Color My Yuan Gold

Those who read my blog certainly know my views on China's role in world economics. I have written on why China can't be the savior of the world and why the Chinese middle class purchasing power has been stifled by a central command policy of keeping the exchange rate range bound. I have also written about the rise of gold and the search for a new alternative reserve currency. With all my not- so- positive views on China there still is a way to profit from a Chinese attempt at giving the yuan a more prominent role in international trade; hoping that one day it will replace, or at least rival, the dollar in international settlements. While I don't believe the yuan is able, as a single currency, to replace the role of the dollar; attempts at doing so by the Chinese government will give rise to both the yuan and gold.

Everyone agrees that a main requirement for an internationalized yuan is free convertibility. That means markets will determine the value of the yuan and that is almost sure to translate into a higher yuan against the dollar. With a still developing economy the question is what will provide the support for such a young currency, on the international platform, to be the trade currency of choice. Of course many other reforms, political as well as economic, have to be implemented first, but the answer was given to us couple years ago when Chinese officials said they will be adding to their gold reserve. That of course makes perfect sense. China still has more poor people than any other country. The Chinese economy is still too immature to provide self support of an international yuan. That support will have to come in the form of physical gold. There is evidence of Chinese accumulation of the metal over the years. The power of the Chinese middle class has been kept in check by a foreign exchange policy that pegs the yuan to the dollar within a tightly managed range. If the Chinese want the yuan to be an international currency, and I believe they do, than they have to let the yuan float. This of course will hurt Chinese exports but will unleash the purchasing power of the middle class. The effect of such policy is not the goal of this article. Here my only objective is to point out that if I am right and China does finally let the yuan float than there is profit to be made. Keep in mind that will not happen overnight or over few months. It is more likely to unfold over a period of few years. But the payoff will be handsome.

There should be room in every investor's wallet for a little Chinese change. Soon you may be able to pay for that "Peking duck" lunch with "Beijing currency". It is easier than ever before to open a yuan account through the Bank of China, New York branch.

From Shang[High] to [Low] Chi Minh City

Globalization is the internationalization of capitalism. It basically applies the old economic concept of division of labor introduced by Adam Smith in his book "Wealth of Nations" (first edition 1776), to modern day movement of capital and the manufacturing of goods around the world.

Once again capitalism, and the inherent economic inequalities that are an integral part of it, proves its superiority to any other system we have seen over time. The differences in economic classes, like I have argued before, are necessary for societies to thrive. Built within capitalism is a safety valve that provides relieve when pressure builds inside the system.

Not long ago multinational corporations were rushing to either establish physical manufacturing presence in China or to outsource their production to the Chinese (and others) to take advantage of cheap labor. That is exactly what capitalism calls for: the pursuit of the most economical way, within an established set of rules, to produce a product or a service. With globalization this pursuit went from a country to a region to an economic bloc and finally worldwide.

The shift of manufacturing to China (China here is used as an example. Throughout the years other countries were the "Chinas" of manufacturing) brought with it an influx of badly needed capital. The result was prosperity, at least to a segment of the population, and the cementationof the idea of free market principles (at least to a certain degree). But the prosperity of China came at the expense, in part, of other neighboring economies. And this is part of the economic circle of life I tried to explain in my post, Money! The Misunderstood Concept And The Financial Pie (January 15, 2011), and the economic ladder with its ever changing upper steps.

The pressure I am talking about here is the inflation in China and the rise of wages. We are beginning to see a reverse of the influx China has seen over the last 15 years or so. Multinationals are now looking for other venues to produce their goods and services. The safety valve that will relieve the inflationary pressures for the multinationals is made available by the same system that gave rise to China at the expense of its neighboring economies, and that relieve will come from some of those neighboring countries.

Vietnam is that safety valve and will undoubtedly take some of that Chinese shine in coming years. Vietnam has a highly skilled but cheap labor. Government policies have been moving more toward free markets and away from centralization. This is the beauty of the economic circle of life made possible by free markets. It detects failures and allows for alternate solutions. Because we all are vying for a bigger share of the same pie and because all resources are limited it is only logical to expect a solution from within.

