Careful what you wish for, China may grant it



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

In Greek mythology, one of the most effective methods the gods used to punish
impudent and hubristic humans was to grant them their most fervent desires.

Inevitably, the weak and feckless mortals would find that getting everything
they ever desired would lead to their total ruination, as befell King Midas when
granted the wish to have everything he touched turn to gold. The implicit lesson
to be learned from these



stories was that mortals must temper their wishes and 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?

The big news currently roiling the financial markets is the rapid rise in yields
for long-term government bonds issued by the world's major industrial powers.
The benchmark US Treasury 10-year note has risen 0.85 percentage points in
yield, from 4.50% to almost 5.35% (in bond trader lingo, that's 85 "basis
points") from early March to early June, with most of that rise coming since
just late May. This represents the highest level of US 10-year rates since 2002.
Other major-traded government debt issuances have risen in yield (and thus
fallen in price) along with US notes. After yielding about 1% for the better
part of a decade, Japanese government bonds have risen more than 50 basis points
over the same period to yield just under 2% now. British government bonds,
called gilts, have risen 70 basis points.

Euro bonds, called "bunds" (from their origins as debt obligations of the German
Federal Republic, the Bundesrepublik) have also risen more than 80 basis points
since late winter. There is concern that these interest rate hikes, by raising
the price of investment capital, will finally act to cool down the current
white-hot global economy.

In my March 6 article Rocking the subprime house of cards, I explained how the
issue of causation, of "why" something happens in the financial markets, is
frequently hard to answer, especially when analyzing something other than
individual stocks. This is the case with the current government-debt rout.

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

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

US economic growth for the January-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 subprime mortgage crisis (explored in my March 6 article, as well as in my
March 16 article The subprime dominoes in motion), recent reports are showing
that growth has not merely slowed in the US real-estate sector, it is now in
full-throttle reverse, as some localized real-estate markets are showing
double-digit average price declines from last year.

The problems in the real-estate sector, along with the fact that anemic sales
reports from many US retailers seem to be indicating that the once
super-avaricious US consumer seems finally to have been banished from the malls
by high energy prices, do not seem to portend the rapidly accelerating economic
growth that could be causing the rising government-bond yields, neither in the
United States nor in the other major industrial capitalist economies.

The "economic growth causing rising rates" argument is not confirmed by certain
internal market indicators, either. There are three major traded instruments
that professional traders watch to see if inflationary fears are seeping into
the markets. These are the so-called "TIPS spread" (the difference 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 basket indices.

You would expect the prices of all three to be appreciating should inflationary
fears be spreading, but, surprisingly, all three have in essence been stable to
minimally higher throughout the worldwide bond-market rout. Something has been
causing the recent rising bond yields, and it has nothing to do with the
conventional wisdom.

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

At first, the corporate elite class that put its man in the White House probably
thought the rise in Chinese economic power was at least serendipitous, since its
main cause, US manufacturers offshoring production to China, was putting intense
pressure on wages; this is a central factor in the fact that a proportion of US
national income going to owners of capital (business and stock owners), as
against labor, has now skewed dramatically in favor of capital.

No one saw it at the time, but a central manifestation of the freedom revolution
that spread across the world upon the fall of the Berlin Wall in 1989 was that
First World employers were now free to put their employees in an employment pool
to compete for their jobs with about a billion other employees from nations with
much lower standards of living, especially China and India. Wages might be being
pressured downward, but on the other side of the seesaw, profits were soaring.

As economists Lawrence Mishel and Jared Bernstein of the Economic Policy
Institute put it, "Over prior business cycles, profits (including interest
income) have accounted for 23% of the growth in corporate-sector income, on
average, with total compensation accounting for the remaining 77%. In the
current business cycle, the distribution is almost reversed: profits have
claimed nearly 70% of total growth in the corporate sector, while increases in
compensation (from increased employment and higher hourly compensation) have
received just over 30% of total income growth."

This is the 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 gross domestic product. The
GDP growth rate has been in double-digit territory since early 2005; figures for
industrial production growth, currently at 18.1% year over year, also lead the
world. This growth is far and away export-led; Chinese internal consumption,
while growing steadily, is a very small part of the story of the Chinese
economic miracle. In May, China reported a $22.5 billion trade surplus, up 73%
from the previous year. More than half of that trading surplus is with the
United States.

