The day China revalued

John Hussman recently said that July 21 was the day when 'we officially started the end game'. Not immune to endgame speculations, Stephen Roach responded to renminbi (yuan) revaluation in kind: “China’s currency adjustment is emblematic of an endgame that could be a linchpin to long overdue global rebalancing". Suffice to say while Hussman, Roach, and numerous others remain unwilling to explicitly forecast a dollar crisis, they were nonetheless quick to add another verse to the dollar is doomed sermon following the first yuan revaluation in a decade.

“My impression is that there's a U.S. dollar crisis ahead...There's nothing to indicate that it's [the dollar crisis] an immediate risk” Hussman

But will July 21, 2005 really be remembered as marking the onset of ‘global rebalancing’?  Will one yuan adjustment inevitably lead to another, and another, until a freely floating yuan (or Asian currency basket) overtakes the US dollar as the de facto currency of the world? I have my doubts.  In fact, unless China announces that it is about to peg its currency to a basket made of gold, there is reason to speculate that US dollar hegemony is at less risk today than it was on July 20.

Has The Demise of Bretton Woods II Been Grossly Exaggerated?

"A few unsound pieces of analysis popped up last week suggesting that China's move might actually increase demand for dollars (e.g. China's purchase of say, Japanese yen would presumably give Japan more money to purchase dollars), but it's ridiculous to believe that any such indirect effect would outweigh the direct effect that China just isn't going to be purchasing U.S. dollar assets as eagerly anymore." Hussman

In Hussman’s pursuit to point out the obvious – that China’s move may not signal an increase in demand for dollars – he fails to acknowledge that revaluation brings with it the possibility of keeping up the norm (or sustaining/broadening the key players in the presumed new global currency arrangement, Bretton Woods II).  As Lehman’s Amitabh Arora opined following July 21, “if China is going to be essentially buying yen assets and reducing dollar assets, Japanese investors would be likely to do the offsetting trade [or to buy USD assets].” As for the other potentially large component in China’s yet unannounced basket, the Euro, is anyone really confident that with union uncertainty and lackluster growth trends in Euroland that Euro strength can be sustained?  Accordingly, while Hussman is basically correct in that China ‘isn’t going to be purchasing U.S. dollar assets as eagerly anymore’*, he is nonetheless using his predetermined conclusion of dollar weakness to insinuate that there is a quantifiable correlation between yuan revaluations and a dollar crisis. Mind you he is probably right that a dollar crisis is the end, but, in responding to July 21, he could be simply grasping at a new event to try and conjure up the means.  

The misnomer proliferating from Hussman and other more rounded BWII experts (see Roubini) is that Bretton Woods II is only sustainable so long as Asian countries continue to recycle dollars (acquired primarily from exports into America) into dollar denominated assets. And while this viewpoint is given weight by the fact that ‘pan-Asian reserves (including Japan) totaled $2.4 trillion as of February 2005 -- fully 64% of the global total’, there is nothing to say that the investment vehicles pan-Asia diversifies into will not serve as a surrogate dollar purchaser. Put another way, in 2005 the UK and Caribbean Banking Centers (Hedge funds) have each purchased more US Treasurys than China, and France has actually purchased more Treasurys in 2005 than Japan (TIC). Point being, the movement of Pan-Asian reserves is important, but recent history suggests that as one party diversifies their interests away from US dollars another party has been willing to take their place.

As a side note, I personally believe BWII will end in tears and that the world’s most profligate debtor ever, the US, will be the country grasping for the most tissues. Nevertheless, I do not see small incremental yuan revaluations as playing the key role in this ‘endgame’. Rather, with revaluation being done by China to appease American policy makers and China unwilling to adopt a freely floating or even creeping currency for fear of domestic instability, the threat of chaotic currency moves being sparked by China is not outstanding. Quite frankly, in order for US dollar hegemony to enter an end game scenario investment alternatives must arise for global capital. Yuan revaluation makes the FX world more complex, but it does little to eradicate the US led FX world altogether.

* Hussman could be wrong: If China’s new basket is heavily weighted in dollars and/or hot money flows into China because of heightened revaluation expectations force China to increase its sterilization efforts, China could become a more eager USD buyer.

Could Yuan Adjustments Actually Promote USD Stability?

Being a long-term dollar bear myself, it is difficult to roundly argue that continued yuan revaluations (vs. USD) would be a dollar positive.  Quite frankly, if China continues to revalue the yuan and/or diversify reserves away from USD there is little doubt that this will, at minimum, have a negative psychological impact on the value of the US dollar.  On the maximum side of the scale continued revaluations could also cause a dollar crisis, but perhaps only if the Chinese economy matures and handles revaluations in a stable manner (I do not believe it will).

When playing devils advocate and trying to view July 21 as an independent trial, consider two points of interest:

1) Snow, Greenspan, and other US policy makers immediately cheered July 21 and Senators Schumer and Graham - already having suspended a vote on their China tariff bill based upon the expectation of yuan revaluation – said they were "watchful [and] waiting" for further revaluations (until, probably, Oct 1).  In other words, a tiny 2.1% yuan adjustment helped curb the threat of protectionism.

2) Following the yuan announcement long-term US interest rates jumped higher, and many analysts believe US long-term interest rates will not decline significantly as China moves away a pure USD peg. Given that the freakish decline in US interest rates is thought to be responsible for some of the unsustainable trends in the US economy (i.e. the real estate bubble and credit bubble) the rise in US interest rates is good news in that it may help slow these unsustainable trends down.  Also, the jump in US interest from July 21 has made US Treasurys more attractive on a yield gap comparison basis.

