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What Black Swan can hit China?

Wednesday, January 18th, 2012

We are now in 2012 and there are plenty of talks in the mainstream media about a possible hand-landing for the Chinese economy. In today’s article, we shall not go too deep into the details. This article by Paul Krugman explains the mainstream thinking very well. Nevertheless, despite the mainstream speculation of a possible hard landing, the financial markets are still pencilling in a soft landing. This may change as more data is released to indicate otherwise.

We don’t dispute Paul Krugman’s thesis of why a hard landing is coming. In fact, as we read his articles, we find his argument familiar- in fact, they seem to come from Michael Pettis, a professor at Peking University’s Guanghua School of Management. We read his articles regularly for insights, along with Patrick Chovanec’s. Even our favourite contrarian, Marc Faber is echoing warnings that while all eyes are looking at Europe’s problems, China may surprise on the downside.

Now, from all these ample warnings, we can establish the fact a Chinese economic hard landing will be the most anticipated ‘surprise’. We say it is a ‘surprise’ because 12 months ago, most mainstream pundits will scoff at the idea of China facing a hard landing. Today, they are talking about it. But you have to bear in mind that despite all these talk about it, the mainstream consensus is that whatever is happening to China’s economy today are well within the designs of the Chinese government (or rather, the Chinese Communist Party). The fact is, the Chinese government are engineering some sort of a landing for the Chinese economy. Maybe they may overdo it and err towards the territory of hard landing, giving the economy an extra dosage of tough medicine. But at the end of the day, the belief is that the government is still in control.

Of course, we are not going to argue for or against that. In fact, any self-respecting contrarian should already be preparing for a possible Chinese hard-landing the same way airline passengers prepare for mishaps by putting on seat-belts. In other words, it should be a routine manoeuvre. But what will separate the average from the excellent will be the look out for unanticipated Black Swans. For us, we are trying to evisage what kind of serious mishaps that are outside the designs of the Chinese government that can happen. We shall call that mishap a ‘crisis.’

As we mentioned before in Warning: China MAY be near an economic crisis, we mentioned that

The question was put forth to Victor Shih on what he thought may be the trigger for a financial/economic crisis in China. The usual suspects of what the trigger may be usually comes in the form of an external shock (e.g. collapse of Euro-zone, global recession) that crunch China?s export industry. Surprisingly, that wasn?t his consideration. Victor Shih offered his favourite theory (though he emphasised that it is by no means a prediction) that when it comes to the point when China?s elite begin to pull its vast wealth out of China, that will be the thing that trigger a crisis. This could happen, for instance, when the elite find that the returns on/of their investments inside China is floundering.

Already, there are some anecdotal evidence that this is already happening as this article from the Financial Times reported. On the macro level, we saw this article recently,

China?s foreign-exchange reserves dropped for the first time in more than a decade as foreign investment moderated, the trade surplus narrowed and Europe?s crisis spurred investors to sell emerging-market assets.

For now, the decline in China forex reserves are blamed on hot speculative money pulling out of China i.e. foreigners. But if it comes a day when China’s own elite are pulling out their wealth out of China en masse in sufficiently large volume, it has the potential to develop into a crisis.

How? Let’s imagine this scenario.

Let’s say the Chinese government get spooked by Europe and the collapsing real estate bubble in China. And let’s suppose the Chinese government decide to print copious amount of money and loosen the credit spigot in an attempt to re-stimulate the economy. What if this does not work? Then firstly, the liabilities of the People’s Bank of China will increase. As we wrote in Is China allowed to use its US$2.4 trillion reserve to spend its way out of any potential crisis?,

According to the chart provided by Pivot Capital?s report, only a little over 20% of China?s total currency (plus gross external debt) are ?backed? by their US dollar reserves, which isn?t spectacular compared to other emerging economies. In fact, South Africa is the winner in this aspect because their reserve coverage ratio is almost 160% i.e. it has $16 of reserves for every $10 of currency.

That aritlce was written in 2010. We believe that today, even less than 20% of China’s today currency are ‘backed’ by US dollar reserves. If China prints money even further in 2012, that percentage may go even lower. Now, combine that with capital flight out of China from China’s elite. Then China can face with two stark choices: (1) maintain the peg and have a currency crisis or (2) let the RMB depreciate further and risking a trade war with the US by pissing off Congress.

Now, we have to make clear that this is just a conjecture, not a prediction. It may not happen. Even if it will happen, it may not happen in 2012. But it is something we keep at the back of our minds. If our conjecture turns out true, this is a real Black Swan. Make sure you tell people that you read about it here!

