Volume 2 No 20 18 June 2007 JOHN MAULDIN’S THOUGHTS FROM THE FRONTLINE BE CAREFUL WHAT YOU WISH FOR In this week's Thoughts from the Frontline our partner, John Mauldin, asks whether we really want China to float the yuan. Although there are advantages to China having the yuan pegged to the dollar, a revaluing might bring previously unforeseen negatives to the fore. He then takes a brief look at the latest US inflation data released. Enjoy the read. Be careful for what you wish, because you may get it, and sometimes as H. L. Mencken wrote, you get it good and hard. The collective brain deficit trust, otherwise known as the US Congress, wish for the Chinese to revalue their currency upwards. Today we look at why they may indeed get their wish and why it is not going to produce their desired results. We look at a possible connection between China and the recent and odd volatility in interest rates, connect the dots on inflation and the US economy. How do you explain higher interest rates on government bonds and a slowing economy, but a relentless march to Dow 14,000? It is a lot to cover, so let's jump right in. Last year, Senators Charles Schumer (D-NY) and Lindsey Graham (R- SC) introduced a bill which would put a 27.5% tariff on Chinese imports. There was not much chance of the bill passing, and given that such a tariff was illegal under World Trade Organization rules, it was clear the Senators were pandering to their various local constituencies. Not that they are not serious about punishing China for have the audacity to sell us cheap goods, while taking our dollars and investing them into US government debt, but their bill was mostly for show. Be Careful What You Wish For I wrote at the time that the Chinese would only revalue their currency when they were ready and not one day before. Bluffs and threats from the US Congress do nothing, as the Chinese will do what they want when they want. This week, however, a more serious bill was introduced, which would require the US Treasury to coordinate with the Federal Reserve and intervene in currency markets when the exchange rates of other countries have become distorted. The bill would send exchange rates disputes to the World Trade Organization by treating them as unfair export subsidies and includes a range of sanctions. This bill has more substance as it actually might work within the rules. And unfortunately, it seems to have widespread bi-partisan support, although it is doubtful that President Bush would sign such a measure. And in two years, the question may be moot, as we shall see. China may decide for reasons of their own that it is time to allow the Yuan to rise at a faster pace. And the unintended consequences of that rise may give us at least as many problems as a clearly under-valued currency. Let's set some background. Let's review some interesting data from this month's Far Eastern Economic Review written by Michael Pettis. (www.feer.com) China saw an astounding rise in their reserves in the first quarter of $136 billion to a total of $1.2 trillion. For sake of comparison, China's reserve increase in all of 2003 was "only" $117 billion. They grew $247 billion in 2006. Reserve growth is clearly out of control, and with it the growth of the money supply. And as we know, if the money supply grows to fast, it can bring an unwelcome round of inflation. And inflation can bring about an instability which the Chinese government definitely does not want. Where does such growth come from? Part of it a rising trade surplus of $46 billion, which almost exactly doubled from last year during the same quarter. Foreigners invested another $16 billion. Growth in the portfolio and currency appreciation (mainly in the euro) adds another $15 billion. That still leaves $60 billion. Chinese authorities commented that some of this comes from the unwinding of swaps between the central bank and Chinese commercial lenders, some of it from foreign IPOs with the money coming back into China. But that number is just staggeringly large by any standards. Last year the total Chinese trade surplus was $178 billion, and Chinese economists expect that to rise by 43% to over $250 billion. That is an astounding number. But there may be more to that story. Simon Hunt writes that some of the trade "surplus" may actually be a way to get around currency controls, as it is difficult to get money into the country as China is desperately trying to keep a lid on investment and speculation. Let's say you are a businessman in Country A with manufacturing and assembly plants in China. If your Chinese subsidiary underpays for the materials imported into China needed to make your products and then overcharges for what is exported, you now have "excess" profits and therefore currency in China. You can take that money and invest it in the Chinese stock market, which is up almost 400% in the past two years, and 200% in the last year. That fact has not gotten lost on the locals, who are withdrawing money from their banks accounts and opening brokerage accounts at prodigious rates. Bank deposits are actually down. P/E ratios are now well over 40. The Chinese market is clearly a bubble, but that doesn't mean the party won't last for some time. The Chinese economy is on target to grow at 11% real. This clearly has the leaders of the country worried. Premier Wen Jiaboa said at a National People's Congress in March of this year that the economy is "unstable, unbalanced, uncoordinated and unsustainable." Can you imagine what would happen if President Bush or any leader of a western country said such a thing? How did China get to such a place? Let's review. The Chinese pegged their currency to the dollar in the mid90's, and after the Asian crisis in 1997-98 the concern among many economists was that the Yuan was heavily overvalued. That has obviously changed. Is It Time for the Yuan to Rise? Even though China has allowed the currency to rise against the dollar in the past few years, in trade weighted terms, the Yuan has actually fallen by about 10% since 2001 on the back of the fall in the dollar. China has become even more competitive. And that competitiveness is fueling its growth. Let's look at a chart and some quotes from one of my favorite sources, Bank Credit Analyst. This undervaluation "has fueled China's economic boom: China's exports have shot up massively, its current account has exploded upwards and its official reserve accumulation has sky-rocketed. Chinese manufacturers, aided by a super-competitive currency, have rapidly gained market share around the world. Chinese exports as a share of global trade was less than 3% in 1997. Today' it is close to 9%." (Bank Credit Analyst) Plexus. Independent Insight in an Uncertain World. Tel: +27 (0) 21 970 2400 • Fax: +27 (0) 21 975 2248 • E-mail: firstname.lastname@example.org • Web: http://www.plexus.co.za DISCLAIMER This e-mail transmission contains confidential information that is the property of the sender and which is legally privileged. The information is intended only for the use of the addressee. If you are not the intended recipient, you are hereby notified that any disclosure, copying or distribution of the contents of this e-mail transmission, or the taking of any action in reliance thereon or pursuant thereto, is strictly prohibited. Should you have received this e-mail in error, please notify us immediately by telephone to arrange for the return of the documents comprising this transmission. In no event will Plexus Mauldin Alternative Investments (Pty) Limited, Plexus Asset Management (Pty) Limited or the sender of this e-mail be liable to any party for any direct, indirect, special or other consequential damages for any use of this e-mail, or on any other hyper-linked web site, including, without limitation, any lost profits, business interruption, loss of programs or other data on your information handling system or otherwise, even if we are expressly advised of the possibility of such damages.