While these two points hardly guarantee that a run on the dollar is not in the making, they do threaten to stymie dollar bears with a short-term horizon. As for the argument that the US economy can not handle yuan revaluations and/or that China will burst the US housing bubble, so what?  A US recession does not guarantee a collapse in the US dollar, especially if the US drags the rest of the world down with it.  To reiterate: in order for US dollar hegemony to enter an endgame scenario investment alternatives must arise for global capital. Think of a major fiat currency that is sure to benefit inside of a global economic recession…most of the world still thinks USD.

Dollar Rebalancing

Needless to say, the ‘unsustainable’ US current account deficit has become the mother of all imbalances.  Economists and the historical record previously suggested that a current account deficit of 5% GDP was dangerous and unsustainable, and that the very thought of 6+% was ludicrous. In the US 7% of GDP is not out of the realm of possibility.

Common sense says that if the US current account deficit continues to widen – if the net indebtedness of the US economy continues to increase more rapidly than US income – debt servicing charges will eventually become prohibitively expensive.  In 2005 this ‘sense’ has become extremely ‘common’, and yet the US dollar has not declined (a weaker dollar would presumably help correct the imbalance). 

The reason why the US dollar continues to hold firm has little to do with economist’s misreading their tea leaves.  Moreover, the dollar has not been stable in 2005 because foreign investors are wearing blinders.  Rather, the dollar has held its own because foreign policy makers are devoid of investment alternatives.  The private investor can buy gold and benefit from inflationist policies, but if a major foreign central bank starts buying gold their US dependent economies suffer (as US interest rates skyrocket from lack of foreign investment).  Think of a major economy that can thrive without the US economic engine...it isn’t easy, even if you try.

This is what makes the endgame so difficult to forecast: economist’s know that things have turned so extreme this time around that to point to historical precedence is foolish, but in order to produce any opinions they must rush in to the forecasting game.  This is why Hussman uses the unscientific word ‘impression’, why Roach has been flip-flopping all year long, and why the usually cocky Fleckenstein has sometimes turned timid.  Why would any USD buyer bite the hand that feeds them?  Because someone eventually will. What are the alternatives to USD?  There will be an alternative.

“Change has occurred. It's certainly not bullish for the dollar or for Treasurys. But just how bearish it is, and how long it takes to have any real impact, remains to be seen” Fleckenstein

The Bearish Buzzword: Endgame

Economies and financial markets are not ebbing closer to some mysterious point of balance. Rather, new imbalances will inevitably take the place of the old.  Accordingly, when Roach and others use the word ‘endgame’ – or period wherein global imbalances such as the US twin deficits somehow get remedied – this conjures up a myopic outlook; an outlook that concludes the forecasting/investing game will one day, when it is all over, get better, easier. 

Unfortunately, insofar as Bretton Woods II is concerned there is no ‘endgame’ per se.  Rather, there is simply the presumed global currency arrangement continuing - in which case US interest rates remain artificially low as foreign appetite for USD never stalls - and the arrangement ending. Given that when the arrangement ends financial destruction immediately sweeps across America, it is difficult to see how there is any ‘game’ being played.

Incidentally, it is important to remember that BWII, and the imbalances that this arrangement proliferates, is not sustainable by choice, but by the lack of choice. And although Hussman and others do not specifically mention BWII often for this very reason (they themselves are devoid of seeing any other choice but USD leadership), they are actually alluding to BWII when they talk about US interest rates, Asian currency reserves, yuan revaluation, global imbalances, etc.

Is Gold About To Really Heat Up?

Following yuan revaluation hot money is pouring into China.  The Asian hot money ‘imbalance’(?) may be worth monitoring for one reason: if this hot money seeks refuge during a financial crisis where will it go?

Will hot money parked in Asia rush into the dollars during the next crisis?  Will this hot money rush into gold?

Recent history suggests that during times of financial crisis money seeks safety in USD. But real history says that during times of financial crisis money seeks safety in gold. Can BWII stay intact for a little while longer, or is real history about to rear its golden head?

Let me clear about one thing: China revaluation does not necessarily mean that we are significantly closer to gold’s revival as the ultimate store of wealth (my ‘impression’, a la Hussman, is that it yuan revaluation is good news for the price of gold). Rather, the better outcome for a serious run in gold would have been US tariffs enacted against China, retaliatory actions from China, hyperactivity in the financial markets (particularly the US bond market), and the genuine threat that protectionism was about to reincarnate the 1930s.  Gold would thrive under these circumstances as it would become an alternative to low yielding bonds and money losing financial/real estate assets. Instead, yuan revaluation, which is supposedly the biggest event in years, caused less financial market volatility than the GM/Ford downgrades earlier this year.

With this in mind, that China is playing along and revaluing is positive but not great news for the price of gold. And while the faith driven (Amen) dollar destruction crowd is arguing that China is up to something sinister (perhaps they are buying gold to crush USD!!!), it is doubtful that the Chinese economy will grow mature enough to live without USD anytime soon.

In short, if China stays in paper the fiat finagling that has been going on since Nixon closed the window will continue.  To be sure, things will remain the same and the US dollar – whether it is falling a lot or rising a bit – will remain the world’s currency…until the day when it isn’t.

         On this day you had better make sure that you own some gold/silver.  And since this day can not be predicted beforehand, owning gold is never a bad idea as you wait for the endgame.