The Rise of the Yuan

by Addison Wiggin & Ian Mathias

  • World rejoices as China unpegs yuan… or did they?

  • Some short- and long-term effects of a stronger Chinese currency… for better or worse

  • States go Enron: Laughable (and frightening) accounting tricks for Illinois pension fund

  • Raters dodge the bullet: How ratings agencies might be completely left out of financial reform

 

The biggest news in the world today didn’t actually happen. Conspiracy!

“China Eases Currency Peg,” The Wall Street Journal announced yesterday. The Journal, along with every paper in the world, has something to say about China’s groundbreaking move Sunday. At long last, we’re told, China has agreed to end its currency manipulation agenda and allow the yuan to float freely.

Or did they?

 “The People’s Bank of China has decided to proceed further with reform of the RMB exchange rate,” read the country’s actual statement. The Chinese government noted that it was now “desirable” to stop fudging the yuan, but didn’t actually announce a plan to do so. In fact, the brief statement made it quite clear that “the exchange rate floating bands will remain the same.”

In other words, keep cool. All we really know is that China has “decided to proceed” with reform and will — eventually — “enhance the RMB exchange rate flexibility.” As Treasury Secretary Geithner noted, “The test will be how far and how fast they let the currency appreciate.”

If China insists on acting so… Chinese… we expect the change to occur in painfully slow motion and in a limited range.

  After all, China has a massive export economy to protect. In fact, China will be the biggest manufacturing economy in the world by 2011. At latest count, according to a new IHS Global Insight study, the U.S. accounted for 19.9% of the global production. China is good for 18.6%. Sometime over the next year, the firm says, the inevitable will occur, and China’s 1.2 billion citizens will start producing more than ours.

Unless, of course, they let the yuan get too strong.

  Nevertheless, the yuan is back in en vogue today. Traders bought the currency up 0.42% overnight — its biggest move since its 2005 revaluation.

Still, at 14 cents, there’s a long way to go before the yuan is even close to a level playing field with the U.S. If history is any guide… buy the dips.

  In the long run, a stronger yuan is just another — very powerful — argument for China’s booming middle class. The Chinese have proven their appetite, for a lack of a better phrase, for “Western living.” Recent labor strikes and labor disputes have demonstrated that the young Chinese poor are ready to give up their role as the world’s cheapest labor. And now a stronger yuan… to boost their purchasing power?

The stars seem to be aligning. For more, and some specific investment advice, you have to check out Chris Mayer’s latest Special Situations report: The New Chinese Middle Class: Eight Tiny Stocks Set to Explode From the Largest Population Trend in History.

We’re currently offering access to the report for just $1. No strings attached… check it out here.

  “A stronger local currency might mean China is changing gears in its economic growth plan,” Dan Denning affirms our suspicion. “That is, rather than relying on export-driven GDP growth, it will shift toward more domestic demand (people spending money). According to the Financial Times, consumption as a percentage of GDP in China has actually fallen from 45% to 35%. In other words, Chinese economic growth has become even more export reliant.

“Is that changing now? Hmm. We'll see. For Australia, there's an argument to be made that a stronger Chinese currency is bullish for commodities. China can use its stronger currency to buy more tangible assets and fewer U.S. Treasury bonds. And maybe the unleashing of Chinese domestic demand will boost demand for certain Australian resources that are used in the production of finished consumer goods and not capital goods.

“The other take on the China move is that it's a race to the Keynesian bottom globally now… it could be that the mantle of leadership for engineering global inflation has shifted East over the weekend.”

(For more on the Chinese growth machine, check out this CNN article. It features Rich Lee, the latest addition to our squad of analysts.)

  One immediate effect of the yuan announcement: China will have a handy card to play at this week’s G-20 summit in Toronto. Or you might say, the U.S. will have one less.

  A “free” yuan is good for just about every asset class except the dollar and U.S. Treasuries, the market claims today. Stocks are up, commodities are up and most foreign currencies are up, too.

It’s just the lonely dollar, which won’t be able to afford quite as many Salad Shooters and Nike shoes, that’s hurting. The dollar index is down almost a full point from last week’s high, to 85.7.

In a similar fold, “China's announcement has to be a shot across the bows of U.S. Treasuries,” explains our friend Chuck Butler. “A stronger renminbi means less currency reserves, which means less money that the Chinese will have to buy Treasuries.”

The yield on a 10-year note is up nearly 10bps today, to 3.3%. That seems particularly low, still, especially with news like this:

  Illinois is resorting to Enron-style accounting to fix its pension programs. After raising the retirement age and capping pension payouts, Illinois’ pension plans are still underwater. So last week, Gov. Pat Quinn announced that “We can’t afford to deny reality or delay action any longer.” In a nearly unheard-of move, he then singed legislation that would slash benefits.

Benefits for those who haven’t yet been hired.

As the NY Times explains: “That vaunted $300 million in immediate savings? The state produced it by giving itself credit now for the much smaller checks it will send retirees many years in the future — people who must first be hired and then, for full benefits, work until age 67.”

So explain to us, valued reader, how this is not the exact kind of mark-to-fantasy model accounting that caused the Enron fiasco?

  Another Monday, another bank failure to report. The FDIC shut down just one bank on Friday afternoon — Nevada Security Bank. That’s the 83rd of 2010. This Monday of last year, we’d crossed just 40.