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Is Germany’s debt position worse than United States?

Tuesday, November 29th, 2011

It is widely believed that Germany’s fiscal position is the strongest in Europe and that it is the pillar of the Euro-zone.

Then something unexpected happened last week.

The German government could not borrow all the money it needed! Well, not at the currently low interest rates, at least. What if the financial market?realizes?that Germany’s fiscal position is actually worse than the United States??Kyle Bass, the manager of a hedge fund called Hayman Capital, ?who made millions by gambling against sub-prime mortgage bond market, explains…

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Posted in Market Observations | 9 Comments »

Is price inflation good for real estate in Australia?

Sunday, July 24th, 2011

One of the assumptions made by many people is that rising price inflation is good for property prices in nominal terms. In other words, many people see property as a hedge against price inflation. The experience of the past (especially 1970s) has a strong influence on this belief.

But today, in Australia, from our observations, we believe that the relationship between price inflation and property prices is breaking down. In fact, we would argue that price inflation probably has a negative effect on property prices.

To understand why, recall that we wrote in Does inflation (deflation) benefits the borrower (lender)?,

Debt servicing burden = (Debt payment rate ? Growth in wage) + Price inflation rate

Today, the problem is that in Australia, with the two-speed economy, wages are rising in one section of the economy but is relatively stagnant on the other. In relative terms, mining wages in Western Australia are sprinting ahead of wages at say, office workers in Sydney.

But unfortunately, since the GFC, cost of living has been rising faster than general rise in wages. For example, as Retail therapy impossible in this housing market reported,

Now look at your pay packet, take away the things you can’t avoid spending money on, remove what you’re paying in rent or paying off a loan, and look at what is left. You may find that’s smaller than ever, despite the fact we’re in a mining boom. But the trickle-down effect of that boom seems a long way away from Sydney. We’re part of the second tier of the economy here, the one that isn’t doing so well. Still, rent and housing prices continue to go up. And the bills come first before that new coat, that new stereo . . . even repairing those cracks on the walls or the dents on your car.

As you can see from our simple equation, with the cost of living rising faster than increase in wages, debt servicing burden will increase. Furthermore, the Reserve Bank did not help by raising interest rates. The increase in debt servicing burden puts a squeeze in discretionary spending- that explains why shoppers seems to be going on strike, putting the retail sector under pressure.

This increase in debt servicing burden is putting on the dampener on house prices. It dampens people’s appetite for borrowing more money and increases their propensity to save. Less borrowing means less capacity to bid up house prices. It also pushes more mortgage holders to be delinquent with their home loans, which increases the likelihood of forced sales. This is the first round of effect on house prices.

Rising cost of living pushes the retail sector deeper into trouble as shoppers shut up their wallets. Since consumer spending account for 60% of the Australian economy, a weak retail sector is hardly good news for employment in the country. As we wrote in RBA committing logical errors regarding Australian household finance,

Given Australia?s high household debt (see Aussie household debt not as bad as it seems?), prime debt can easily turn sub-prime when unemployment rises.

Rising unemployment will put further pressure on house prices. As we wrote in Does house price crash follow unemployment or is it the other way?,

[Rising unemployment] will feed into the second round of impact of lower house prices, which in turn lead to further rising unemployment. This will feed into the? third round of impact.

Now, cost of living is rising despite a rising Australian dollar. What if the dollar falls substantially? What will happen to the cost of living?

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Posted in Market Observations | 4 Comments »

China is slowing down

Wednesday, March 23rd, 2011

Many things happened since we last wrote. The earthquake in Japan was the biggest news of the day. As Japan’s nuclear crisis unfolded, stock markets around the world panicked amidst screams of “nuclear meltdown.” Today, the nuclear situation in Japan seemed to be stabilising, even though the long-term radiation impacts are still unclear at this moment.

To help you keep things in perspective, please note one thing about Japan’s nuclear crisis: despite screams of “nuclear meltdown,” there is ZERO chance of a nuclear explosion. A nuclear reactor is NOT a nuclear bomb. Our guess is that this nuclear crisis is just a blip in the economic big picture, even though in some localised areas in Japan, it is the end of the world (e.g. some areas may not be habitable for a long time). Therefore, contrarian investors may use this opportunity to buy Japanese stocks (we know it is probably too late to do so now).

