China: It just got worse – more bad news and more policy mistakes: http://t.co/h6pwguOJl9 #China #PBoC #EndOfTheDollarBloc @bill_easterly
— Lars Christensen (@MaMoMVPY) September 1, 2015
China’s conundrum: Capital flight or deflation
China's conundrum: Selling FX reserves to support the yuan threatens deflation. But falling yuan fuels capital flight http://t.co/XGz6S4HPz6
— Colin Twiggs (@Colin_Twiggs) August 29, 2015
AND capital flight causes collapsing stock and real estate prices, which could lead to…… deflation.
S&P 500 during the 1997 Asian financial crisis
Here is the performance of the S&P 500 during the 1997 Asian financial crisis and the ensuing Russian financial crisis in 1998.
The index gained 31% in 1997, and 26.7% in 1998, despite the upheaval in Asian markets. Global markets are nowadays a lot more interconnected, however, than in 1997/98.
All the same, gradual decline on 13-week Twiggs Money Flow suggests medium-term selling pressure — a secondary rather than a primary movement.
Australian Dollar during the 1997 Asian financial crisis
Performance of the Australian Dollar during the Asian financial crisis. The falling Dollar acted as a buffer, protecting the Australian economy from the Asian contagion.
A similar 25% fall from today’s 72 US cents would offer a target of 54 US cents. No science to this. Simply speculation.
George Soros: Regulation of global financial markets
It is time to recognize that financial markets are inherently unstable. Imposing market discipline means imposing instability, and how much instability can society take? …. To put it bluntly, the choice confronting us is whether we will regulate global financial markets internationally or leave it to each individual state to protect its interests as best it can. The latter course will surely lead to the breakdown of the gigantic circulatory system, which goes under the name of global capitalism.
~ George Soros: The Crisis of Global Capitalism (1998)
China’s dangerous currency manipulation
I am surprised at John Mauldin’s view in his latest newsletter Playing the Chinese Trump Card:
….This whole myth that China has purposely kept their currency undervalued needs to be completely excised from the economic discussion. First off, the two largest currency-manipulating central banks currently at work in the world are (in order) the Bank of Japan and the European Central Bank. And two to four years ago the hands-down leading manipulator would have been the Federal Reserve of the United States.
John is correct that China has in recent years engaged in less quantitative easing than Japan, Europe and the US. And these activities are likely to weaken the respective currencies. But what he ignores is that these actions are puny compared to the $4.5 Trillion in foreign reserves that China has accumulated over the last decade. That is almost 2 years of goods and services imports — far in excess of the 3 months of imports considered prudent to guard against trade shocks. Arthur Laffer highlights this in his recent paper Currency Manipulation and its Distortion of Free Trade:
Accumulation of excessive foreign reserves is the favored technique employed by China, and Japan before that, to suppress currency appreciation over the last three decades. Dollar outflows through capital account, used to purchase US Treasuries and other quality government and quasi-government debt, are used to offset dollar inflows from exports. This allows the exporting state to maintain a prolonged trade imbalance without substantial appreciation of their currency. And forces the target (US) to sustain a prolonged trade deficit to offset the capital inflows. Laffer sums up currency manipulation as:
….. when a country either purchases or sells foreign currency with the intent to move the domestic currency away from equilibrium or to prevent it from moving towards equilibrium.
Even Paul Krugman (whose views I seldom agree with) has been wise to the problem for at least 5 years:
…..economist Paul Krugman and a group of senators led by New York Democrat Chuck Schumer wanted to impose a 25% tariff on Chinese imports.
Prolonged current account imbalances cause instability in global financial markets. A sustained US current account deficit was one of the primary weaknesses cited by Nouriel Roubini in his forecasts of the 2008 financial crisis (the other side of the equation was a sustained Chinese surplus). But currency manipulation is not only dangerous, it is also short-sighted. International trade is a zero-sum game. For every dollar of goods, services, capital or interest that goes out, a dollar of goods, services, capital or interest must come in. For every country that runs a current account surplus, another must run a deficit. Without international regulation, each country will try to engineer a trade surplus in order to boost their domestic economy at the expense of their trade partners. An endless game of beggar-thy-neighbor.