While for a period of time globalization may be, or seems to be, unfair to a particular country; its long lasting effects are positive, constructive, educational and motivational. Globalization allows for division of labor. It frees up capital in consuming nations to import more or consume more locally produced goods and services while providing exporting countries (those with lower standard of living) with a better life and an opportunity to climb the economic ladder. Countries, like China, have acquired a new set of skills that will remain with them in good and bad times. Ups and downs are part of the system, hence the economic circle of life within the limitations of the pie.

Remember while the objective of a manufacturing company is to move from Shang[High] to [Low] Chi Min City, an investor's goal is to buy [Low] and sell [High]. If you think about it, in this case, the reverse is the same and both producer and consumer benefit.

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The Train Has Left The Station And It Is Full Of Gold

In a sense it really no longer matters what the politicians in Washington decide to do with our debt problem. That issue has become a secondary determinant, along with the European debt problem and the Chinese inflation/hard landing story, of the price movement in gold over the long term. All these issues remain important factors in short term fluctuation in the price of gold. An agreement on the U.S. debt and debt ceiling issue will definitely cause gold to go down. The European deal to create a super fund to rescue failing EU members was responsible for a drop in gold prices last week. But given the few details about this agreement and what appears to be a lack of private participation in debt forgiveness is really not very encouraging with respect to finding "the" solution for the European debt issues.

But all these problems mentioned above have no baring, longer- term, on gold prices. In other words assuming all three issues are resolved gold prices will remain on the rise for the next few years. The IMF's latest figures show that the percentage of central banks reserves around the world that is held in dollars has been on the decline reaching 60.7% by the first quarter of this year compared to 71% in 2001*. Central banks bought more gold in 2010 than in previous years. The single most important determinant of gold prices in the long term now is the process of finding an alternate reserve currency, and while this process may have been set in motion a while ago it certainly has gotten a huge boost from the kind of behavior that we have seen coming out of Washington that sends tremors through the international economic system and shakes the confidence in our ability to provide a politically stable environment. The reason is simple: uncertainty. Uncertainty as to what will replace the dollar. This will be a long process as the world goes through a "figuring it out" period likely to last years. While the replacement may not be gold (even though it is likely to be) there is nothing that boosts the price of gold like a world full of economic problems in search of a reserve currency. The train has indeed left the station and it is only a matter of when it will reach its destination. The smart ones will be ready to help unload the content (or should I say the profit?). All aboard??!!

* From an article by Matthew Lynn, MarketWatch on 7/7/11

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Do The World A Favor And Let Greece Default

It's a movie we have seen before and are likely to see again unless certain things happen. A year or so ago some praised the first Creek bailout and declared an end to the European financial crisis. But there was one thing I could not comprehend back then about this end-all solution. How do you solve someone's inability to pay off his existing debt by piling on more loans without a significant increase in that individual's earnings? While austerity measures can be effective in certain situations this was not, and is not, the case here. Politicians do not solve problems, they just paper over them. They are fully aware of the causes and the solutions but intelligent enough to offer illusionary fixes that guarantee their re-election.

Capitalism is the best and most efficient economic system mankind has ever seen but only if allowed to function based on the principles of free market with minimal government interference. That means risk is rewarded and failure is punished. Not risk distorted and failure not allowed by government interference. Yet this is exactly what has been happening in the U.S, Europe, Asia and elsewhere, and people wonder why the world still can't shake off the consequences of the 2008 financial crisis.

By not letting Greece default the first time around (a nicer way to say it is to let them restructure their debt) the problem was magnified. This is how. Back then the ECB lowered its standards for the quality of collateral it would accept against lending European banks money to keep them afloat, including Greek banks. But since Greek banks could not raise money in the bond market they issued bonds with the Greek Central Bank guarantee and turned these over to the ECB for cash. On top of that billions from the IMF allowed Greece to pay off the interest due and retire its maturing debt. But two things were missing from this solution. First, the hope was that the world economies would recover and together with the austerity measures implemented (or not) then would allow Greece to generate enough revenue to service its debt and find its way back to prosperity. This hope did not pan out and we ended with Greece still in the same situation it was in a year ago but with much more debt added to its books. The second, and more important missing part, is that the bailout did not involve a restructuring of the debt that would have caused private bondholders, including other European banks, to lose portion of their investments therefore putting Greece in a much better situation able to service the now much smaller debt load. This is the distortion part by not allowing failure. So the result is that a year later we have a world economy that at best is not getting worse and a country with more debt and less means.