  Ratings agencies may have just completely dodged financial reform. Last week, the House and Senate removed the one amendment in the coming financial reform bill that addressed the ratings agencies. In its place — really, you can’t make this stuff up — Congress will commission a two-year SEC study. The SEC, apparently not busy enough, will spend the next couple years poking and prodding the agencies and ultimately deliver Congress a report, which will announce whether a conflict of interest really does exist, and the commission’s advice as to how to fix it.

Now, we will admit, the “reform” that this study will replace was a complicated mess. The brainchild of Sen. Al Franken, it was a plan all too typical of Washington: The amendment would have empowered the SEC to set up a new agency with its own fun acronym (the Credit Rating Agency Board, or CRAB), which would in turn give the ratings agencies new sets of hoops to jump through and papers to file. In short, we don’t blame Congress for wanting a different solution.

But a commissioned study by the SEC? C’mon.

(If you’re interested, we had a whole lot more to say on this matter, including one reasonable solution to the ratings mess, in the latest weekend edition of The Daily Reckoning.)

  Today’s fun fact: Fannie Mae and Freddie Mac currently own around 164,000 foreclosed homes — more houses than there are in all of Seattle. They take a new one every 90 seconds, says the NY Times… that’s three in every 5 Min. Forecast! Scary stuff, especially considering they are at least $146 billion in the red.

  “Instead of locking in on Atlas Shrugged, perhaps better reading might include Andrew Carnegie's essay on the duties of wealth,” a reader writes us, this one referring to the debate we’ve been having over Warren Buffett and Bill Gates’ pledge to give their riches to charity postmortem.

“Buffett, by his own admission, is largely a product of the culture in which he resides. Were he to have been born in Peru or Bangladesh, the outcome would be far different. Social capital — infrastructure, stable government, educational opportunity — constitutes about 90% of the success that can be attributed to such people. The principles upon which this country was founded include proper distribution of wealth to those who actually create it through their labor and ingenuity… Show me a unionized company and I'll show you a company that did not properly distribute wealth and treat its wealth-creating workers properly…

“Who among us actually creates millions of dollars worth of wealth in one year? No, not professional athletes, not movie stars, not clever investors and not the overpaid corporate managers who utilize the phrase ‘efficiencies of scale’ to justify higher salaries for themselves while divesting or destroying much of the wealth-creating human capital accrued through years of honest labor. No, I'm not a socialist, nor a "tea party" person; however, I am educated (MBA) and a businessman (fitness industry), and my grandparents came to this country to build a better life though hard work.”

  “As an expat, I can personally attest to the benefits of expatriation being very real and hugely rewarding,” a reader writes, who has his own interpretation of his “duties of wealth.” (We must thank Joel Bowman from The Daily Reckoning for passing on this letter.)

“I obtained what is called economic citizenship from St. Kitts and Nevis, and then dropped my U.S. citizenship. St. Kitts and Nevis is a British Commonwealth nation in the Caribbean, and a tropical paradise tax haven. If you visit and can swing the tab, stay at the Four Seasons — it's very nice.

“Anyway, to cut to the chase, the annual amount I save by no longer paying the raft of U.S. taxes covers ALL my living expenses in my new home. It also quickly paid the cost of getting my new passport.

“Being able to buy and sell stocks, gold, silver, oil, currencies, options, bonds — you name it — while paying ZERO taxes is such a boon it's hard to overstate. It's a total game changer to be able to invest freely and not even think about taxes. The process of investing becomes so much clearer that until you're there, I don't think it's possible to fully ‘get it.’ I certainly didn't, and I can't believe the mental haze I lived in for so long when it came to investing.

“The other benefits you mention on your list have been true for me as well. Not filing tax returns any more and flushing money on accountants year after year is something I give thanks for every April. It's like a second Thanksgiving! I express my thanks by giving more money to charitable causes than I could afford to when I was property of Washington, D.C…”

Best,

Ian Mathias

The 5 Min. Forecast

P.S. Given today’s news on the Chinese yuan — no matter how ambiguous it might be — it’s hard not to get excited about what may come. Whether its “China Boom” or “China Bust,” we are still preparing for some sort of rise in the quality of life for the average Chinese family, especially those within reach of “middle-class” status. Their ascension seems awfully likely, whether China meets its quarterly GDP projections or not.

So as we stressed earlier, you should check out Chris Mayer’s latest report on the rise of the Chinese middle class. We’ve made it available for just $1… can’t beat that. Read it here.

P.P.S. Rumors of Addison’s return to The 5 have been mildly exaggerated. Just as soon as he got back from a New Hampshire vacation yesterday, he’s back in New England this morning. This morning, he’s dragging our documentary crew to Harvard Yard, where they’re interviewing Clayton Christensen, a Harvard business professor, and a leading popularizer of Schumpeter’s thesis on “creative destruction” and the impact of disruptive technologies on the “recovery.”

Later in the day, they’ll be back with Juan Enriquez. The crew will be taking a look at a company that produces antibiotics. And asking the tough question: Why has only one compound in the tetracycline class of antibiotics been approved by the FDA in the last 30 years?

Scintillating stuff. Stayed tuned…

rspertzel

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