Naturally, this has resulted in a tremendous shift of wealth from the US to
China. Chinese economic officials would not allow this tremendous surge of First
World wealth to be loosed upon a Third World economy, with the limited domestic
consumption opportunities of the Third World. It was feared, probably correctly,
that this tremendous wave of cash hitting the underdeveloped

markets for domestically traded goods would cause a dramatic spike in inflation.
Therefore, the Chinese have decided to let most of their export proceeds rest
comfortably as reserves, currently at a world-topping $1.2 trillion (growing at
a rate of a billion dollars a day), at the central People's Bank of China.

When, as World War II drew to a close, it became obvious that a new
international financial architecture would be needed to fund



the postwar world, allied financial chiefs gathered at Bretton Woods, New
Hampshire, to hammer out what became known as the Bretton Woods accords.

These replaced the gold-centered prewar international financial structure with
fixed exchange rates focused around the US dollar. When this system collapsed in
the early 1970s, it led to the introduction of the current system of variable,
market-derived exchange rates. In this system, the currencies of countries that
run large trade surpluses, such as the China, were supposed to appreciate in
value, thus making it cheaper for their citizens to purchase imports; countries
that ran big trade deficits, such as the US, would see their currencies fall in
value so that, eventually, they would not be able to afford so many imports.

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

This has not happened with the Chinese/US trading relationship of this decade.
The Chinese currency, the yuan, does not "float" in value, as do such currencies
as the euro or pound. For many years it was fixed at a rate of about 8 yuan to
the dollar (meaning that each individual yuan was worth 12.5 cents). Over the
past year or so, it has been allowed to rise to 7.62 yuan per dollar, meaning
that each individual yuan has gone up all the way to be now worth 13.1 US cents.
This meager yuan appreciation is not nearly enough to reverse Chinese trade
surpluses, which are still growing. Instead, a new international financial
architecture seems to have developed, one that economists Nouriel Roubini and
Brad Setser, on their weblog RGE Monitor, call Bretton Woods 2.

Here's how Bretton Woods 2 works. China (or the other, lesser players in this
game, Japan, Taiwan and South Korea) does not sell its export-earned dollars.
Rather, it banks them. Without this excess selling pressure, the dollar does not
fall in value against the yuan; it remains stable, which allows American
consumers to continue their monthly billion-dollar overseas spending spree.
Chinese factories keep humming, employment is strong, the Chinese people are far
too content buying new stuff to come out to protest again at Tiananmen Square,
and China's Communist Party rulers are very happy about that.

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

But no human agency or endeavor lasts forever. The internal contradictions of
Bretton Woods 1 caused it to fall, and the same seems to be happening with
Bretton Woods 2. Specifically, what if China doesn't want 1.2 trillion in US
dollar reserves?

Bretton Woods 2 greatly benefited Bush administration officials, by both
pressuring wage rates to help out their business buddies and spurring the
economic growth that got them re-elected in 2004. Still, it is somewhat
embarrassing to be the president of the nation with the most massive trade
deficits in history. Like spoiled rich kids since time immemorial, the Bush
administration is blaming somebody else.

The administration, along with its mouthpieces in the corporate conservative
media machine, is arguing that, even with a huge budget deficit and virtually
non-existent national savings, the trade deficit is not America's fault. It's
not that the US is spending too much and saving too little, it's that the
surplus countries, especially China, are saving too much and spending too
little.

This interpretation of savings as bad is certainly new in the working theory of
capitalist economies; in classical economics, savings are a very good thing,
since the market can direct them to future investments that will maintain
economic growth. A rough parallel would be an inebriate claiming that he doesn't
have a problem, it's the rest of the world that suffers from inadequate alcohol
consumption syndrome.

But in business, the customer is right even when he's not, and the United States
is now far and away China's biggest customer. For example, it is now estimated
that up to 70% of Wal-Mart's inventory is of Chinese origin; a remarkable
turnaround for a company that until this decade broadcast advertisements that
trumpeted the red, white and blue all-American manufacture of its products.
Wal-Mart's current trade with China alone, estimated at more than $25 billion a
year, surpasses the GDP of the smallest 112 national economies of the world.

In letting the yuan appreciate, although maddeningly slowly, China is responding
to demands for action from US officials, especially in Congress. Another demand
is that China stop just letting its huge stash of foreign-currency reserves sit
around earning interest. They should go out and buy American stuff, preferably
goods and services, so that the trade balance can start to equalize.

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

In my July 6, 2006, article Hedge funds: Playing dice with the universe, I
explained how hedge funds, very lightly regulated pools of private capital used
as high-octane investment vehicles to the world's supranational moneyed elite,
were having more and more impact on events in the world's financial markets. I
postulated that hedge funds acting in unison may have been a prime cause of the
May 2006 cross-border equity-market meltdown. It was estimated then that,
collectively, the thousands of the world's hedge funds had more than $1 trillion
in assets under management.