I am very careful here to advocate a market lead restructuring and not a government forced one. You see one of the main principles of capitalism is that a set of understood laws be allowed to govern private business transactions free of government interference. Otherwise, lenders in the future will be very hesitant to help finance the world economies.

For the Greek bailout to be effective the European governments and the ECB should make it very clear that they would step in to help only after the private bondholders, including European banks, have negotiated a restructuring of the debt. I understand that many of these bondholders are European banks, even the ECB itself. But this would send a very powerful message to the private sector that government is not going to step all over laws that allow for a clear way to determine and price risk. The pain will be severe if this action is taken, banks would have to be recapitalized, standard of living will have to come down for many years but at the end there is going to be a bright prospect for all. The alternative is the same severe pain extended many years out and another visit of the Greek debt a year or two from now. Yes this action may cause a recession in the short run but as long as the restructuring shaves enough off the overall debt, together with the austerity measures, Greece will be just fine albeit with a lower standard of living. After all who says I am entitled to live the high life with my neighbor's wealth? This solution is a bold one that many governments may not be willing to endorse. However, it is the best and most fair for it punishes those who took the risk and lost, both the lenders and the borrowers in this case, while preserving and re-enforcing the foundation of capitalism. So please do us all a favor, make us suffer, take away our luxuries and let's get on with the healing process. Is there a better feeling than the feeling of not having debt? isn't a mind free of worries indeed a luxurious one?.

On a different note I have been watching China very carefully over the past couple of years. My thoughts, for the most part, have not been positive. But two fairly recent events have reconfirmed my belief about China and have given rise to an alternative investment vehicle to the factory of the world. First, news abound in the last few weeks about unrest in several Chinese cities and provinces (to include a car bomb) whereby the state had to deploy thousands of security/military personnel to ensure these demonstrations don't spread or become acute. Simply put the have not (the vast majority of the Chinese) are protesting inflation and the lack of jobs. Second, closely related to this rise in inflation is the skyrocketing wage increase for Chinese labor. Combine that with an appreciating Yuan (perhaps even as a desire to make it an international currency) which will make Chinese imports cheaper but Chinese exports more expensive and you can see why multinationals will be looking for alternatives. One country that comes to mind is Vietnam (more on that in a later post).

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Gold, Oil and Short Treasuries: The Trinity of Investment Plus One

Indeed this is a time unlike any we have seen since WWI, perhaps even earlier. A time so full of economic and political tribulations of worldly proportions that has left the best and brightest of Wall Street and World Street scratching their heads trying to make sense of it all. It is never an easy task to rationalize market movements because investing is not an exact science. Rather it is a behavioral science, sometimes with the logic of exact science. In this behavioral science the numerical value of "1+1" doesn't always have to be "2". A change in the value of any of the components of the equation "1+1+1=3" may or may not maintain its equality, yet it would still make perfect sense. The reason for that is the unpredictability with any certainty of the actions and reactions (+ and -) of the different components of the investment equation and of market forces that are sometimes hard to identify. Investment books and literature, as well as CNBC, tell us that the existence of certain elements guarantees a specific outcome such as when the dollar falls the price of oil goes up, or an increase in supply leads to lower prices, etc... in other words 1+1+1 must equal 3.

Here are the reasons why the "trinity of investment plus one" make perfect sense even though they may seem, at times, contradictory. One has to sidestep the CNBC conventional wisdom for a second and engage in out of the box thinking in these unusual times.

