Careful what you wish for, China may grant it(ZT)

Jun 22, 2007
AsiaTimes

Careful what you wish for, China may grant it
By Julian Delasantellis

InGreek mythology, one of the most effective methods the gods used topunish impudent and hubristic humans was to grant them their mostfervent desires.

Inevitably, the weak and feckless mortalswould find that getting everything they ever desired would lead totheir total ruination, as befell King Midas when granted the wish tohave everything he touched turn to gold. The implicit lesson to belearned from these stories was that mortals must temper their wishesand desires, lest they suffer the same fate.

Is the administration of US President George W Bush learning the same fate as regards its trading policy with China?

Thebig news currently roiling the financial markets is the rapid rise inyields for long-term government bonds issued by the world's majorindustrial powers. The benchmark US Treasury 10-year note has risen0.85 percentage points in yield, from 4.50% to almost 5.35% (in bondtrader lingo, that's 85 "basis points") from early March to early June,with most of that rise coming since just late May. This represents thehighest level of US 10-year rates since 2002.

Othermajor-traded government debt issuances have risen in yield (and thusfallen in price) along with US notes. After yielding about 1% for thebetter part of a decade, Japanese government bonds have risen more than50 basis points over the same period to yield just under 2% now.British government bonds, called gilts, have risen 70 basis points.

Eurobonds, called "bunds" (from their origins as debt obligations of theGerman Federal Republic, the Bundesrepublik) have also risen more than80 basis points since late winter. There is concern that these interestrate hikes, by raising the price of investment capital, will finallyact to cool down the current white-hot global economy.

In myMarch 6 article Rocking the subprime house of cards, I explained howthe issue of causation, of "why" something happens in the financialmarkets, is frequently hard to answer, especially when analyzingsomething other than individual stocks. This is the case with thecurrent government-debt rout.

When bond-market investors handover their money to buy a government bond they have to hold for anextended period of time, be it one, five, 10 or 30 years, they want tobe confident that inflation will not eat away at the purchasing powerof what they will receive back at the bond's expiration. If they thinkthat might be the case, they will demand higher interest rates ofreturn before forking over their wealth.

However, in thiscase, the standard explanations/conventional wisdom for rising interestrates, a spreading market perception among bond investors that economicgrowth is accelerating, soon to be followed upon by rising inflation,don't seem to have been sufficient to have engendered interest-raterises this high this quick.

US economic growth for theJanuary-May period was a measly 0.6%, the slowest rate since late 2002.As the US economy gets pulled down by the heavy weight of the subprimemortgage crisis (explored in my March 6 article, as well as in my March16 article The subprime dominoes in motion), recent reports are showingthat growth has not merely slowed in the US real-estate sector, it isnow in full-throttle reverse, as some localized real-estate markets areshowing double-digit average price declines from last year.

Theproblems in the real-estate sector, along with the fact that anemicsales reports from many US retailers seem to be indicating that theonce super-avaricious US consumer seems finally to have been banishedfrom the malls by high energy prices, do not seem to portend therapidly accelerating economic growth that could be causing the risinggovernment-bond yields, neither in the United States nor in the othermajor industrial capitalist economies.

The "economic growthcausing rising rates" argument is not confirmed by certain internalmarket indicators, either. There are three major traded instrumentsthat professional traders watch to see if inflationary fears areseeping into the markets. These are the so-called "TIPS spread" (thedifference between standard Treasury bond yields and newer,inflation-indexed TIPS - Treasury Inflation-Protected Securities -bonds), the price of gold, and the levels of various commodity basketindices.

You would expect the prices of all three to beappreciating should inflationary fears be spreading, but, surprisingly,all three have in essence been stable to minimally higher throughoutthe worldwide bond-market rout. Something has been causing the recentrising bond yields, and it has nothing to do with the conventionalwisdom.

It may not seem so now, but in the future, George WBush will probably go down foremost in history as the US president whosat by with his cowboy boots up on the table (as he shoveled what willprobably turn out to be the better part of a trillion dollars into thebloody furnace called Iraq) as world economic dominance passed from theUS to China.

At first, the corporate elite class that put itsman in the White House probably thought the rise in Chinese economicpower was at least serendipitous, since its main cause, USmanufacturers offshoring production to China, was putting intensepressure on wages; this is a central factor in the fact that aproportion of US national income going to owners of capital (businessand stock owners), as against labor, has now skewed dramatically infavor of capital.

