Asset protection or export growth: Politics suggest which matters more to China

Fascinating post from Brad Setser detailing China's holdings of USD holdings.

Therein, he describes the dilemma facing China: On the one hand, it wants the US to demonstrate fiscal restraint to protect the value of its USD holdings. But, China also wants a large and vigorous government stimulus package to keep exports humming along.

One dimension that isn't addressed in Brad's post is how (Chinese) politics affect how this dilemma gets resolved.

In my view, the political calculations made by China's leadership should make export growth the preferred option. Exports will bolster employment both directly and through continued attraction of foreign direct investment. This, of course, promotes social stability and keeping the party in power.

While any losses in Chinese USD holdings will likely provoke a firestorm of criticism, this will likely be contained and less likely to up-end the CCP apple cart than the former outcome. Also, losses due to debt monetization may not be as great as when the value of China's holdings are viewed in term of purchasing power parity.

This suggests that the US will, of course, offer the requisite genuflecting to China's concerns. But, from a practical perspective, it isn't in the political interest of China to take any serious action to deter the US from any fiscal actions that threaten the value of its USD holdings.

Why China may come roaring back

James Fallows, as usual, offers a clear and compelling description of what's going on in China:

The small-business culture of China is one of the few parts of the world where Americans are considered sluggish and hyper-deliberative. As small companies scramble against each other to cut pennies from costs and minutes from schedules, they have become more nimble as subcontractors. But they still don’t keep much of the final rewards for themselves. Thus today’s shock is more than such companies can offset just by cutting costs.


In Beijing, in Shanghai, in Shenzhen, and elsewhere, I’ve recently visited companies that are trying to use the disruption of this moment to enter wholly new markets and do what so few Chinese firms have yet done: make high-tech, high-value products that bring high rewards.

The rest of this excellent article from this month's Atlantic is well-worth a careful read.

Our experience confirms Fallows' description. We are seeing keen interest from Chinese professional service companies as well as product manufacturers looking to ramp up their U.S. presence. In fact, I'll be in Shanghai and Hangzhou for a good two weeks meeting with some of these companies.

Tom Friedman: We are so cooked

A Biblical Seven Years
By THOMAS L. FRIEDMAN
Beijing

After attending the spectacular closing ceremony at the Beijing Olympics and feeling the vibrations from hundreds of Chinese drummers pulsating in my own chest, I was tempted to conclude two things: “Holy mackerel, the energy coming out of this country is unrivaled.” And, two: “We are so cooked. Start teaching your kids Mandarin.”

However, I’ve learned over the years not to over-interpret any two-week event. Olympics don’t change history. They are mere snapshots — a country posing in its Sunday bests for all the world too see. But, as snapshots go, the one China presented through the Olympics was enormously powerful — and it’s one that Americans need to reflect upon this election season.

China did not build the magnificent $43 billion infrastructure for these games, or put on the unparalleled opening and closing ceremonies, simply by the dumb luck of discovering oil. No, it was the culmination of seven years of national investment, planning, concentrated state power, national mobilization and hard work.

Seven years ... Seven years ... Oh, that’s right. China was awarded these Olympic Games on July 13, 2001 — just two months before 9/11.

As I sat in my seat at the Bird’s Nest, watching thousands of Chinese dancers, drummers, singers and acrobats on stilts perform their magic at the closing ceremony, I couldn’t help but reflect on how China and America have spent the last seven years: China has been preparing for the Olympics; we’ve been preparing for Al Qaeda. They’ve been building better stadiums, subways, airports, roads and parks. And we’ve been building better metal detectors, armored Humvees and pilotless drones.

The difference is starting to show. Just compare arriving at La Guardia’s dumpy terminal in New York City and driving through the crumbling infrastructure into Manhattan with arriving at Shanghai’s sleek airport and taking the 220-mile-per-hour magnetic levitation train, which uses electromagnetic propulsion instead of steel wheels and tracks, to get to town in a blink.

