Devaluation and a Chinese Warning Shot

Devaluation has begun. Two weeks ago the Federal Reserve announced its intentions to start “quantitative easing.” Quantitative easing is the “new” term given by officials to printing money. We know it as inflating the money supply. It is also called “increasing liquidity.” Essentially, the government will create money and distribute it through various channels. Then it will watch the effects as it funnels down through the economy.

This is a government’s last resort when it can no longer ease monetary policy by lowering interest rates. And with an official rate of 0%-.25%, there is really no room for the Fed to go lower. In fact, the Fed seems to have an inherent dislike of saying our official rate IS actually 0%. So they keep this charade of a rate “range” in place for a little window dressing… and quickly turn to quantitative easing.

By pouring money directly into the economy, effective rates are supposedly made lower, money is made cheaper and everybody has more of it. That, of course, makes people feel wealthier (whether they are or not), so they spend more money. This creates more sales. More sales create more jobs. More jobs create bigger companies. Bigger companies create bigger profits. Bigger profits make companies less nervous about taking out corporate loans. Corporate loans helps companies expand.

Expansion makes Wall Street think the company will have bigger future profits.  Wall Street’s hopes drive up the company’s stock price, and their bond rating. This helps the company borrow more money at an even better rate, and the expansion cycle continues.

But all of this is contingent on the cheap price of money.

You may have heard the term “cheap money” before. And it’s not easy to wrap your head around the concept. After all, isn’t a dollar always a dollar? Not exactly…

Whether money is “cheap” or “expensive” depends on what it costs to borrow money. When interest rates are high, the cost to borrow is high — and money is said to be expensive. When rates are low, the cost to borrow is low — so money is said to be cheap.

Common monetary theory says that cheap money jumpstarts an economy. People feel like they have more money, so the cycle gets going, just in the way I described earlier.

However, there is a hidden cost to cheap money — and it’s called inflation. When a government pumps too much money into the economy, it will overheat. More money chasing the same amount of products raises prices.

Now, to the first recipients of this new money, it doesn’t matter. When the money first enters the system, prices have not adjusted upward yet. So people have new purchasing power without price increases.

The last people who receive the money (after it trickles down) are the worst off. They have seen prices rise already, but by the time the new money gets to them, it has less purchasing power. So you have some pretty angry folks.

Then a day eventually comes when the government has to turn off the money faucet. Prices continue to rise, but everybody has less cash to buy things with. The masses begin complaining and wanting the government to “do something.”

So the government starts raising rates, and everybody complains some more. But by that time, the pinch is on, and the yeast has started working its way through the bread. It is much easier started than stopped, and everybody hurts until it does. There are no winners in inflationary periods. There are only people who lose less than others because they were better prepared.

The Fed’s quantitative easing will try to lower the cost of money by pushing it through the economy. The question is, how much is too much? At what point do people stop feeling wealthy and only feel the squeeze of higher prices?

The whole circus is beginning to happen now. When the Fed announced its plans, traders, investors, institutions and governments around the world began selling off the dollar. Hard. It fell 6.3% in 24 hours against the euro. Every major currency appreciated against the U.S. dollar. Simply put, traders were saying that the Fed’s actions made the dollar worth less.

But two big concerns remain. First, why did the Fed decide to take this action? As I said, this is usually a tactic of last resort… so what piece of news or indicator mandated this huge policy change?

Perhaps more importantly, how much longer will the Fed take this course? The monetizing (inflating) of trillions of dollars in debt calls into question the safe-haven status of the U.S. currency. Devaluing makes it seem less like a stable reserve currency and a lot more vulnerable.

On a broader view, the European Central Bank may attempt to do the same. They have publicly stated they are nearly at the end of their rate adjustments, although their rate is currently more than a full point higher than the United States. Honestly, it is questionable whether the European Union can perform a Quantitative Easing operation across all 16 member countries. It would be technically difficult to pull off… and next to impossible politically.

But if they do attempt quantitative easing, it will mute the Fed’s actions, blowing through trillions of dollars more with little or nothing to show for it.

So to sum up, if the ECB does not inflate, the dollar looks very bad going forward. If they do, the prospects for an inflationary “recovery” for the United States are slim to none. And slim just left town…
And now we have to add in another piece of the puzzle…the People’s Republic of China.

Red Storm Rising

China has been attempting to flex its newfound economic muscle. Chinese Premier Wen Jiabao’s veiled warning that the United States had better watch its step and keep its promises.

