the Chinese currency and the Chinese stock market

Throughout my financial career I’ve found that in sizing up currency markets traders from the big banks have always been ten steps ahead of me.

I’ve hopefully learned to live with this–meaning that because I’m never going to outthink them I believe my best currency strategy should have two parts:

–to avoid making future currency movements a major element in constructing my portfolio, and

–to be a “fast follower” if I can–that is, to figure out from a trend change what the banks must be thinking and to consider getting on board if I think the trend is going to have legs.

 

China has moved the price at which it will buy and sell renminbi down by 1.9% yesterday and by another 1.6% today.  Informed market speculation seems to be that another couple of downward moves of the same magnitude are in the offing.

From a domestic policy perspective, China would prefer a strong currency to a weaker one.  As I mentioned yesterday, the country has run out of cheap labor and must, therefore, transition away from the highly polluting, cheap labor employing, export-oriented basic manufacturing that is the initial staple of any developing country.  This kind of business has been the bread and butter of many Chinese companies, some of them state-owned, for decades.  Many are resisting Beijing’s call to change.  The strong currency is a club Beijing can use to beat them into submission.  In this sense, the fact that the renminbi has appreciated by 10%+ against other developing countries’ currencies over the past year, and by around the same amount against the euro, China’s largest trading partner, is a good thing.

On the other hand, the developed world has made it clear to China that if it wants to be included in the club that sets world financial policy, and in particular if it wants the renminbi to be a world reserve currency, the renminbi cannot be rigidly controlled by Beijing.  It must float, meaning trade more or less freely against other world currencies.  So China has a long-term interest in doing what it has started to do yesterday–to allow the currency to move as market forces drive it.

Why now, though?

World stock markets seem to be thinking that a severe erosion of China’s GDP growth is behind the move toward a currency float–that it’s backsliding from a committment to structural reform.

I’m not so sure.

I think what currency traders have concluded is that Beijing has enough money to prop up its stock market and enough to keep its currency at the present overvalued level–but not both.  So they’re borrowing renminbi  and selling it in the government-controlled market in the hope of pushing down the currency and buying back at a lower price.  Understanding what’s going on, and realizing the risks in defending a too-high currency level, Beijing is bending in the wind.  Doing so limits the amount of money that can be made this way, effectively short-circuiting the strategy.

Offshore renminbi, which can’t be repatriated into China, trade about 5% cheaper that domestic renminbi.  That’s where we should get the next indication of how far renminbi selling will go.

As far as my personal stock investing goes, my strong inclination is to bet that renminbi-related fears are way overblown.  I’ like to see markets calm down a bit before I stick a toe in the water, though.

 

 

 

 

 

the Chinese renminbi “devaluation”

devaluation?

Every day the Chinese government sets a mid-point for trading of its currency prior to opening.  The renminbi is then allowed to trade within a 2% band on either side of the setting.  At this morning’s setting, Beijing put the mid-point 1.9% lower than it was yesterday.  This is an unusually large amount and can be (is being) read as an effective devaluation of the currency.

What does this really mean?

background

In the late 1970s, when China made its turn away from Mao and toward western economics, it chose the tried-and-true road toward prosperity trod by every other successful post-WWII nation.  It tied its currency to the dollar and offered access to cheap local labor in return for technology transfer.

Late in the last decade, the country ran out of cheap labor.  So it was forced to begin to transform its economy from export-oriented, labor-intensive manufacturing to higher value-added more capital-intensive output and toward domestic rather than foreign demand.  The orthodox, and almost always not so successful, method of kicking off this transition is to encourage a large appreciation of the currency.  That causes low-end production to leave for cheaper labor countries like Vietnam or Afghanistan.

China, armed with a cadre of young, creative economists with PhDs from the best universities in the West, decided to do things slightly  differently–to hold the currency relatively stable and to boost domestic wages by a lot to achieve the same end of making export-oriented manufacturing uneconomic.  The idea is that this doesn’t bring the economy to screeching halt in the way currency appreciation does.  So far this approach seems to be working–although the shift does involve slower growth and a lot of domestic disruption.

At the same time, forewarned by the immense damage done to Asian economies by speculative activity by the currency desks of the major international banks during the 1997-98 Asian economic crisis, China elected not to let its currency trade freely.

what’s changed?