No one saw it at the time, but a centralmanifestation of the freedom revolution that spread across the worldupon the fall of the Berlin Wall in 1989 was that First World employerswere now free to put their employees in an employment pool to competefor their jobs with about a billion other employees from nations withmuch lower standards of living, especially China and India. Wages mightbe being pressured downward, but on the other side of the seesaw,profits were soaring.

As economists Lawrence Mishel and JaredBernstein of the Economic Policy Institute put it, "Over prior businesscycles, profits (including interest income) have accounted for 23% ofthe growth in corporate-sector income, on average, with totalcompensation accounting for the remaining 77%. In the current businesscycle, the distribution is almost reversed: profits have claimed nearly70% of total growth in the corporate sector, while increases incompensation (from increased employment and higher hourly compensation)have received just over 30% of total income growth."

This isthe dynamic that has fueled China's explosive recent economic progress,with first-quarter year-over-year economic growth a more than healthy(in fact, a rather inflationary) world-leading 11.1% rise in grossdomestic product. The GDP growth rate has been in double-digitterritory since early 2005; figures for industrial production growth,currently at 18.1% year over year, also lead the world. This growth isfar and away export-led; Chinese internal consumption, while growingsteadily, is a very small part of the story of the Chinese economicmiracle. In May, China reported a $22.5 billion trade surplus, up 73%from the previous year. More than half of that trading surplus is withthe United States.

Naturally, this has resulted in atremendous shift of wealth from the US to China. Chinese economicofficials would not allow this tremendous surge of First World wealthto be loosed upon a Third World economy, with the limited domesticconsumption opportunities of the Third World. It was feared, probablycorrectly, that this tremendous wave of cash hitting the underdevelopedmarkets for domestically traded goods would cause a dramatic spike ininflation.

Therefore, the Chinese have decided to let most oftheir export proceeds rest comfortably as reserves, currently at aworld-topping $1.2 trillion (growing at a rate of a billion dollars aday), at the central People's Bank of China.

When, as WorldWar II drew to a close, it became obvious that a new internationalfinancial architecture would be needed to fund the postwar world,allied financial chiefs gathered at Bretton Woods, New Hampshire, tohammer out what became known as the Bretton Woods accords.

Thesereplaced the gold-centered prewar international financial structurewith fixed exchange rates focused around the US dollar. When thissystem collapsed in the early 1970s, it led to the introduction of thecurrent system of variable, market-derived exchange rates. In thissystem, the currencies of countries that run large trade surpluses,such as the China, were supposed to appreciate in value, thus making itcheaper for their citizens to purchase imports; countries that ran bigtrade deficits, such as the US, would see their currencies fall invalue so that, eventually, they would not be able to afford so manyimports.

Like the water levels in the opened locks of a canal,eventually, the system intended that the countries with trade surplusesand deficits would see their numbers equalize, and the system wouldeventually balance itself without any government intervention.

Thishas not happened with the Chinese/US trading relationship of thisdecade. The Chinese currency, the yuan, does not "float" in value, asdo such currencies as the euro or pound. For many years it was fixed ata rate of about 8 yuan to the dollar (meaning that each individual yuanwas worth 12.5 cents). Over the past year or so, it has been allowed torise to 7.62 yuan per dollar, meaning that each individual yuan hasgone up all the way to be now worth 13.1 US cents.

This meageryuan appreciation is not nearly enough to reverse Chinese tradesurpluses, which are still growing. Instead, a new internationalfinancial architecture seems to have developed, one that economistsNouriel Roubini and Brad Setser, on their weblog RGE Monitor, callBretton Woods 2.

Here's how Bretton Woods 2 works. China (orthe other, lesser players in this game, Japan, Taiwan and South Korea)does not sell its export-earned dollars. Rather, it banks them. Withoutthis excess selling pressure, the dollar does not fall in value againstthe yuan; it remains stable, which allows American consumers tocontinue their monthly billion-dollar overseas spending spree. Chinesefactories keep humming, employment is strong, the Chinese people arefar too content buying new stuff to come out to protest again atTiananmen Square, and China's Communist Party rulers are very happyabout that.