Participants will suffer long-term consequences. The power of financial markets is unstoppable. Central banks attempt to hold back the tide, distorting price signals and shoring up surpluses (or deficits), at their peril. The market will have its way and restore equilibrium in the long term. As Japan in the 1990s and Switzerland recently experienced, the further you move markets away from equilibrium the more powerful the opposing backlash will be. The scale of China’s market manipulation is unprecedented, and caused large-scale distortions in the US. The end result forced the Fed to embark on unprecedented quantitative easing which, in turn, is now impacting back on China.
The impact will not only be felt by China, as John points out:
The low rates and massive amounts of money created by quantitative easing in the US showed up in emerging markets, pushing down their rates and driving up their currencies and markets. Just as [governor of the Central Bank of India, Raghuram Rajan] (and I) predicted, once the quantitative easing was taken away, the tremors in the emerging markets began, and those waves are now breaking on our own shores. The putative culprit is China, but at the root of the problem are serious liquidity problems in emerging markets. China’s actions just heighten those concerns.
Chinese hopes for a soft landing are futile.
Currency Manipulation and its Distortion of Free Trade | A B Laffer
Extract from Arthur B. Laffer’s paper on currency manipulation:
….Successful currency manipulation inhibits the exchange rate from acting as an automatic stabilizer to macroeconomic events, and thereby leads to growth and trade imbalances. Currency manipulation has therefore, in part, inhibited the world from fully recovering from the financial crisis. For instance, real growth has been tepid at best for developed countries that do not intervene in the foreign exchange market, while countries that have been identified as currency interventionists have experienced a much steadier pace of recovery from the financial crisis—this has been dubbed as the two-speed global recovery.
The two-speed recovery has shown, in part, that persistent currency undervaluation has benefited the currency manipulators at the expense of countries allowing the flexible adjustment of exchange rates, since the latters’ export-related activities must quickly respond to the external balances caused by trading partners’ currency devaluations. As of 2012, the scope of currency manipulation is estimated to be approximately $1.5 trillion per year, with about 60 percent of these flows channeling into dollar assets. Moreover, the impact of currency manipulation has potentially dampened the U.S. current account by about 4 percent of GDP in 2012, which was approximately the size of the U.S. output gap in the corresponding year. While providing an exact number of U.S. jobs lost due directly to currency manipulation is tricky, it is likely that millions of jobs in the U.S. were lost as a result of current account imbalances that were generated, in part, by currency manipulation.
These spillover effects would likely disappear if exchange rates were liberalized to better exhibit market fundamentals, which would also potentially improve welfare in undervalued currencies’ economies by improving domestic demand. In fact, further movement toward freely floating exchange rates and the removal of capital account restrictions will help rebalance global growth, which in turn will reduce financial and economic risk. Moreover, research has found that future financial crises can be, in part, predicted by large current account imbalances as such distortions suggest the misallocation of capital. In fact, earlier studies from Laffer Associates confirm this link between current account imbalances and financial crises helped explain the Asian currency crisis in the late 1990’s.
Considering the employment and economic impact of currency manipulation on the United States and given that the United States is negotiating a free trade agreement, the Trans-Pacific Partnership (TPP), to avoid further harm and ensure the agreement’s benefits aren’t undermined by countries that have a history of manipulating their currencies, it is vital that the TPP include defined monetary policy standards and a means to identify currency manipulators and enforce violations…..
Read more at Currency Manipulation and its Distortion of Free Trade | A B Laffer
Desperate times, desperate acts
A sharp fall in global trade is the most likely reason for China’s decision to devalue the Yuan — not aspirations for CNY to be considered a reserve currency.
