Rumblings of troubles at some of the biggest hedge funds raised fears of market contagion, particularly following the downgrades to junk status of former icons, General Motors and Ford Motor Co. Huge losses were linked to the liquidation of exotic credit derivatives or as Warren Buffett calls them, "weapons of financial destruction". In 1998, Long Term Capital Management was considered too big to fail, then as now, the hedge funds are over-leveraged. As overall returns from stocks and bonds dropped in recent years, the largely unregulated hedge funds have accumulated more than $1 trillion of assets promising above average returns. Many are forced to unwind their leveraged positions causing an uptick in the dollar to offset mammoth derivative losses and the dumping of oil, Canadian dollars, and gold. Alan Greenspan reinflated the credit balloon in everything from oil to real estate to hedge funds but now after eight successive interest-rate increases, $50 oil and the credit downgrades, the after shocks are being felt as the hedge funds unwind their big derivative bets.
Amidst contagion, gold historically has been a good thing to have. Let's look at the fundamentals.
The US economy averaged about 4 percent growth over the last three years and GDP growth this year is forecasted at 3.7 percent which is well within the norm despite a spike in the price of oil to $50 a barrel. However, this growth has come at the expense of unprecedented large deficits and a large drawdown of US savings, mortgaging America's future. The cumulative effect of these deficits is a large increase in indebtedness, to the point that the Americans have become the largest debtor in the world. The trade deficit alone requires nearly $2 billion of external funding a day. According to the US Treasury, net portfolio inflows in the US dropped to $45.7 billion in March from $84.1 billion in February which was not enough to cover March's $55 billion trade deficit. At the same time, the Asian economies are not only attracting direct foreign investment due to their more promising growth opportunities but are also accumulating large stocks of international reserves, principally in dollars. As a consequence they are running large account surpluses and in holding more than half of the American deficit, they are subsidizing America's lifestyle. This is clearly unsustainable.
A Financial Marathon
"We are escalating the rhetoric and time is running out", said US Treasury Secretary John Snow.
China-bashing has become de rigueur. The United States is pressuring Beijing to allow its currency to appreciate to help cut the American deficits and Congress talks of punishment, if China does not do so. Amidst this red ink, Washington has placed huge international pressure, rattled its sabres, targeting China and its fixed exchange rate regime for America's trade woes, which could spill over into other areas. The US Congress is trying to impose a whopping 27.5 percent tax on goods from China. Bush would veto such a bid since it breaks World Trade Organization rules, but it serves to fuel protectionist measures on behalf of "special interests" groups. However, floating the yuan would not cure the US trade deficits but would more likely will lead to a global slowdown hurting the very groups that seek protection. Rather than renewed protectionism or finger pointing, in our view, policymakers should look to correct the fiscal imbalances before they further erode the underpinnings of the global financial markets, causing a financial meltdown.
In the first quarter, China racked up a huge trade surplus with the United States and Western Europe. Chinese exports in the quarter rose to $155 billion, up 35 percent from a year ago. China's biggest trading partner is with Japan. Yet China's trade surplus with the United States jumped $21 billion in the first quarter, up from $12.4 billion, a 73 percent increase. Last year, China had a $162 billion trade deficit with the United States, the largest ever recorded. China sends one third of its exports to the United States, accounting for twenty-five percent of the US trade gap. Most of the exports are manufactured products made by workers earning a fraction of the US factory wage.
Here Is The Problem
The US Congress overlook the most obvious fact that the main source of the deficit is not China's fixed exchange rate but its abysmal US savings rate and profligate government expenditures. The underlying and wider problem, the US current account deficit, reached another record in March because of the sharp drop in personal savings and out-of-control federal spending. For a higher level of investment and a reduced trade deficit, the United States must have higher savings. Today's negative real interest rates will not encourage Americans to save more. Time is running out on the Americans, not the Chinese.
In 1985, America's current account deficit was at 3.5 percent of GDP compared with 6.5 percent of GDP today. Now, America has become the world's largest debtor and China its creditor. China holds more than $600 billion of dollar denominated securities and has made intentions of diversifying its large foreign exchange holdings. And the current round of China bashing will not be lost on China's policymakers. If the Americans cannot make the tough political choices on revenues and spending to contain their deficits then China and others will be forced to take the necessary actions.
Be Careful What You Wish For
The Chinese for example, are hinting that they too are losing their appetite for piling up more dollars, which fund the twin US deficits. Time is running out. The loss of China buying would cause the dollar to collapse, soaring interest rates and a recession. It is not about subsidies, it is not about low wages, nor is it about China's fixed exchange. It is about America's indebtedness with the world. Trade makes up less than 12 percent of the American deficit, so China bashing is a red herring, and more accurately a simple revival of old fashioned protectionism spawned by a beleaguered auto industry. China bashing is also an empty threat because many of the American multinationals have major operations in China, thus a floating yuan would do little to reduce the trade gap. A lot of China's exports are by American businesses, such as Wal-Mart, so tariffs would only be hurting themselves. The Americans will find that globalisation is a double-edged sword.
The move to decouple the yuan would also trigger a wider revaluation of currencies around Asia. And if the yuan were allowed to float upwards, demand for foreign goods would shift simply to Japan, India or other countries. Letting the yuan rise however would lessen the cost of importing oil and iron ore to China making their goods even more competitive.
Equally important is that there is no economic rationale for balanced trade; indeed there are more countries with trade imbalances than balanced. And should the yuan float upward, US real interest rates would go higher in order to compensate investors for taking increased currency risks. The Chinese and others would be forced to cut back on buying those Treasury Securities, forcing interest rates even higher at the same time the Fed is pushing up rates. Asian central banks would have another reason to sell their surplus dollars. Indeed the Chinese probably have more say on US interest rates than Alan Greenspan.
In our view, a stronger yuan would also result in painful foreign exchange losses in the holdings of the Asian central banks. The peg to the dollar allowed China to survive the wrenching 1997-98 Asian crisis and has been in existence for more than eleven years. America's problem is that they import too much goods, oil, and money. The Chinese recently responded to American criticism, telling the Americans to fix their current account deficits by curbing its spending and save more - good advice but no one is listening except the Chinese. Time is running out.
So what to do?
We believe the Chinese will eventually loosen their currency regime in a gradual, deliberate manner and on their terms. Most likely they will widen the trading band slightly. Eventually, however they will leave the dollar, but link the yuan instead to a basket of Asian currencies. Ironically such a move would cause the yuan to be more sought after and that would be a good thing. By linking to a basket of its Asian neighbours' currencies, foreign exchange markets would have an alternative to the dollar bloc and euro bloc. China, Japan and South Korea together hold over a third of the world's central bank foreign exchange reserves. Such a basket would also require gold. Perhaps the European sellers could accommodate the Asian buyers?
John R. Ing
Maison Placements Canada
130 Adelaide St. West - Suite 906
Toronto, Ont. M5H 3P5
25 May 2005
The information contained herein has been obtained from sources which we believe reliable but we cannot guarantee its accuracy or completeness. This report is not and under no circumstances is to be construed as an offer to sell for the solicitation of an offer to buy any securities. This report is furnished on the basis and understanding that Maison Placements Canada Inc. is to be under no responsibility whatsoever in respect thereof. Directors, shareholders or employees of this company may be beneficial owners of the securities referred to herein.