This is much like what happened with the billionsof petrodollars that were raised by oil-exporting countries after theoil-price rises of the 1970s. The billions of dollars of China'scurrent export earnings get sent back to the US, mostly to be investedin Treasury securities. This keeps dollar interest rates, includingmortgage rates, lower than they would have been, and this keeps the USeconomy humming and the consumer, still fat, dumb and happy, flush withcash and plastic to keep the cycle going for at least one more round.

Butno human agency or endeavor lasts forever. The internal contradictionsof Bretton Woods 1 caused it to fall, and the same seems to behappening with Bretton Woods 2. Specifically, what if China doesn'twant 1.2 trillion in US dollar reserves?

Bretton Woods 2greatly benefited Bush administration officials, by both pressuringwage rates to help out their business buddies and spurring the economicgrowth that got them re-elected in 2004. Still, it is somewhatembarrassing to be the president of the nation with the most massivetrade deficits in history. Like spoiled rich kids since timeimmemorial, the Bush administration is blaming somebody else.

Theadministration, along with its mouthpieces in the corporateconservative media machine, is arguing that, even with a huge budgetdeficit and virtually non-existent national savings, the trade deficitis not America's fault. It's not that the US is spending too much andsaving too little, it's that the surplus countries, especially China,are saving too much and spending too little.

Thisinterpretation of savings as bad is certainly new in the working theoryof capitalist economies; in classical economics, savings are a verygood thing, since the market can direct them to future investments thatwill maintain economic growth. A rough parallel would be an inebriateclaiming that he doesn't have a problem, it's the rest of the worldthat suffers from inadequate alcohol consumption syndrome.

Butin business, the customer is right even when he's not, and the UnitedStates is now far and away China's biggest customer. For example, it isnow estimated that up to 70% of Wal-Mart's inventory is of Chineseorigin; a remarkable turnaround for a company that until this decadebroadcast advertisements that trumpeted the red, white and blueall-American manufacture of its products. Wal-Mart's current trade withChina alone, estimated at more than $25 billion a year, surpasses theGDP of the smallest 112 national economies of the world.

Inletting the yuan appreciate, although maddeningly slowly, China isresponding to demands for action from US officials, especially inCongress. Another demand is that China stop just letting its huge stashof foreign-currency reserves sit around earning interest. They shouldgo out and buy American stuff, preferably goods and services, so thatthe trade balance can start to equalize.

But as the Greek gods warned, be very careful what you wish for.

Inmy July 6, 2006, article Hedge funds: Playing dice with the universe, Iexplained how hedge funds, very lightly regulated pools of privatecapital used as high-octane investment vehicles to the world'ssupranational moneyed elite, were having more and more impact on eventsin the world's financial markets. I postulated that hedge funds actingin unison may have been a prime cause of the May 2006 cross-borderequity-market meltdown. It was estimated then that, collectively, thethousands of the world's hedge funds had more than $1 trillion inassets under management.

That's just about what the singlepersonage of Zhou Xiaochuan, the governor of the People's Bank ofChina, has at his disposal for investment from foreign-exchangereserves.

Last year, the big chatter in the world's financialmarkets was over the growing power of hedge funds, and how their hugeconcentrated financial resources had the possibility of dwarfing any orall governments' ability to regulate national markets. This year, a newspecter haunts the markets, one whose potential impact on markets farexceeds the puny $1 trillion-plus that the hedge funds have at theirdisposal.

They're called sovereign wealth funds (SWFs).Basically, it seems that many of the countries that lately haveaccumulated huge foreign-exchange reserves exporting to the UnitedStates are getting bored with just having their money sit aroundearning interest at US Treasury rates. China and the other bigexporters, which until recently were seemingly happy at lending back tothe US the dollars to continue to buy their stuff, now see the need toearn greater rates of return than the 5% that US Treasuries currentlyearn.

Many of them are facing demographic time-bombsconsisting of their growing elderly populations needing eventualpension support, and, for all the glamour and glitz of today'sShanghai, going beyond China's big cities still reveals grinding ruralpoverty that the central government knows it must address.

SWFswill act as super-hedge funds, in that they will look for opportunitiesall across the investment spectrum. China is in the process of settingup its own SWF, which reportedly will be funded with some $300 billionof reserves.

And that's $300 billion that will not make its way into the market for Treasury securities.

Inmy March 24, 2006, article US living on borrowed time - and money, Iintroduced readers to the US Treasury's monthly TIC (TreasuryInternational Capital) report, the data that enumerate just how muchforeign capital the US is importing every month to finance itsextravagant lifestyle. During much of 2005, the US was net-importingmore than $100 billion of investment capital every month, but thebottom line net number is falling sharply; last December, the USactually failed to attract any capital at all.