For some years, China has been upset about the fact that despite being the biggest global manufacturing power, and by Purchasing Power Parity measure the largest economy on earth, it has virtually no say in world financial or trade regulatory bodies.  Those are dominated by the US and EU.  The main reason for China’s limited influence is that its financial system isn’t open.  (The other, of course, is that fearing China organizations like the new US-led Pacific trade alliance pointed excludes the Middle Kingdom.)

So China has been gradually lessening state control over the banks, the financial markets and the currency, in hopes of being admitted into the inner sanctums of bodies like the IMF.

In one sense, this is why China is becoming less rigid in its control of renminbi trading.

why now?

There’s no “good” time to let a currency float.  China doesn’t want to cede control over currency movements at a time when the renminbi might appreciate a lot, since that would be a severe contractionary force.  On the other hand, it doesn’t want the currency to fall through the floor either, since that would result in new export plants sprouting up all over the place.

China is growing more slowly than normal and is experiencing currency outflows as a result of that.  Letting the currency slide a bit relieves some of the pressure–although it may simultaneously attract speculators to try to push the renminbi lower.  So, yes, it is a sign of economic weakness.  At the same time, the loosening comes shortly before the IMF will decide on admitting the renminbi as one of its reserve currencies.  And it follows by a few months Beijing allowing banks to issue certificates of deposit at market rates, rather than at yields set by central planners.  So it’s also a step toward a healthier, more economically advanced, future.

my take

I think worries about the stability of the Chinese economy are overblown.  I also think that traders are using the Beijing move as an excuse for selling that they’ve been wanting to do anyway.  Beijing may have been the trigger for this, but it isn’t the cause.

 

 

 

 

negotiating: Casio, China and Greece

requesting an investment banking client meeting

Years ago, so long ago in fact that Tokyo was by a wide measure the largest stock market in the world, I received a call from a broker asking whether I wanted to meet with the top management of electronics maker Casio in my office in Manhattan the next day.

I knew the company a bit.  I’d visited it in Japan.  It wasn’t a particularly well-run firm.  And it was an exporter, a weak yen beneficiary, at a time when the yen was soaring and only domestic-oriented companies went up.  So I had little interest.

But I said yes anyway.

The broker was in a bind.  He was supposed to be showing Casio the power of his firm’s client list in New York and some manager had cancelled at the last minute, creating a potential loss of face for both the broker and Casio.  I had only a small pool of money under management and my acceptance would obligate the broker to provide me a return service that my commission volume alone couldn’t buy.

Apparently, the CEO of Casio felt under the same sort of obligation.  The meeting was interesting and informative, although it gave me no reason to want to buy the stock.

negotiations with China

The main topic was the company’s negotiations at that time to increase manufacturing capacity in China.

Casio met with Chinese government officials over several sessions and came to a preliminary agreement.  When the two sides met again, ostensibly to cross the ts and dot the is, the Chinese side reopened the negotiations, demanding substantial new concessions.   What Casio expected to be the end point turned out to be the new starting point for further haggling.  It went along because it figured the costs of starting again elsewhere from scratch were too high.

This happened several more times.

Then a contract signing was scheduled.  At that meeting, the Chinese side accused Casio of complicity in the rape of Nanking and demanded still more concessions as a form of reparation.  Casio did so, even though the last contract changes removed all chance of profit from the new plant.

With some distance, the CEO’s main conclusion from this experience was that the long-term relationship of mutual respect and trust that he hoped to find in China was simply not there.  He’d already decided to cut his losses and do no more expansion in China.

Greece today

I was already quite familiar with this negotiating style, which might be described as death (of the other guy) by a thousand cuts.  I’d seen a former boss to the same thing to Lehman.  In that case, however, Lehman eventually picked up and left in disgust.

In its negotiations with the rest of the EU, Greece has been following the same playbook Casio described to me decades ago, down to the accusation of wartime atrocities.  The main casualty in this approach is the loss of trust between the parties, once the Casio-side party realizes the other has no interest in a solution that brings mutual benefit.

It seems clear to me that we’ve passed that point in the Greece-EU discussions.  We’ll find out over the weekend whether this precludes any agreement from being reached.

 

 

 

the Chinese economy (i): background

size by GDP

According to the CIA World Factbook, the US is the largest economic power on the globe, with 2013 GDP (calculated using the Purchasing Power Parity method) estimated at $16.7 trillion.