Then ask yourself: Who is living in the third world country?

Yes, if you drive an hour out of Beijing, you meet the vast dirt-poor third world of China. But here’s what’s new: The rich parts of China, the modern parts of Beijing or Shanghai or Dalian, are now more state of the art than rich America. The buildings are architecturally more interesting, the wireless networks more sophisticated, the roads and trains more efficient and nicer. And, I repeat, they did not get all this by discovering oil. They got it by digging inside themselves.

I realize the differences: We were attacked on 9/11; they were not. We have real enemies; theirs are small and mostly domestic. We had to respond to 9/11 at least by eliminating the Al Qaeda base in Afghanistan and investing in tighter homeland security. They could avoid foreign entanglements. Trying to build democracy in Iraq, though, which I supported, was a war of choice and is unlikely to ever produce anything equal to its huge price tag.

But the first rule of holes is that when you’re in one, stop digging. When you see how much modern infrastructure has been built in China since 2001, under the banner of the Olympics, and you see how much infrastructure has been postponed in America since 2001, under the banner of the war on terrorism, it’s clear that the next seven years need to be devoted to nation-building in America.

We need to finish our business in Iraq and Afghanistan as quickly as possible, which is why it is a travesty that the Iraqi Parliament has gone on vacation while 130,000 U.S. troops are standing guard. We can no longer afford to postpone our nation-building while Iraqis squabble over whether to do theirs.

A lot of people are now advising Barack Obama to get dirty with John McCain. Sure, fight fire with fire. That’s necessary, but it is not sufficient.

Obama got this far because many voters projected onto him that he could be the leader of an American renewal. They know we need nation-building at home now — not in Iraq, not in Afghanistan, not in Georgia, but in America. Obama cannot lose that theme.

He cannot let Republicans make this election about who is tough enough to stand up to Russia or bin Laden. It has to be about who is strong enough, focused enough, creative enough and unifying enough to get Americans to rebuild America. The next president can have all the foreign affairs experience in the world, but it will be useless, utterly useless, if we, as a country, are weak.

Obama is more right than he knows when he proclaims that this is “our” moment, this is “our” time. But it is our time to get back to work on the only home we have, our time for nation-building in America. I never want to tell my girls — and I’m sure Obama feels the same about his — that they have to go to China to see the future.

Inflation to take off?

Scary article about the outlook for inflation in the US

Washington Is Quietly Repudiating Its Debts
By GERALD P. O'DRISCOLL JR.
August 22, 2008; Page A15

Will the U.S. Treasury repudiate its obligations to its creditors, be they citizens or investors around the world? Most observers would answer "no" without hesitation. But Congress, with the complicity of the White House and the Fed, has arguably embarked on a stealth repudiation.

In his famous treatise, "The Wealth of Nations," Adam Smith noted there had never been a "single instance" of sovereign debts having been repaid once "accumulated to a certain degree." We may have reached Smith's threshold.

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The bond markets are certainly not protecting creditors from the risk of what Smith called "pretended payment" through inflation. Nor did they do so until far into the great inflation of the 1970s. Not until late 1977 and into 1978 did the bond market fully incorporate the reality of the debased dollar, by demanding higher long-term interest rates.

How can this happen? Markets are supposed to be forward-looking and efficiently price in all relevant risks. Yet monarchs have been repudiating debt explicitly and implicitly throughout recorded history.

Many years ago, the Austrian economist Ludwig von Mises offered an explanation. He suggested that while you can't, in Abraham Lincoln's words "fool all of the people all of the time," you can fool all of the people at least some of the time. And this is easier to do if a central bank has in the past earned credibility in fighting inflation.

In the 1980s, Ronald Reagan and Paul Volcker worked together to get inflation under control. They were greatly assisted by the "bond vigilantes," traders who were by then exerting discipline in bond markets by bidding up interest rates to double-digit levels. The outcome of the Reagan/Volcker policy of tight money and low marginal tax rates was not only a great economic expansion, but also a great boost to the Fed's credibility. The Fed proved it was able and willing to withstand political heat in the fight against inflation.