However, do not let the nuclear crisis distract you to a more important development that is already brewing for quite some time- the coming slowdown in China. This development is far more important than the Japanese nuclear crisis, which by now is no longer a crisis. Remembered we wrote in January last year at Chinese government cornered by inflation, bubbles & rich-poor gap,

By not allowing the yuan to appreciate, the Chinese government shows that at least for now, they fear unemployment and excess capacity more than inflation.

But there will be a day when they have to tackle the inflation problem. As long as the inflation problem is not solved, there will be rising prices and bubbles in the asset markets.

Today, we can say that the Chinese government are tackling the inflation problem. 2009 and 2010 was the year when they pumped in steroids into the economy. Today, they are dealing with the effects of the steroids- price inflation. China is tightening monetary conditions (e.g. rising interest rates, increasing bank reserves requirements) for quite some time already. They are serious about dealing with price inflation, at least for now. Premier Wen Jiabao had already declared that China’s target for economic growth will be lower (see China lowers growth rate target in sustainability drive), from 8% to 7%. Incidentally, the lower target of 7% is pretty close to Gary Shilling’s (a respected bear on China) definition of a ‘hard landing’ in China, which is a growth rate of 6% or less.

So, it should be extremely obvious by now that China’s economy will slow down this year. In other words, China is aiming for a soft landing.

The big question is, when the slowdown begins to bite, will China step on the accelerator again? Our belief is that there’s too much vested interests in China to keep the growth going and to prevent the bubble from bursting spectacularly. Also, the central bank in China is not independent. Thus, as we wrote in Why should central banks be independent from the government?, without an independent central bank, the bias in China is towards more inflation.

The risk for China (and by extension, Australia- see Turkeys fattened for slaughter in the Chi-tralia bubble) is that the control freaks in Beijing may stuff up and either turn the soft landing into a hard landing or losing control of inflation.

Watch this space.

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Deleveraging in the Australian economy bites

Sunday, March 6th, 2011

If you read the newspaper headlines and billboard advertisements recently, you may notice something interesting (if not, strange) happening. National Australia Bank (NAB) announced that it is ‘breaking up’ with the rest of the banks in a new campaign. That immediately provoked reactions from the other banks, including Suncorp with its “breaking up” theme in a recent billboard advertisement.

Soon, bank investors are fretting about a price war among the banks, which means the race is on to the bottom for profits. As this news article reported,

Investors are becoming nervous about the prospect of a price war breaking out between the banks, with one major brokerage labelling the attacks a ?negative sum game?.

What on earth is happening?

Only as recently as four months, politicians were aiming their gun sights on the banks for ‘lack’ of competition, when Commonwealth Bank (CBA) initiated a rise in their mortgage rates that was almost twice the rate rise of the Reserve Bank (RBA). There were talk about building a “fifth pillar” in the banking system. Today, the banks seem to be starting a price war among themselves, in a race to the bottom.

Well, the reason is dead simple. To put it simply, banks are in the business of lending money. That’s their core business. As we wrote before in The dark side of rising bank profits,

One way to make more money is to increase lending.

Banks, as publicly listed companies in the stock exchange, are always under pressure to increase their profits year after year (i.e. seek growth). Heavens forbid that their profits ever fall! All hell breaks lose if that ever happens!

But there’s one big problem for them today- the savings rate of Australians have shot up to 10%, which is the highest since the early 1990s! That means that Australians are saving more money and repaying their debts. In other words, the Australian economy is now undergoing a deleveraging process. Consequently, it is becoming harder for the banks to make more money by lending more money. A very crude (and thus, inaccurate) analogy would be to compare the banks to dogs fighting among each other for a shrinking pie. As that article reported,

The infighting is an indirect result of the sluggish credit market, with banks under pressure to find growth, the report said.

What does this mean for the Australian economy?

As we explained in detail in Significant slowdown for Australia ahead?, deleveraging sucks away the aggregate demand from the economy. The first to get hit will be the retail sector that is related to discreditionary spending. The structural shift of Australian consumers from shopping in retail stores to shopping in the Internet is a symptom of deleveraging.

Given that the retail sector accounts for approximately 60% of the economy, continuation of this structural shift in consumer behaviour imply that more pain is in store for the retail sector.

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Posted in Economics/Finance, Market Observations | 8 Comments »

Marc Faber: correction coming

Monday, January 31st, 2011

In a recent interview (about a week ago), Marc Faber warned of a coming correction in asset prices. In this correction, he reckoned that emerging markets (e.g. China) will fall harder than the markets of the developed world (e.g. US, Europe).

