Yuan

Big Brother in the form of an increasingly powerful government and in an increasingly powerful private sector will pile the records high with reasons why privacy should give way to national security, to law and order, to efficiency of operation, to scientific advancement and the like.
– Justice William O. Douglas (1898-1980), U. S. Supreme Court Justice

Those who take the most from the table, teach contentment.  Those for whom the taxes are destined, demand sacrifice. Those who eat their fill, speak to the hungry, of wonderful times to come. Those who lead the country into the abyss, call ruling difficult, for ordinary folk.
– Bertolt Brecht (1898-1956) German dramatist, stage director, and poet

Idealism is the noble toga that political gentlemen drape over their will to power.
– Aldous Huxley

China Better Have a Plan
The fact that the Central Planners in China are basically standing around like deer in headlights as their economy plunges into the abyss is nothing short of astounding.  Sure they have lowered the bank Reserve Requirement but so what?  That is an epic joke of a move in light of the gargantuan problems that economy is facing, and is blatantly pathetic in its irrelevance.  I’m not going into detail for the thousandth time why China’s economy is nothing more than a Keynesian Centrally Planned house of cards on steroids with mal-investments that make the U.S. housing market look benign.  I have done that too many times over too many years to exert energy on that topic once again.  That said, what I do want to do is look back at the post 2008 period and try to figure out why they never really took polices to rebalance the economy away from fixed asset investment toward consumption.  In fact, not only did they not rebalance but they doubled down on the prior strategy!  Well now the chickens have come home to roost and we are about to find out if China has any real “long term” plan to get themselves out of this mess.

Although I never bought the “China bull” story over the last few years, where I did agree with a lot of these pundits was the notion that the Chinese currency, the yuan, was inevitably going to strengthen materially.  The primary reason that I agreed with this notion was the fact that I believed it to be the most effective means for the government to transfer global purchasing power to their citizens and also rebalance its economy more toward consumption.  Well the yuan did appreciate from mid 2010 to December of 2011, but the appreciation was a measly 8%.  That is basically nothing and in no way could have done anything to rebalance the economy in any way shape or form.  The lack of appreciation has been one of the biggest surprises to me, and indeed, now represents one of the scariest aspect of the macro backdrop globally.

As I mentioned recently in another piece, the cessation of the strengthening trend in the yuan back in July 2008 foreshadowed the collapse of the global economy.  Is the same thing happening now?

Chart of the Chinese Yuan (inverse so a decline represents strength vs. the U.S. dollar).

I have thought over and over again in my head why they didn’t allow the yuan to appreciate more, and at the end of the day, it comes down to one main point in my mind: Political Power.  As we all know, China is run by a very small group of bureaucrats that are fabulously wealthy and fabulously corrupt.  As is the case back here in the United States of Banana Republic, the Central Planners, politicians and financial/corporate oligarchs have made themselves fantastically wealthy and powerful through the parasitic controlled crony capitalist economy that they have put in place.  This is why they fight tooth and nail against reform.  Reform would restore power to the people and away from them; and of course, they don’t want that.  China and the United States are exactly the same in that regard, and since the old model has worked so well for the few in power they have been reluctant to change the model.  Indeed, they haven’t.

So here we are today and things are much different for China.  In fact, from a fundamental perspective it is now difficult to argue for a yuan appreciation.  The terms of trade have started to go against China and go against it strongly.  The entire export model was driven by the mobilization of rural workers from the interior to the coasts.  This seemingly endless cheap labor coupled with an undervalued currency made the cost of mass producing manufactured good exceedingly cheap relative to the rest of the world.  Factories in the West packed up and moved to China, the trade surplus boomed, and the rest is, well, history.

Those days are over.  Chinese wages have been skyrocketing and with global commodity prices elevated China’s trade surplus is not what it used to be.  There may even be a dollar shortage in China as the government foolish put its dollars into treasury bonds for some insane reason.  Why the government there would take a currency that is doomed in the long run and then put it in to an asset they will never be able to liquidate in an orderly manner is beyond my comprehension, but that is what they did and now they are stuck with that garbage.  There was a great article on this topic yesterday at FT Alphaville by Izabella Kaminska that I suggest everyone read.  You can find it here.

The following paragraphs I consider to be the most important part of the article:

The sad truth that many don’t realize is that these moves to internationalize the currency have less to do with Beijing’s wish to modernize and much more to do with a need to draw dollars into the system to cover the country’s growing “dollar short” position.

But what happens if the strategy fails? What happens if foreigners decide the last thing they want is yuan exposure (due to China economic bubble fears), and would much prefer to keep hold of their US dollars?

What happens if instead of a dollar inflow you get a mass capital outflow from China, with as many Chinese as possible converting yuan-denominated assets into dollars, seeing the yuan fall in value versus the dollar due to what is now an over-valued position?

Recent developments in offshore/onshore markets and forward markets, unfortunately, seem to suggest this is exactly what’s happening.

Wow, so if this article is correct then we have just made a 180 degree turn from where we were just a few years ago.  Rather than the market assuming a major appreciation in the Chinese currency, it seems as if financial players are becoming terrified of the currency considering the reversal in the terms of trade and the much more negative prospects for the economy going forward.  Believe me when I tell you that this is an absolutely terrifying scenario to be faced with for all of us.  If this is correct, the risk from China is likely to be as great if not greater than anything happening in Europe.  Here’s why.

The reason I say this is because I think there are two options from here, and both of them would have seismic effects on the global economy for the foreseeable future.  The first scenario assumes that China has a plan to deal with a loss of faith in its currency.  That plan in my view would be that they would come out with a gold backing to their currency.  This is something many people have written about for many, many years, including myself.  If China has enough gold to pull this off, they would immediately become the one currency in the world that everyone wants.  Capital would flee to China and the Chinese consumer would receive an overnight boost in purchasing power that will be written about for centuries to come.  This fits into the theme that I wrote about last year in my piece “Does China Need the U.S. to Collapse.”  The basic premise is that in a resource constrained world the only way China can ever actually utilize the massive excess capacity it has built is through a massive transfer in purchasing power to its citizens.  The West could collapse into third world status if this were to happen (it’s already on that path anyway).

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