Alan Greenspan built on the Volcker legacy and, at least in the early years of his long tenure, continued the fight against inflation. In the 1990s, when Mr. Greenspan faced his own banking crisis, he was able to adopt a policy of comparatively low short-term interest rates. Banks used the opportunity to borrow cheaply and lend profitably to grow their way out of the crisis. Credibility allowed the Fed to engineer a recovery without stoking inflation fears.

After the collapse of the dot-com bubble in 2000, and then 9/11 and its aftermath, Mr. Greenspan again relied on the Fed's credibility to drive down the federal-funds rate to 1% and then hold it there for a year. This time there was a rumbling of doubts. But eventually the Fed did reverse course to preserve its inflation-fighting credentials, and briefly hiked the federal-funds rate to over 5%.

Now Fed Chairman Ben Bernanke has decided to try for a hat trick, and spend the Fed's reputational capital on an easy credit policy. He is doing so under considerably more adverse circumstances than his two predecessors.

Thanks to Reagan and Volcker -- and the credibility he built up on his own early on -- Mr. Greenspan did not face strong inflationary forces in the 1990s. But Mr. Bernanke began his easy money policy with inflation already picking up steam. Worse, we have the accumulated effects of seven years of loose fiscal policy.

Yes, we had the Bush tax cuts, but their beneficial, growth-enhancing effects have long since been swamped by an explosion of government spending. As Milton Friedman long ago taught us, government spending is the ultimate tax on the economy: It extracts real resources from productive, private use and puts them to unproductive, public use. And there is the rub.

Not even a President Obama and a Congress controlled by House Speaker Pelosi and Senate Majority Leader Reid is going to hike taxes enough to pay for all their spending. Indeed, they have shown themselves quite unwilling to engage in honest budgeting. The best example is saddling Fannie Mae and Freddie Mac with $500 million of new (off-budget) obligations to fund cheap housing at a time when the two companies were already on the ropes. Is it any wonder the stock prices of these two companies are imploding?

The markets have long assessed the debt of Fannie and Freddie at AAA because of the Treasury's guarantee, now explicit. But no one has ever seriously assessed the Treasury's creditworthiness with Fannie and Freddie on its books. The public guarantee is entirely open-ended and unbounded. The appetite of the two companies to balloon their balance sheets and take on risk has not been curtailed. Meanwhile, Congress spends apace with new programs for constituents in an election year.

We are at a Smithian moment, in which the temptation for the Fed to spend its last dime of credibility may prove irresistible. Investors are already being taxed by inflation and can rationally expect that tax rate (the inflation rate) to be raised going forward. Wages are not keeping up. Main Street is being taxed to fund Wall Street excess. Anyone who works, saves and invests is exposed to confiscation of his capital and earnings through inflation.

If the Fed maintained its independence of action and said no to the inflationary finance of Congress's profligacy, we wouldn't have reached this point. But the Fed has forsaken that independence amid an absence of leadership.

Perhaps, as rarely happens, Adam Smith will be proven wrong. Let us hope so, because hope appears to be all we have.

Mr. O'Driscoll is a senior fellow at the Cato Institute and a former vice president and economic adviser at the Federal Reserve Bank of Dallas.

The price of pork in China

Inflation is becoming an increasingly important problem in China. The price of pork in particular is crucial.

Consumer prices in China rose by 8.7% in the year to February, the highest rate for more than 12 years. Food prices were 23.3% higher than a year earlier.



Pork has been a cornerstone of the Chinese diet for centuries. Rows of 2,100-year-old terra cotta pigs were recently discovered near Xian, a city better known for terra cotta warriors. China’s 1.3 billion people eat more than 92 billion pounds of pork a year — a fifth of a pound a day for every man, woman and child.