The EU is a close second, with GDP of $15.8 trillion.

China is in the #3 spot, with GDP of $13.4 trillion.

Together, the trio make up about half the world’s GDP.  (A quarter century of stagnation has left former co-#1, Japan, a mere shadow of its former self, with GDP of $4.7 trillion.)

China’s economic strategy

Since turning away from central planning toward a market economy under Deng Xiaoping, China has faced two related issues:

–creating enough new jobs to absorb new entrants to the workforce, thereby avoiding political instability, while at the same time,

–reining in the inefficient, loss making, often corrupt state-owned industrial sector, which accounted for three-quarters of all employment in the late 1970s.

Two other constraints:  China had to do this without an effective central bank and with a cadre of state and local government officials who thought (many still do) that the fastest and most lucrative road to the top was to create more labor intensive, inefficient (and corrupt) local analogues of big state-owned enterprises.

China has achieved spectacular economic growth by embracing capitalism.  To some degree, the remaining state-owned sector, which now accounts for just over one quarter of the economy, has also shaped up.  But while doing this, China has tended to lurch between periods of substantial credit restriction to try to force state-owned enterprises to become more efficient or die, followed by excessive expansion when layoffs become too severe.

the latest wrinkle

Emerging economies, following the post-WWII Japan model, start by offering cheap labor for simple manufacturing businesses, so that they can acquire training and technology from foreign firms.  At some point, a given country will run out of labor.  It must then transition to higher value-added endeavors.  Few succeed without a lot of heartache, because–I think–vested interests attached to the status quo are so powerful.

China now finds itself at this transition point, an issue which dominates its current economic policy.

More tomorrow.

 

problems in emerging countries (ii): financial markets

First, a small–but important–distinction.  There are emerging markets located in wealthy nations.  They focus almost exclusively on trading of local securities in countries where not many companies are listed and where locals have little interest.  Germany used to be one such backwater–and still is, to some extent.  Eastern European countries, members of the EU but with rudimentary securities markets, are another.

Then there are emerging countries, and their stock markets.  This latter group is what I’m writing about today.

emerging countries’ markets

The securities markets in emerging countries have two important characteristics that I think most investors are unaware of:

1.  There’s very little local demand for stocks or bonds.  There are usually no institutional investors, because there are no pension funds.  The average citizen works a 60-hour week to make, say, US$125.  He has no money to put at risk by buying bonds or stocks.  He may not trust his local financial institutions.  Instead, he may buy gold and bury it in the back yard.

This means that the local markets rise and fall on demand from foreigners.  When times are good, foreigners pile in and financial instruments soar.  The longer the boom, the deeper into unknown waters (smaller markets, micro-cap stocks) they wade.

Eventually, the tide turns.  The first to leave quickly exhaust local demand.  The rest can find no one to sell to.  Around 1990, for example, developed country investors “discovered” Indonesia toward the end of a long bull run in emerging markets.  After the party wound down, it was at least two years before investors with large holdings in Indonesian stocks could even begin to pare them.

2.  Local rules can change quickly.  Changes can apply either to everyone or just to foreign investors.  Capital controls can be imposed that would allow foreigners to sell securities but prevent them from exchanging the local currency they get for anything else, or would forbid them from removing sale proceeds from the country.

Or the government might simply tell foreigners they couldn’t sell   …or could unofficially tell local brokers they could not accept a sell order from a foreigner or process a completed transaction.

Not good.

active managers vs. index funds/ETFs

Veteran investors in emerging markets generally understand that the battle of wits between buyer and seller can sometimes turn into a game of Whack-a-Mole, with them in the role of the mole.  They cope either by staying completely away from the riskiest markets or holding only the safest names in small amounts.  They meet redemptions by selling some of their holdings in larger, more stable markets if they’re caught in a no-liquidity market.

This is a plus and a minus.  On the one hand, fund investors can get their money back.  On the other, by rerouting selling from risky to more stable markets, meeting redemptions ends up creating a minor kind of contagion.

Index entities, on the other hand, have little discretion.  They don’t have active managers to do selective selling.  They don’t want active managers, either.  What if the manager sells the wrong stuff and the fund/ETF underperforms, as a result?