GOLD

Gold prices continue their climb on a path charted by the world central banks in an effort to stimulate economies that pulse only because of governments borrowed money . Despite QE2 and the purchases of the Federal Reserve of government bonds interest rates continue to rise in the U.S. The tragedy in Japan increases the likelihood of a QE3 by the Fed further debasing the dollar and cementing the role of gold as a reserve currency. Inflation is popping out everywhere, in China, in India, in Brazil and in the U.S. Inflation was the spark that launched the rolling revolutions in the Middle East and will catapult gold to its destined status (see previous posts on gold).

OIL

The unthinkable has happened. People in the Arab world have finally said enough is enough. And while democracy does wonder for a free economy this is not the case here. For starter we don't know yet if the Middle East is going to adopt democracy (there are hopeful signs but nothing more). Tonight we hear that the cries for freedom have taken four lives in Syria ( a very serious development). The rolling revolutions in the Middle East are not what will cause the price of crude to go even higher from its currently decried levels. The actions of Iran to counter Saudi presence in Bahrain will be the main determinant of higher oil prices. By creating uncertainty and a perception of a potential oil supply disruption through attempts to destabilize regimes in the region Iran can enjoy a much needed higher oil revenues while scoring a political point or two.

I am at a loss to understand the prediction that the unfortunate events in Japan will be a drag on oil prices. While this may be true in the very short time, absent the events in the Middle east, I see the Japan situation very bullish for oil. Not only is the rebuilding going to require a lot of energy but also the drop of the dollar and the strengthening of the yen (not necessarily against each others) will encourage more oil buying. Once the nuclear reactors problems are under control Japan will embark on a rebuilding campaign that will be very bullish for oil. The intervention of the G7 to halt the appreciation of the Yen is meant to ensure a robust recovery for Japan.

Short Treasuries

Everyone seems to be concerned about the repatriation of Japanese money to pay for the costly rebuilding. But what worries me is the possibility of non-Japanese money leaving U.S. treasuries in search of a better investment opportunity in Japanese equities. No matter how you look at it Japan is going to further add to its debt, which stands at 200% of GDP, to finance its rebuilding. In this case additional debt is a good thing because of the immediate return on investment that will be measurable and productive. If this shift of non-Japanese money from treasuries takes place it will indeed be a negative for U.S. bonds. Couple this with inflation and larger and larger debt as a percent of GDP (in many countries) and you can see the effect on bonds prices.

Plus One

Sometimes the components of the investment equation must be looked at individually and in isolation in order to understand the risk reward ratio. While together they may not maintain the integrity of the equation, individually they make perfect sense. Food is the "plus one" in this equation. Despite all the worries facing the world economies, despite debt and inflation, despite wars and revolutions, or perhaps because of all of that, and despite the lack of wage increases people of the world will consume more food and nations of the world will rush to buy more agriculture products to make sure their populations are fed. Does China want a food revolution? Yet because of the world limited resources (see the post about Financial Pies ) higher food prices are inevitable irrespective of a broader inflation.

so in this perspective 1+1+1 equals 4. Go figure, who says there is no new invention in math?

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The Visible Ghost Of Inflation

Can you see a ghost? I can if we are talking about inflation, and I am. For about two years now, and following the unprecedented money printing the Fed has been doing, some have been adamant that inflation is not a problem nor would it be because the Fed has a "plan" to drain out all, or most, of the liquidity it pumped into the economy. Even today with gold at around $1,350 some still refuse to acknowledge that inflation is even a possibility. Really!!! tell that to the rioters in India and Bangladesh. Tell that to the Tunisian people who toppled a well entrenched dictator because food prices are rising fast. Convince the Egyptians, whose government may fall before these lines are finished, that price increases are a figment of their imagination. Inflation is spreading throughout the world mainly as a result of all the money the central banks have been printing but partly because some up and coming societies like Chindia and others are now consuming more because of their new found prosperity. Those who believe inflation does not exist cherry pick their data. While they acknowledge some basic commodities prices are higher they counter that real estate values have plummeted. They got that right! except that for the most part plummeting home values do not result in increase in disposable income . People don't have to buy something they can't afford but they do need to buy wheat, rice, butter etc...so this attempt at arguing there is no inflation doesn't really hold water. Additionally, because of globalization what used to be a home grown phenomena, inflation, is now like any other commodity that can be imported from far away places. As the factory of the world China exports its inflation just as easily as, and through, its exports of manufactured goods. Like other economic concepts inflation can take many forms including outright increases in the price of basic raw materials and the appreciation of a currency. That is why countries have been rushing to fight off inflation by increasing interest rates or imposing measures to devalue, or at least limit the appreciation of, their currencies by making them less attractive to foreign investors hoping to discourage foreign capital inflows.