As he elaborated further, for the past two years, the emerging markets and commodities were doing very well. In fact, so well that there’s talk that China’s economic/political model is superior to the model of the Western liberal democracies because it managed to dodge the GFC and thrived in the aftermath while the developed economies were going nowhere and being plagued by sovereign debt crisis.

However, Marc Faber reckoned that for the next few months, this trend can reverse for a change. The implication is that US Treasuries, US dollar may do very well, while US stocks may outperform emerging market stocks by falling less. So, the S&P500 may correct by say, 10% while Chinese stocks may correct by say, 20-30%.

For investors, it is easy to get lost in the minute details and lose sight of the forest for the trees. For one, it is clear to us that even though the massive money printing exercise of the Federal Reserve is not showing up in the US, price inflation is rearing its ugly head in the emerging economies. In other words, we believe that the US is exporting its price inflation to the emerging economies. This is because all nations are engaging in competitive devaluation of their currencies (to protect their exports in order to ‘stimulate’ their economies). However, since the US dollar is still the world’s reserve currency, the US is able to export the resulting price inflation to the emerging economies.

The price inflation had been growing for the past two years. At first, it seems benign and even seen as a badge of vindication for countries like China. And if you read our article, Turkeys fattened for slaughter in the Chi-tralia bubble, the growth and inflation is fueled by a massive credit bubble and monetary inflation. Since it is an axiom that all bubbles deflates/bursts eventually, there are speculation of when the bubble in the Chinese economy is going to burst.

Judging from the chatter in the blogsphere and mainstream news article, it seems that the spotlight is shifting towards the price inflation and asset price bubble in China. More and more articles like Crouching tiger, soaring cranes, rumbling doubts are telling us that there’re growing doubts on the Chinese economy. As we wrote 12 months ago in Chinese government cornered by inflation, bubbles & rich-poor gap,

But there will be a day when they have to tackle the inflation problem. As long as the inflation problem is not solved, there will be rising prices and bubbles in the asset markets.

Indeed, price inflation is turning into a serious problem in China. As Patrick Chovanec wrote,

China used to be cheap.? According to figures the World Bank uses to calculate Purchasing Power Parity (PPP), in 2003, a dollar?s worth of currency bought nearly five times as much in China as it did?the U.S.? A?bag of groceries,?or a hairdo, or a hotel room?that would have cost $50 in the U.S. cost only RMB?90, or roughly $11, in China.

Talk to anyone in China, though ? local or expatriate ? and they?ll tell you that, lately, things have been getting a lot more expensive.? When I went back to the U.S. a few months ago, I had the?strange sensation ? for the first time ? that a lot of things were actually cheaper there than in Beijing.

We are increasingly seeing signs that the Chinese government are taking more and more actions to attempt to control price inflation via administrative measures. But with money supply increasing 50% over the past two years, such measures are mere pin-pricks. The exploding supply of money is the root of China’s price inflation problem. And the reason why the money supply is exploding is the peg of the RMB towards the USD (see Why is China printing so much money?).

Unfortunately for the Chinese people, there are too many vested interests (e.g. corrupt officials, provincial governments, big businesses with links to government) in China who wants to keep the credit and asset price bubble going. Since asset price bubbles and price inflation are the symptoms of a common course (monetary inflation), the bias of the Chinese government (and for most governments in the world for that matter) is towards more inflation. Once the root cause of the price inflation is tackled, the asset price bubble will deflate/burst as well. With that, the massive wealth of many vested interests will deflate/disappear as well. Since we doubt those vested interests want that to happen, the price inflation problem will continue to rage in China.

Now, here comes a crucial point. As long as the masses in China believe that the government is working towards ‘solving’ the inflation problem, there are still hope. Indeed, a friend in China told us that her country (i.e. government) is “working its brains” to solve the inflation problem. Unfortunately, this is something that has yet to be dawned on her. As Patrick Chovanec wrote,

I find it incredibly ironic that the two hot populist issues among Chinese citizens these days are the high price of housing and U.S. pressure for a stronger RMB.? People are hot under the collar about both issues, but they never draw stop to think that China?s position on currency (maintaining a weak RMB) might be fueling inflation in the form of?rising housing and other living costs.? ?Of course, I don?t expect average citizens to draw the connection, but economists should.

However, the truth is this: the vested interests who control the government are NOT serious about solving the price inflation problem. The danger is that once the masses realise this, hyperinflation begins. As we quoted Ludwig von Mises in What is a crack-up boom?,

But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against ?real? goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them.

