Thursday, April 15, 2010

China, TBTF, and dancin' with the gal that brung ya'

QUESTIONER: Changing the part of the world and going to China. Yesterday I read a statement from Mr. Strauss-Kahn about the yuan, the currency, being definitely undervalued. I wanted to know if you had anything to articulate on this or to comment. Thank you.

MS. ATKINSON (IMF): We have said a number of times that the yuan appears to us to be substantially undervalued. We've also said that what's important is to think about the rebalancing of China's economy. More broadly it's important that the Chinese themselves are interested in boosting domestic demand and private consumption, and exchange rate movements would be just a part of that. It's also of course important to think about global rebalancing, and that means that deficit countries as well as surplus countries need to make some adjustments. IMF Press Briefing 3/18/2010

Perhaps because of my rebellious nature, I've always been attracted to the counter-trend trade. Back in my days as a Hedge Fund trader, I learned about the "max pain" (there are more colorful descriptions) trade. When the market is positioned for a currency price rise, IF (timing is everything, here) you can catch the changing winds of news, you can make a killing (or at least avoid getting caught in the slaughter). In Sorosian jargon, this is the bet against the false premise.

As James Chanos has been arguing: We’re all looking at -- one of the most obvious, obvious trades of the world right now is that the RMB, the Yuan is undervalued. Mr. Geithner, I think, is in Beijing tonight talking about whether or not China is a currency manipulator. Everyone is assuming China needs to peg its currency higher to avoid the export deflation going on.

Well, Chinese exports aren’t the problem here. And what if it turns out that by having to nationalize lots and lots of real estate, bad debts, the RMB is devalued?

These days, the mother of all "max pain" trades would be an RMB decline.  How likely might such an event be?

Let me preface my view (with which, and $4.50, you can get a coffee at Starbucks) with my more general sense that China is in the midst of an amazing transformation which has many more years to run. I wouldn't bet against China in the long term (or at least until demographics catch up to them).

However, other countries which have similarly transformed have hit speeds bumps in the process. Rapid growth creates a financial environment that begs (usually temporary) over-extension.  In China's case, their history of modern financial corporate governance is quite short (on that score, we, in the US still have more than a few kinks to work out). The burned hand, as they say, teaches best (or will after the stove is touched a few more times).

For the past few months China has been trying to slow the economy down, in particular the property market, probably in search of the elusive soft landing.  I've never been much of a believer in the "soft-landing" thesis. There are too many unknowns in a huge economy so policy inevitably over-shoots (or never uncovers the excesses at all). At some point, a threshold will be reached and we'll find out just how sound Chinese property (et alia) lending has been.

My guess is, as almost always tends to be the case, there will be a big difference between viable credit levels of an economy growing at 8% (or, according to the latest data more than 11%) and one growing at 1-2%.

Given that the Chinese banking system totals upwards of $11.5T in assets, even a small "hair-cut" means a couple $100Bil.  

China is now a key piece of our increasingly interconnected global economy. It certainly qualifies, in a more profound sense than the largest US banks, as Too Big To Fail.  We may even find that China's economy has grown sufficiently to ensure that when China sneezes, the rest of the world gets a cold.

In the event of a speed bump, support, in one form or another, will certainly be forthcoming and that support will not be predicated on how the IMF or other nations wish China to develop but on the infrastructure already in place in the same way that TBTF banks were given support based on their infrastructure in place (i.e. continued prop. trading, continued derivatives, etc.) and not on the proposed models envisioned in reform plans.

In times of crisis, ya' gotta dance with the gal that brung ya'.

China is an export driven economy (net exports were 8.9% of 2009 GDP), and the best way to goose such an economy is by letting the currency slide. Moreover, China has been the recipient of substantial capital inflows (the cumulative current account surplus only accounts for roughly 65% of the growth in FX reserves over the past 15 years- just to give a flavor and sense of magnitude). During a crisis, these flows will tend to reverse (or minimally, stop flowing in).

In other words, I wouldn't be surprised to see a not insignificant RMB decline in the medium term, as palliative to a domestic credit problem, before it resumes its more general uptrend against the US$.

I leave for future essays questions of the impact of China's first "speed bump" as a maturing, and huge world power on the international financial architecture (and the impact of a necessary increase in China's current account surplus on the US). Suffice it to write that if such an event occurs (and it will sooner or later) I suspect many known, but currently politically intractable flaws in the regulatory arena (or lack thereof) will come into sharp focus. But they will have to wait.

To repeat, in times of crisis, ya' gotta dance with the gal that brung ya'.

And from a broader perspective, the gal that brung us all to the dance is the gal of monetary stimulus to fix all that ails us.  I'm not, at the moment, arguing for a rethink of this policy, just observing.