And just as higher gasoline prices can lead to a political reaction in the United States, the Chinese government is particularly worried about soaring pork prices because of their impact on household budgets and the way they can exacerbate income inequality.

Commodities "Supercycle" - The Long Boom

Imports of both soya beans and oil increased 35x since 1999. Wow!



From the Economist:

China, with about a fifth of the world's population, now consumes half of its cement, a third of its steel and over a quarter of its aluminium. Its imports of many natural resources are growing even faster than its bounding economy. Shipments of iron ore, for example, have risen by an average of 27% a year for the past four years.

Chinese demand for raw materials of all sorts is growing so fast and creating such a bonanza for farmers, miners and oilmen that phrases such as “bull market” or “cyclical expansion” do not seem to do it justice. Instead, bankers have coined a new word: supercycle.

China signs investment MOU with WA State

This is an early step in the PRC government's policy of promoting outbound investment. Like most policy decisions taken by the PRCG, this is likely to have a big effect on China and the world.



From 5/12/2007 Seattle Times:

More than 50 government and business leaders from China visited Seattle on Friday, part of a multibillion-dollar buying-and-investment mission paving the way for a major meeting between the U.S. and China later this month.



Earlier Friday, Gov. Christine Gregoire met the group in Olympia during the signing of a memorandum of understanding to enhance cooperation between Washington and China.



State officials believe it is the first bilateral agreement between a state and the Chinese government.



Officials from China's Ministry of Commerce signed an agreement with the state's Community, Trade and Economic Development office to promote two-way investment.



Wang Chao, assistant minister of the Ministry of Commerce, said he hoped the agreement would help usher in deals aimed at expanding imports from the U.S. and Chinese investment to the U.S.



China has become the largest export market for Washington state, with exports totaling $7 billion last year, he said.



Wang said Chinese companies such as shipping giant Cosco, China National Petroleum Co. (CNPC), Haier and Huawei have all invested in the U.S.

Commercial Real Estate Fire Sale?

I'm guessing that commercial real estate values will take a bigger hit than forecast in the article below.



Also, it's surely a sign of how bad market conditions are when an almost 50% increase in delinquencies for non-residential commercial mortgages can be called a "slight increase" (compared to a 4x increase for condo construction loans that's not too bad, I suppose).


A few big sovereign fund deals can't be far behind. And, with the recent pullback in mainland stock markets and the Chinese affinity for real estate, I'm sure they will be another important source of transaction volume.



It will be interesting to see how this impacts the Seattle market.




This is from the WSJ:

During the current downturn, commercial real-estate values are likely to fall 20% from their recent peaks, according to J.P. Morgan Chase. By contrast, Credit Suisse projected late last month that home prices, which peaked in 2005 and have declined substantially since, will fall an additional 25% to 40% in some regions before hitting bottom. The average price of a house in the Miami area, which has already fallen around 6%, is expected to tumble an additional 40%, the report says.




For banks lending to condo developers, the pain was even worse. Delinquencies for condo-construction loans rose to 10.1% in the fourth quarter, up from 2.6% a year earlier. By comparison, delinquencies on nonresidential commercial mortgages, secured by properties like office buildings and shopping malls, were 1.6% in the same quarter, up slightly from 1.1% according to Foresight Analytics.




The problem is that while most properties' cash flows are holding up, their values are falling primarily because financing is so much more costly. That's particularly scary for owners (and their lenders) who borrowed aggressively during the easy-money years of 2005 to 2007 and need to refinance soon. Many won't be able to borrow nearly as much or get the same terms, putting them at risk of default.

Another boost to China's foreign reserves

With the strengthening RMB, it looks like no end in sight for China's continued accumulation of foreign reserves. $2 trillion here we come! This is from the WSJ:

Brad Setser, a fellow at the Council on Foreign Relations in New York,
estimates that more than $200 billion in hot money may have flowed into China
last year, eclipsing the $82.66 billion in foreign direct investment.