An American Ultimatum

If the revaluation of the Chinese yuan is a sure thing, as everyone seems to think, buying yuan is a guaranteed way to make money. But is it? Mark Tier explores…

After years of American pressure on China to revalue its currency, the yuan, Congress recently threatened to impose a 27.5% tariff on all Chinese imports within six months if China doesn’t revalue – or float – its currency.

A revaluation would give speculators who’d bought yuan an instant – and guaranteed – profit.

Let me explain. Since 1996, the Chinese yuan has been fixed at a rate of 1 yuan = 12 US cents. If the yuan was revalued it would be worth more … say, 15 cents.

And since this will be a new fixed rate, the government of China would, in effect, be committed to giving 15 cents to each person who’d bought yuan at 12 cents.

Sounds like a good deal for buyers of yuan, right?

Apparently, currency speculators around the world agree: in 2004 $1.2 trillion in "hot money" poured into China, China’s foreign exchange regulator said recently.

Yuan Revaluation: Two Questions Before You Invest in the Yuan

Before you rush in to join the crowd, there are two questions you should have answers to. First, will China revalue the yuan? If so, when, and by how much?

Let’s take the second question first.

The answer to this question is simple: nobody really knows. Say China revalued the yuan by 10% two years from now. That would give you a 5% per annum return on your capital. Not very interesting. (And nor would it satisfy the Americans.)

Of course, it could be more, and it could be sooner. But whatever it turns out to be, the ultimate profit is uncertain.

If there is to be a profit…

A major attraction of buying yuan is the general assumption that there’s no downside risk because there’s only one way that Chinese currency can go: up. But is this true?

To answer that question, imagine you’re president of China’s central bank. You have some choices. You could do nothing. You could revalue the yuan. You could devalue it. Or you could float the currency, so its exchange rate would be set by the free market instead of government fiat.

Looking at the economic data, it’s hard to find anything that would justify a revaluation. For example, according to a Federal Reserve Bank of Cleveland analysis, in the 10 years the yuan has been fixed to the dollar, its real value has actually fallen against the greenback – if only by 2.4%. That implies it’s really worth less than 12 cents.

Secondly, that $1.2 trillion inflow of "hot money" that I mentioned above, when converted into yuan, has caused China’s money supply to explode. It was up 14.4% last year, compared to and increase of just 2.7% in the United States.

What’s more, in the past six months, as Alan Greenspan has tightened the screws, the supply of dollars (using the M1 measure of the money supply) has actually declined.

While Chinese yuan have become more abundant, dollars are actually getting scarcer! You don’t have to be an economist to figure that the dollar should rise in value, and the yuan should fall.

Yuan Revaluation: What to Do in the Face of the Ultimatum?

So, as president of the central bank of China, faced with this American ultimatum, what are you going to do?

Obviously, you can’t devalue the currency. That’s out.

Ideally, you’d probably prefer to do nothing. That’s usually the safest bureaucratic path.

Perhaps you could try and persuade American politicians that their demands are illogical. But logic is a poor tool to use with people who are blinded by their emotions and politics.

You could give in to the American demand, and revalue the yuan by some amount that would satisfy them. Probably in the region of 25%.

The very next day, however, the speculators would all be knocking on your door, wanting to turn the yuan they bought for $1.2 trillion back into dollars at the new, higher rate: you’d have to pay out $1.5 trillion.

The speculators’ $300 billion profit would come straight out of your foreign exchange reserves. Better to let the Americans impose their tariff. After all, that wouldn’t affect Chinese exports to the rest of the world; and you’d keep your foreign exchange reserves intact. (In any case, most Chinese goods would STILL be cheaper than the alternatives – even with the tariff!)

What about letting the yuan float free?

Since most everybody seems to think the yuan is undervalued, there would probably be a rush into the currency, which would send it up.

But very quickly, speculators who are already there will start to take their profits, pushing the yuan back down. That could easily trigger a rush for the exits, sending the yuan into freefall.

Worse, a collapsing yuan could easily expose the serious weaknesses of China’s banking system, sparking an economic crisis the fixed exchange rate was designed to avoid.

Frankly, I have no idea what the president of the central bank of China is going to do – and I’m very thankful that I’m not in his shoes. But I imagine he’ll move Heaven and earth to avoid giving speculators a $300 billion profit.

One thing, though, is clear: as is usually the case in the markets, what seems to be a "sure thing," with a guaranteed profit and no downside risk, in reality has a return somewhere between zero and something, with a very high chance that you could lose a bundle of money.

So unless you’re George Soros, and currency speculation is firmly within your "circle of competence," probably best to leave this one right along. That’s what I’ll be doing.


Mark Tier
for The Daily Reckoning

July 20, 2005

Mark Tier founded and edited (until 1991) the investment newsletter World Money Analyst, and is also the author of Understanding Inflation, The Nature of Market Cycles, and How To Get A Second Passport. His articles have appeared all around the world, in publications varied as Time, Reason and Business Traveler.

In his latest book, Becoming Rich: The Wealth-Building Secrets of the World’s Master Investors Buffett, Icahn, Soros, he outlines the mental habits and strategies these great investors ALL follow.

Seven years ago he adopted them himself, sold all his business interests and now lives solely from the returns on his investments.

We know the price…what we don’t know is the value.

Today’s Daily Express, for example, tells us that 25,000 Iraqi civilians have been killed since the United States and Britain invaded the place. We know the financial price too – more than $100 billion. What we don’t know is what it is worth.