There are clear signs that global trade is contracting. Shipbrokers Harper Petersen’s Harpex weekly index of charter rates for container vessels fell 9 percent in July and August is following a similar path. Reduced demand for container shipping reflects a sharp fall-off in international trade in manufactured goods.
Tyler Durden from zerohedge.com highlighted China’s falling exports last week (August 8):
Goldman breaks down the geographic slowdown:
- Exports to the US contracted 1.3% yoy, down from the +12.0% yoy in June.
- Exports to Japan fell 13.0% yoy in July, vs -6.0%yoy in June
- Exports to the Euro area went down 12.3% yoy, vs -3.4% yoy in June.
- Exports to ASEAN grew 1.4% yoy, vs +8.4% yoy in June
- Exports to Hong Kong declined 14.9% yoy, vs -0.5% yoy in June.
Slower sequential export growth likely contributed to the slowdown in industrial production growth in July. Weaker export growth is likely putting more downward pressure on the currency, though whether the government will allow some modest depreciation to happen remains to be seen.
Durden presciently concludes:
As global trade continues to disintegrate, and as a desperate China finally joins the global currency war, it will have no choice but to devalue next.
Michael Leibowitz at 720Global.com also warns of the destabilizing effect carry trades may have on any adjustment:
The “one-off” adjustment has now become two…. this devaluation is likely not a one-time event but rather the beginning of an ongoing and persistent depreciation of the CNY versus the USD. The embedded USD short position within the [estimated $2Tn to $3Tn] carry trades will begin to result in losses and margin calls as the USD appreciates versus the CNY, thus forcing investors to liquidate some of their positions. These trades, which took years to amass, could unwind abruptly and exert an influence of historic magnitude on markets and economies.
Read more at 1997 Asian Currency Crisis Redux | Zerohedge.
Dollar strengthens on low inflation
Core CPI continues to hover below the Fed’s 2.0% target, while plunging oil prices keep the broad index close to zero. Core CPI is likely to weaken as the beneficial effect of lower energy costs flows through to all sectors of the economy.
We often read of the threat of impending deflation — which may well occur. But one needs to differentiate between deflation caused by a surge in aggregate supply, as in the present situation, and a fall in aggregate demand as in 2008. The former may well act as a stimulus to the global economy, while the latter threatens a negative feedback loop between income and consumption which can lead to substantial falls in output.
Low inflation takes pressure off the Fed to raise interest rates but we can expect the first increment later this year. 10-Year Treasury yields respected the rising trendline and support at 2.10%, suggesting another test of 2.50%.
The higher trough on the Dollar Index indicates buying pressure and breakout above 98 would signal another test of 100. In the longer term, breakout above 100 would signal resumption of the primary up-trend but is likely to meet push-back from the Fed as a higher dollar would hurt both exporters and domestic producers competing against imports.
Gold-Oil ratio warns of further selling
The Gold-Oil ratio, comparing the price of bullion ($/ounce) to Brent crude ($/barrel), has long been used as an indication of whether gold is in a bull or bear market. When the oil price is high, demand for gold, anticipating rising inflation, is normally strong. The current plunge in oil prices indicates the opposite: weak inflation and low demand for gold. Bullion prices are falling but not fast enough to keep pace with crude, driving the Gold-Oil ratio to an overbought position above 20. Expect a long-term bear market for gold.
Spot Gold is consolidating in a narrow rectangle below $1100/ounce. This is a bearish sign, with buyers unable to break the first level of resistance. Breach of support at $1080 is likely and would signal a decline to $1000/ounce*. Declining 13-week Twiggs Momentum below zero confirms a strong primary down-trend.
* Target calculation: 1200 – ( 1400 – 1200 ) = 1000
The Gold Bugs Index, representing un-hedged gold stocks, has fallen close to 30 percent since breaking support five weeks ago.
Barrick Gold, one of the largest global gold producers, is falling even faster.
If long-term crude prices continue to fall, like the June 2017 (CLM2017) futures depicted below, gold is likely to follow and support at $1000/ounce will not hold.