So, as it becomes increasingly clear that the current trends in China is unsustainable, investors should watch the reaction of the Chinese government.

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Posted in Economics/Finance, Looking Forward, Market Observations | 3 Comments »

Dumb politicians trying to push interest rates down

Thursday, December 2nd, 2010

In Australia, banks are very unpopular. They are seen by the public as greedy blood-suckers who are out there to rip the people off with fees and oppress them with debt repayments. Thus, when the Big 4 oligopolistic banks raised mortgage rates by up to twice the increase in rates by the Reserve Bank, there was an outcry by the heavily indebted majority.

As a result, politicians have to be seen to be doing ‘something’ to rein in the ‘greedy’ bankers. They have to engage in populism by coming up with policies to improve ‘competition’ in the banking sector in order to put downward ‘pressure’ on interest rates. But as we wrote two years ago in Support mortgage lenders to keep borrowers in indentured servitude?,

These economists do not understand the concept of competition. In the real economy, competition means utilising scarce resources in a more efficient way to produce more, create new products or make better products. But for the mortgage industry where the product is credit, how can the idea of ?competition? be applied when the product (money and credit) can be created limitlessly out of thin air by the government (central bank) and financial system?

If higher interest rates are that evil, why bother with difficult policies to put downward ‘pressure’ on interest rates? Why not legislate interest rates to zero? As we wrote in Why does the central bank (RBA) need to punish the Australian economy with rising interest rates?,

Think about this: if raising interest rates is ?bad? and cutting interest rates is ?good,? then why don?t the RBA set interest rates to zero, thereby putting the economy into a path of eternal boom (plus runaway inflation)? For those who think this is a good idea, then this article will set to let you understand why this is a bad idea.

Politicians are toying with the idea of introducing a fifth pillar to the banking system (in addition to the current Big 4) to increase ‘competition.’ But the fact that they are thinking about this shows that they are either dumb or extremely short-sighted. For example, as this article reported,

CREATING a ”fifth pillar” of banking through building societies and credit unions would require small players to almost triple their lending levels within four years, analysts say, raising questions over its impact on financial stability.

…

Australia’s housing debt is already equal to 82 per cent of gross domestic product, one of the highest proportions in the world. He said competition and financial stability had an ”inverse relationship,” a point demonstrated in recent years.

”There was no shortage of mortgage competition in the US and [Britain] between 2000 and 2007,” Mr Mott wrote.

Oh dear! Do we need to teach our politicians how to spell “SUB-PRIME?”

Furthermore, our Reserve Bank (RBA) had already explicitly said that they take into consideration the banks’ interest rates when they set their monetary policy. So, it follows that any downward pressure on mortgage rates will mean that the RBA has to increase interest rates even more.

If the idea of fifth pillar is not harmful enough, both side of politics are considering an even more insidious idea in to put downward ‘pressure’ on mortgage rates- they are considering allowing banks to issue covered bonds to make credit cheaper and more available.

Just what are covered bonds? Take a read at this news article,

Historically, regulators have banned banks from issuing [covered bonds] as they are at odds with legal requirements that depositors rank first in claiming bank assets if a bank fails – a cornerstone of the Australian banking system.

In other words, covered bond investors have a higher claim to the bank’s asset than depositors! Someone wrote of this idea as

The reason covered bonds are cheaper to issue is because they are stealing from the security enjoyed by depositors under existing banking laws. No complicated financial structuring… just straight-up queue jumping.

If the ban on covered bonds are lifted in Australia, how secure will depositors be when the government guarantee on deposits expires next year?

Now, with dumb politicians coming up with dumber and dumber populist policies, Australian investors should now be planning exit strategies for their risky cash at bank!

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Will there be a surprise rally in the USD?

Wednesday, October 27th, 2010

Everyone knows that the US Federal Reserve is going to print money (quantitative easing) in November. Hence, the financial markets have already priced that in. To them, this is a foregone conclusion. Surely, Bernanke is going to print trillions of dollars right? There?s no way he?s not going to do that right?

At this point, investors should be alert. When almost everyone thinks that a future outcome is a slam-dunk certainty, it?s the time when the market is most vulnerable to a significant setback. Since everyone is expecting that Bernanke is going to print so and so amount of money, and if it turns out that he is not printing as much as expected, the reaction by the financial markets can be savage. Any hints of dithering by Bernanke will be very negative for asset prices in the very short term.

Surely it wouldn?t happen right?

Well, who knows.