"We are still at war," says George W. Bush. We don’t have any doubt about that, but we don’t what good – or evil – the war really accomplishes.

What we might have mentioned in our easy reference Value Guide yesterday is that the public seems to get carried away from time to time and greatly overprice things. This is true in the markets. It is true in politics too. Wars, in particular, are usually extremely overbought. When men go off to kill someone, people feel it is unpatriotic not to support them. Yet, when the battlefield grows hush and years pass – it is hard to recall what the fever was all about. The price is still there, written in the history books, but the value of it seems to have disappeared.

Of course, that is the whole problem with the deathward-going tribe. Since we all end up in the grave, all that matters is how we get there. So what if 25,000 Iraqis are dead a little sooner than they intended to be? So what if 20 million died in WWI or 2 million in Vietnam? Blood dries quickly, said de Gaulle.

That is true of money, too. The idea is to get it…but you know you can’t take it with you. Once it is gotten, it has to go. Since it has to pass out of your hands, the real issue is how (and how quickly) it goes.

Money – and life – will disappear eventually. The only things left are questions of value. There may be nothing wrong with bringing a man’s life to a close a bit prematurely, but what is the value in doing so for a phony cause? Nor is there any particular shame in getting rid of money by bad investments; but neither is there any glory. Nor is there anything wrong with "wasting" money. Why not? What were you going to do with it? The real question is: what is the value to you? What is it worth to you?

You can’t answer these questions without knowing what you want. The real threat of terrorism, from a military or geo-political standpoint, is insignificant. But if you like the American Empire you will probably like the War Against Terror; it gives the imperium something to do. What is the real value of it? Who knows? At one level, it is just a matter of taste. At another it is a matter of historical necessity; an empire has to figure out a way to exhaust or destroy itself…in order to make room for the next empire. At another level, it is a moral issue. People who kill other people for no apparent reason probably go to Hell. But then…what good would Hell be if no one went there?

Hmmm…we seem to be in danger of derailing this morning. We will turn to our team at The Rude Awakening…


Tom Dyson, reporting from Baltimore:

"There’s an interesting approach to market forecasting that starts with Murphy’s Law. If it can go wrong, it will go wrong, and when it does, it’ll take down the greatest number of people with it…"


Bill Bonner, with more thoughts…

*** "Our baseline outlook for the U.S. economy is one of sustained economic growth and contained inflation pressures," Greenspan told members of the House Financial Services Committee today, in the first of two days of his semiannual testimony on the economy and monetary policy.

We didn’t find any surprises in what could be the last of Big Al’s appearances before Congress…he recommended that the Fed continue to raise interest rates at a "measured" pace.

On housing prices, Greenspan had this to say: "If declines were to occur, they likely would be accompanied by some economic stress, though macroeconomic implications need not be substantial," he said.

Dear reader, you didn’t really expect him to admit to anything more than "froth" in the housing market – did you?

There will be more to come from Greenspan tomorrow…and you know we’ll be on the edge of our collective seats…

*** Our friends in the Far East are beginning to run out of juice…

Heat waves arrived early this throughout China, bringing about power and water shortages across the nation. The State Electricity Dispatch predicts this summer will bring China’s worst energy shortfall in 20 years.

United Press International reports, "962 Beijing-based industrial enterprises had started paid leave this week… Altogether 4,689 businesses will have ‘weeklong summer vacations for their employees’ over the next month.

"The Beijing government issued a document saying affected businesses are allowed to adopt a temporary six-day week schedule to offset shutdowns and ‘catch up with their original production plans’ this fall."

Justice Litle, our resident energy expert, fills us in…

"Last year, over 6,400 factories in China had to shut down because they didn’t have enough electricity to run their machinery.

"Another 10,000 manufacturers had to ration power. Even big-name companies like Sony and Volkswagen had to cut back production in their Chinese plants.

"Demand for electricity is continuing to soar worldwide…in China alone, electricity demand is 150% higher right now than it was when China first started to boom, back in 1980. Worldwide electricity demand is expected to explode by another 85% before the year 2020, faster than demand for any other kind of energy.

"You can’t help but wonder what will happen when the rest of China and India hop onto the power grid."

*** "I’m leaving my husband," said a very attractive friend over dinner last night. "There’s just no value there. Ever since the very beginning, we’ve been at odds. I just have had enough. I can’t take it anymore. I’m 42 years old and I think I should take my chances while I still can. I’m not looking for bliss…I just want some peace."

The dinner conversation surprised us. Maybe that is what put us in a reflective mood.

Always and everywhere – it is values that count. The rest is moonshine.

*** Speaking of which…the Wall Street Journal notices that the great consumer economy may not be as sober as it thought:

"Thanks to rock-bottom interest rates and easy ways to borrow, consumers have been on an all-out spending spree for several years. Now, though, there are signs that the bills may be piling up too high.

"The portion of Americans’ disposable income devoted to paying off debt hit a record high recently, even though interest rates have stayed at record lows. That could put a financial squeeze on many households if and when long-term interest rates finally start to go up."

"…Could put a squeeze on many households?" We will take a wild guess: the coming contraction will grab them by the neck. Many will suffocate.

We wrote four years ago that Alan Greenspan wanted to avoid a Japan-like slump in the worst possible way. Well, he found the worst possible way – the destruction of America’s middle class homeowners.

The Daily Reckoning