The ghost is here. It may not be fully visible yet because most companies have not been able to pass on the increase to the final consumer. Make no mistake business to business inflation is here and widely acknowledged. If there is no relief at some point (soon) businesses will have to make the decision of whether to take a hit to the bottom line or attempt to pass on the extra cost. Do you want to bet which way they will go?

It is nearly impossible to reverse the flow of water once it starts down the drain. But again maybe this is the plan. Bernanke said a little inflation is not a bad thing. The problem is how do you engineer and control a little inflation with such a huge amount of liquidity. The answer is you can't. You just hope that the length of the drain that water has to travel is short. And short treasuries is what you do to keep your head above water.

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Money! The Misunderstood Concept And The Financial Pie

I once had a friend say to me "I don't know why our government does not print enough money for everyone to have everything they want so we can all be rich". My reply was if printing, or having, money was the answer than Latin Americans would be the richest people on earth. To the contrary, printing money without economic productivity to justify such an action is a slow but sure way to the poor house. It creates a false sense of prosperity. Money is nothing but an agreed upon medium of exchange. Money by itself does not make a person rich. The purchasing power of that money is what determines the wealth of an individual. Many factors go into determining the purchasing power of a specific currency. Chief among these factors are free market forces and government economic policies. However there is another less talked about , or should I say less understood, but equally important factor that determines the purchasing power of a currency. That is the limiting factor. This translates into productivity within the confine of what I like to call the financial, and other, pies. That is what makes an individual or a nation rich. Rich only in comparison to other not so productive society(ies).

Our ability to produce (economic activities) is limited by many factors including human resources, natural resources, political stability, free market principles or the lack thereof and yes financial resources as well. Economic activities require, among other things, financing and the financial pie is by my definition finite, no matter how big it is or how big it grows. There is always a limit on our ability to grow that pie. Limits are imposed ultimately by the value of money. Money is just another commodity that has a price that is determined by, among other factors, what the perceived value is and what others are willing to pay for it. That could be in the form of outright purchase or exchange for other currencies, services or simply the interest rate attached to that currency's debt. All financial pies are limited (by definition) but all are not equal. In other words Americas' financial pie is limited but much bigger than all other countries' pies including China's.


Today, America is faced with the phenomena of other economies vying for a greater share of the financial pie which ultimately determines the size of all other pies these economies can afford (production pie, consumption pie, etc...). Even though the size of the pie does grow over time to reflect changes in demographics and economic activities and changes in human economic behavior ( desire for more goods and services whether as luxury or as necessity as we see today in Bangladesh and Tunisia), its borders are always defined. As I always say if everyone is economically equal society could not function. Economic inequality is a necessary beast in our society as we know it today. Of course that does not mean that individuals or nations can't progress. They can, they should and they do. But it does mean that the progress ladder will always have lower steps that have to be climbed to reach the ever changing upper steps. If one tries to jump to the top they run the risk of falling hard. The point I am trying to make here is that because of the pie shaped limitations the betterment of any economy(ies) always comes, in the long run, at the expense of another economy(ies). China at the moment seems to be capturing a bigger share of some of the pies, certainly the financial pie. However, this comes at the expense of denying its people the right and opportunity of a better life by keeping the value of the yuan artificially low and at a substantial risk to the economy going forward. But China can't be ignoring market forces for good and it certainly can't keep artificially growing its economy much longer. So eventually China's share of the pie will stop growing and start declining giving others an opportunity.

Because money in itself has no value other than being a medium of exchange printing more of it causes the value determining factors of that currency to assign it lower valuation.

As for me I have always liked apple pies because they are as American as pies can be.