One TIC dataset of particular interest to bond players is just how great theinvestment in US government securities by foreign governments is eachmonth. These numbers are the core of the flows that constitute BrettonWoods 2, for they derive mostly from US dollar reserves held at foreigncentral banks.

They've been falling, too. From averaging morethan $6 billion a month in 2006, foreign government purchases of USTreasury have fallen to average just over $1 billion a month for thefirst four months of 2007.

It is of course far fromcoincidental that, when US Treasury 10-year notes were at their lows inyield, in mid-2005, TIC data were showing foreign flows into Treasuriesat their highest. The central reality of the bond market is that theyield of bonds traded in it go down as more people buy them; moreimportant for the current moment, yields go up as fewer people buythem.

If China has sharply curtailed its US Treasurypurchases, unless other buyers step up to the plate, then Treasurysecurities prices have nowhere to go but down, and yields have nowhereto go but up - just as they have recently.

The US Treasurywill not release May TIC data until mid-July, but there are indicationsthat suggest that is precisely what is happening here. A recentTreasury auction of new 10-year notes had the lowest rate of foreigngovernment purchase participation in years. On some financial traderblogs it is being noticed that, on many days during the current marketrout, the US Treasury market has opened, at 8:20am New York Time (whenthe Treasury futures markets open in Chicago), with large orderimbalances to the sell side.

The speculation here is that thisresults from Chinese sellers putting in big sell orders before theyretire for the night (Shanghai time is 12 hours ahead of New York) sothey can see whether, or how significantly, their orders moved themarket.

Of particular significance to the future is theconnection between SWFs and interest rates. On May 21, China'sstill-nascent SWF announced its first prospective investment; it wasgoing to take a $3 billion stake in the upcoming initial publicoffering of the Blackstone Group, the huge US private equity buyoutfirm (I wrote about the current mania for private equity in my February22 article The highs and lows of buyouts). It was after thatannouncement that the fiercest selling befell the world's Treasurymarkets, as if traders suddenly realized that the long-feared prospectof Asian central banks abandoning bonds for other investments wasfinally coming true.

World equity markets stuttered a bit inthe face of the world bond selloff, but they soon recovered theirfooting and are once again moving up. That should not be surprising; ifSWFs are about to pounce on the world's stock markets, that will beunquestionably good news for share prices.

But will it be toomuch of a good thing? Even with buying support from SWFs, can worldstock markets appreciate much further in the face of rising bondyields? Or would continued equity-market appreciation in the face ofrising bond yields be prima facie evidence of what Alan Greenspan oncecalled irrational exuberance? Right now the only world stock marketthat Chinese prosperity is supporting is the Shanghai Stock ExchangeA-share exchange.

That market has tripled in 14 months, andacademic economists the world over are frightened that when thisspeculative bubble finally bursts, as all speculative bubbles mustinevitably do, it will take the world's economy with it. Specifically,with so many ordinary Chinese citizens playing the Shanghai market likea never-losing roulette wheel, will the Chinese government feelthreatened by the rapid destruction of domestic wealth that a burststock market would cause? Will they try to support the shares withreserves, either from the People's Bank of China or from its SWF? Whatwill that do to the investments in the West that the reserves had beensupporting?

A more frightening prospect is if non-China stockmarkets start acting like Shanghai - if SWF money starts supporting or,more likely, deluging them. Trading volumes in Shanghai are still smallenough, compared with Western equity markets, that the Chinesegovernment probably could backstop a Shanghai crash, but if the world'sother stock markets, supported by Asian SWF money, start replicatingShanghai's parabolic, meteoric rise, then all the reserves, tea, oranything else in China will not be sufficient to support them whentheir towers finally topple.

This decade's boom started in China. Will it end there too?

Willthe economic historians of the future, when tracking back to ascertainthe cause of the world crash of 2007, find that the dominoes were putin motion when George W Bush started urging the Chinese to buy moreAmerican stuff, and the Chinese responded with purchases of UScompanies and stocks?

Like the Sorcerer's Apprentice oflegend, perhaps it would have been better if, while anbusiness-administration graduate student at Harvard in the early 1970s,the future president would have actually read the instructions on howto run the world economy.