ETF selling, which I’ve read has been quite heavy recently, exerts downward pressure on everything in the index–good or bad, sound country or not.  This ends up being another, stronger kind of contagion.

The question I don’t know the answer to is what an emerging markets index fund/ETF does with illiquid securities that its mandate (to mirror a specific index) forces it to sell but for which it can find no buyers.  My guess is that the firm that runs the index entity purchases the securities in question, after having a third party determine fair value.  I don’t know, though.

Anyway, problems in a few emerging markets can quickly spread to the whole asset class.

what to do

At some point, I think the right thing to do will be to look for an experienced emerging markets manager with a good track record, who works in a strong no-load organization.   Let him/her sort through the rubble for us.  I don’t yet feel a strong urge to do so, however.

problems in emerging countries (i): economic

There has been a lot of hand wringing lately about emerging markets.  Worries are two-fold:  economic problems and stock/bond market problems.  Today I’m going to write about the first, tomorrow the second.

Even when I was in school, there was a well-understood, coherent, all-encompassing theory of how a closed one-country system works economically.  There’s nothing like that, even today, for a multi-country system with open trade, differing political philosophies and involving countries at various states of economic development.

I guess I’m saying that what follows is highly simplified, although I think it still gets across what the basic forces at play are.

an emerging country

Suppose the citizens of  an emerging country, or the government for that matter, want to obtain goods made by another country.  Let’s also say the seller won’t accept the buyer’s local currency but wants to be paid either in its own currency or in some global standard, like dollars, or euros or renminbi.

The buyer has several choices.  It can:

–barter with the other country, avoiding the forex issue,

–sell domestic goods in international markets, obtain foreign currency that way and use it to buy the foreign goods,

–use foreign currency it has previously piled up somewhere,

–sell domestic assets, like farmland or mineral rights, to foreigners or

–borrow the foreign currency it needs.

If the country routinely generates enough foreign exchange to meet its needs (think:  oil exporters), there’s no problem.  It can buy all the foreign goods it wants.  But that’s not normally the case.  Emerging countries routinely run trade deficits (that is, they buy more stuff from foreigners than foreigners buy from them).  To make up the difference, they borrow any extra foreign currency they require.  [an aside:  it’s also possible that the government of the country we’re talking about runs a budget deficit, meaning it spends more than it takes in.  That’s also a problem, but it’s not what we’re talking about here.)

In economic boom times, investors tend not to worry too much about how and when they’re going to be repaid.  (In fact, a generation ago international banks deliberately made loans to emerging countries that they knew could not be repaid.  The banks figured they’d collect big fees when the loans were restructured.  The possibility of default never entered their heads.)

In leaner times, investors look more carefully.  They make a (crucial) distinction between borrowing that pays for factories that will manufacture goods for local use or export, and borrowing that pays for purchases that produce no economic return (think: flat screen TVs, gold jewelry or military gear).  Building factories that will generate foreign exchange in a year or two is ok.  Borrowing to buy consumer items isn’t.

Lenders may initially be willing to make loans that are payable in local currency.  As/when the country begins to have a chronic trade deficit, lenders are no longer willing to do so  They shift to loans repayable in dollars…, which makes the foreign currency problem worse.

In cases where lenders see the probability getting their money back declining, new lending dries up.  The local currency begins to weaken.  The government has to raise interest rates–this supports the local currency and cuts into demand for foreign goods by slowing overall economic activity.  This is all toxic stuff politically.  Sometimes (think:  Argentina) local governments find any form of austerity to be impossible.

In my experience locals sense the beginning of a downward spiral long before the international investing community does.  Capital flight begins.  This makes the situation worse.

loose worldwide money policy

One of the side effects of qualitative easing in the US + Abenomics in Japan + Chinese efforts to promote the renminbi as a world currency has been to flood the world with money.  A lot of that has found its way into sketchy emerging countries that are economically unstable and on the verge of a currency crisis.  It appears many yield-chasing investors were unaware of the risks they were taking.  The presence of relatively high yields was all they saw.  Others were playing the greater-fool theory, figuring they could sell before the music stopped.

When the Fed began to talk about an end to tapering, the latter group knew the game was up and began not only to cease new lending to,but also to extract their money from, what has since become known as the Fragile Five.   That has led to weakening currencies, lower securities prices and a higher cost of lending in these countries.

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