That's just about what the single personage of Zhou Xiaochuan, the governor of
the People's Bank of China, has at his disposal for investment from
foreign-exchange reserves.

Last year, the big chatter in the world's financial markets was over the growing
power of hedge funds, and how their huge concentrated financial resources had
the possibility of dwarfing any or all governments' ability to regulate national
markets. This year, a new specter haunts the markets, one whose potential impact
on markets far exceeds the puny $1 trillion-plus that the hedge funds have at
their disposal.

They're called sovereign wealth funds (SWFs). Basically, it seems that many of
the countries that lately have accumulated huge foreign-exchange reserves
exporting to the United States are getting bored with just having their money
sit around earning interest at US Treasury rates. China and the other big
exporters, which until recently were seemingly happy at lending back to the US
the dollars to continue to buy their stuff, now see the need to earn greater
rates of return than the 5% that US Treasuries currently earn.

Many of them are facing demographic time-bombs consisting of their growing
elderly populations needing eventual pension support, and, for all the glamour
and glitz of today's Shanghai, going beyond China's big cities still reveals
grinding rural poverty that the central government knows it must address.

SWFs will act as super-hedge funds, in that they will look for opportunities all
across the investment spectrum. China is in the
process of setting up its own SWF, which reportedly will be funded with some
$300 billion of reserves.

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

In my March 24, 2006, article US living on borrowed time - and money, I
introduced readers to the US Treasury's monthly TIC (Treasury International
Capital) report, the data that enumerate



just how much foreign capital the US is importing every month to finance its
extravagant lifestyle. During much of 2005, the US was net-importing more than
$100 billion of investment capital every month, but the bottom line net number
is falling sharply; last December, the US actually failed to attract any capital
at all.

One TIC data set of particular interest to bond players is just how great the
investment in US government securities by foreign governments is each month.
These numbers are the core of the flows that constitute Bretton Woods 2, for
they derive mostly from US dollar reserves held at foreign central banks.

They've been falling, too. From averaging more than $6 billion a month in 2006,
foreign government purchases of US Treasury have fallen to average just over $1
billion a month for the first four months of 2007.

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

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

The US Treasury will not release May TIC data until mid-July, but there are
indications that suggest that is precisely what is happening here. A recent
Treasury auction of new 10-year notes had the lowest rate of foreign government
purchase participation in years. On some financial trader blogs it is being
noticed that, on many days during the current market rout, the US Treasury
market has opened, at 8:20am New York Time (when the Treasury futures markets
open in Chicago), with large order imbalances to the sell side.

The speculation here is that this results from Chinese sellers putting in big
sell orders before they retire for the night (Shanghai time is 12 hours ahead of
New York) so they can see whether, or how significantly, their orders moved the
market.

Of particular significance to the future is the connection between SWFs and
interest rates. On May 21, China's still-nascent SWF announced its first
prospective investment; it was going to take a $3 billion stake in the upcoming
initial public offering of the Blackstone Group, the huge US private equity
buyout firm (I wrote about the current mania for private equity in my February
22 article The highs and lows of buyouts). It was after that announcement that
the fiercest selling befell the world's Treasury markets, as if traders suddenly
realized that the long-feared prospect of Asian central banks abandoning bonds
for other investments was finally coming true.

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

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

That market has tripled in 14 months, and academic economists the world over are
frightened that when this speculative bubble finally bursts, as all speculative
bubbles must inevitably do, it will take the world's economy with it.
Specifically, with so many ordinary Chinese citizens playing the Shanghai market
like a never-losing roulette wheel, will the Chinese government feel threatened
by the rapid destruction of domestic wealth that a burst stock market would
cause? Will they try to support the shares with reserves, either from the
People's Bank of China or from its SWF? What will that do to the investments in
the West that the reserves had been supporting?

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

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

Will the economic historians of the future, when tracking back to ascertain the
cause of the world crash of 2007, find that the dominoes were put in motion when
George W Bush started urging the Chinese to buy more American stuff, and the
Chinese responded with purchases of US companies and stocks?

Like the Sorcerer's Apprentice of legend, perhaps it would have been better if,
while an business-administration graduate student at Harvard in the early 1970s,
the future president would have actually read the instructions on how to run the
world economy.

Julian Delasantellis is a management consultant, private investor and educator
in international business in the US state of Washington. He can be reached at
juliandelasantellis@xxxxxxxxxx


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