect in 2010.



world trade crashed in the 1930’s. Politicians reassure us that they have learnt the lessons from that period. Unfortunately, what is evident is more and more protectionist measures being implemented, belying the soothing rhetoric.

The fact that China is heading into trade DEFICIT throughout 2010, has major implications for the global financial markets. First and most obviously is that China is not be accumulating FX reserves at anywhere near its recent pace. This has implications not just for US treasuries etc., but also for the pace of Chinese growth itself, as the rise in reserves has previously been a major stimulus to domestic monetary growth and activity

The western economies (plus Japan) are sliding back into recession as the lack of additional fiscal stimulus reduces 2010 GDP growth back to its weak underlying rate (deficits need to widen to boost the economy). The Chinese economy is beginning to roll over. China's vulnerability is far higher than the bulls suppose, having engaged in the same sort of recession defying stimulus as the US in 2003. The US authorities in no way thought gently tapping the monetary brakes in 2005/6 would end in the biggest economic and market crashes since the Great Depression. The Chinese conjuncture is no different - in particular, the market's confidence that the authorities are in control of events opens the possibility of a rude shock.


Any synchronized end in Chinese and US recovery will undoubtedly heighten geo-political tensions and accelerate the inevitable trend towards protectionism. The trend towards competitive devaluation will also increase. And in the case of China, if its economy founders unexpectedly and unemployment soars, no lever to restore growth should be ruled out, including devaluation. With the the dollar to soaring, in the same way the yen did in 2008, this is too much for a beleaguered Chinese economy. With a Chinese trade deficit and a loss of confidence in the growth miracle, China's reserves will be in decline. What better way of meeting the American’s call for greater flexibility than to give them what they want? The Chinese will respond to the new market pressures and devalue.


A devaluation in the renminbi relative to the dollar will short-circuit all the millions of FX algos that expect a perpetual peg if not outright Chinese currency appreciation.