Last Monday, the nation fired another warning shot across the bow. Zhou Xiaochuan, president of China’s central bank, issued a very well-written and forceful essay to the World Bank. Without naming names, he expressed concern about the world’s dependence on just a few reserve currencies.

He called for the introduction of a world reserve currency, based not on a sovereign country’s currency, but rather on an IMF-based note. He suggested basing it on the IMF’s SDRs, or Special Drawing Rights, a unit of account that the IMF has been using since the 1960s. The proposed currency could also be grounded upon a basket of commodities for the backing of its value, and member countries would make “contributions” to this universal monolith.

Of course, other nations would have to be open to such an arrangement, and even if they were, developing this idea would likely take a long time. But that’s not really the point. The point is, China is expressing its displeasure at what it perceives to be a real inequity between itself and the rest of world. While China is doing its best to weather the downturn, the collapsing demand for its exports has closed many factories and put 20 million people out of work.

What China wants is for its investments to be spared. And for it to be considered above our own national agenda. Because right now our agenda of inflation and their agenda of a stable or appreciating dollar are at odds.

And this provides some of the background for our Australian play. Take a look…

Looking for Thunder from Down Under

I have said before that the likely winners in this worldwide economic crisis will be countries like Canada and Australia. They have an edge because of their commodity-related economies and currencies. Oftentimes you’ll hear them called the CommDolls (commodity dollars) for short.

Of the two, I like Australia better. Canada is inextricably tied to its neighbor to the south (namely, us), and that’s more than just a little problematic. Australia, on the other hand, is not tied to the United States and has many other real positives going for it.

Keep in mind, the U.S. dollar devaluation is under way. And the words of warning from China’s top officials suggest the country is already considering moving its investments to whatever other possibilities exist. Indeed, is has already begun doing so — mainly, into its own economy.

It has produced a stimulus that has been roughly estimated at somewhere just above $550 million, or 14% of the country’s GDP. Its infrastructure expansion is already up 30% from last year, hoping to boost domestic demand. Bank lending is up 24% due to its own monetary easing. Yes, exports are off substantially, and I think will likely continue to drop, but even so, the personal savings rates there are much higher, and China does have the reserves to continue moving things along with little to no borrowing. Plus, they have promised to do more stimulus if it appears to be necessary.

As China attempts to lift itself up by its own bootstraps, Australia comes into the picture. It has been widely understood that Australia is a little China. Not in culture, custom or language, but in economics. A significant part of Australia’s commodities flow into China, and the more the Chinese move ahead, the better it is for Australia.

Also, let’s consider that Australia’s central bank is still holding its interest rates at 3.25%. In a fairly stable country, with a fairly stable currency, that is one heck of an attractive rate. Why, it is downright appealing! It is true that they have followed other developed countries in lowering their national rates. But I think it is the propensity of all central banks to err in their “corrections” of the market. That is, they often lower rates too quickly and too far — as I think is the case here — then they raise them far too slowly to stave off the coming of inflation.

Indeed, Australia may now become the benefiting member of the next carry trade.  After all, if can you borrow money at .25% and invest it at 3.25%, you stand to make a decent haul. And as risk appetite re-enters the market, you can bet your bottom dollar that Australia will likely be a real beneficiary.

More importantly, the continent’s economy has not been too rattled by the worldwide crisis. Wages are up 5.7% by official statistics. That’s great, especially when you consider that full-time employment is up. Now some people may question the importance of Australian employment given that the recent figures showed only a marginal improvement in job numbers. But inside the figure, we have a strong drop in temporary employment, but a surge in full-time filled positions. Going forward, this is good!

Business investment is up 6% over the last quarter — also a sign of good health. As business expands, so does the work force, followed by wages… and next thing you know, interest rates are headed north as well.
Retail sales are up 0.8% this quarter. Even their housing market has only suffered a 3% decline. On top of all that, it has recently run a trade surplus, another sign of a healthy economy.

Now this does not mean it is just smooth sailing ahead, or that there aren’t downside risks. Its central bank could continue to overreact. That would be detrimental. Or commodity prices could take another hit. After all, many producer contracts were locked up last June, and many producers are still protected by them. This June could be an entirely different story. Producers may have to take a big hit compared to last year. That would be detrimental. And the China factor may not pan out as quickly or as well as it appears.

But all things considered, a long position in the Australian dollar doesn’t seem like too bad of a bet.

Bill Jenkins

March 30, 2009

The Daily Reckoning