As the Americans accused the Chinese of manipulating their yuan, the Chinese will be accusing the Americans of manipulating their dollar through money-printing devaluation. Perhaps behind the scenes, both sides are negotiating a middle road. Maybe the Chinese will promise the Americans that they will appreciate their currency a little more than expected and the Americans will promise the Chinese that they will print a little less than expected. That way, the Chinese can cool their economy and pop their speculative property bubble while the Americans can benefit from a sell-off in gold and commodity prices and trigger a mad scramble for US Treasuries, which the US government will happily oblige because they are in need of cash to borrow.

Be ready for surprises!

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Posted in Looking Forward, Market Observations | 8 Comments »

China’s Aluminum Industry – where to from here?

Sunday, October 17th, 2010

Today, we will be having a guest post by Paul Adkins, Managing Director of AZ China Limited. Paul lives in Beijing and thus, has a first hand view of what is going on in China. Many of our readers appreciate the insights offered by Paul that can be found in no where else.

One issue facing China?s government as it mulls the next five-year plan: What to do about the country?s aluminium industry? While this might seem a minor matter, it symbolizes a major dilemma that faces the country, namely, how to balance concerns for economic growth with those for energy use and environmental protection.

China is now the largest single producer?and consumer?of aluminium and will make about 17 million tonnes this year, up 20 percent from last year. But that record comes at a steep price. Aluminium production not only consumes about 8% of all electric power in China, but also is responsible for large amounts of carbon dioxide (CO2) emissions.  And the electricity needed to power the industry has a multiplier effect on pollution problems because 70% of China?s electricity comes from coal, a major contributor of CO2 emissions.

The China Nonferrous Industry Association (CNIA), which represents the aluminium industry, recently published a draft plan calling for aluminium capacity to be limited to 20 million tonnes in the next five-year plan. But China is already over that cap, with about 21 million tonnes right now. Given the new smelters already under construction, total capacity could reach as much as 28 million tonnes by 2012.

Beijing recently indicated it is serious about reducing energy intensity ? the amount of energy consumed per unit of GDP ? and sees aluminium as a major culprit. As an example, it takes at least 12,000 kilowatt hours (kwh) to produce one tonne of metal. But so far, the authorities have chosen to target the steel and cement sectors, and largely left aluminium untouched.

The choices now in front of the planners and politicians are profound. They could simply allow market forces to dictate the industry?s future, with the laws of supply and demand determining not only metal production, but also energy use and CO2 emissions. Then again, the China aluminium industry has not shown itself to be totally subject to such forces. Smelter capacity has run well ahead of consumption, especially in the last few years. Meanwhile, proprietors have struggled to make a decent return on the huge investment needed for a smelter, as the price of aluminium is determined on the Shanghai Futures Exchange, and may have no relation to operating costs, much less capital costs.  Because of the huge capital costs, long-term contracts for electricity and other key inputs, and the cash flows involved, producers often run at full operating speed to maximise efficiency, despite apparent losses on the metal price.

Alternatively, they could put limitations on the aluminium industry, with the caveat that such efforts can have unintended repercussions. In 2003, for example, the Government decided to crack down on old inefficient smelters and ordered those with less than 50,000 tonnes of annual capacity to shut by the end of 2004.  Many proprietors simply built expansions or upgraded their technology, and industry capacity shot up, not down.. Indeed, even the CNIA has admitted that it is virtually impossible for the government to control the industry. One risk is that Beijing could be left embarrassed if the industry ignores new edicts.

Even if Beijing were successful in reducing aluminium capacity, it would come with economic costs. In addition to the loss of thousands of jobs in the country?s 120 smelters, it would cause ripples in associated businesses, including raw materials suppliers, downstream factories, and the many support industries that surround a smelter. For stockholders, any limitation on capacity would cause the share price of China Aluminium (Chalco) and other publicly listed smelters to soften. Investors needed to see growth strategies, which would not be available in the Aluminium industry. (Chalco has already started alternative strategies, embarking into iron ore, copper, gold and now rare earths.) As well, such a decision could affect billions in loans outlaid for the many new projects currently under construction.

There is also a global dimension to this dilemma. Russia stands poised to sell aluminium to China in the event of supply shortages. The world?s aluminium companies source many of their raw materials from China. If Chinese smelters are constrained, the value of China’s exports of raw materials will decline.

In the end, the decision on aluminium might come down to one of the country?s scarcest commodities: energy. Aluminium is called ?frozen electricity? because of the huge amounts of electricity needed to produce it. It seems more sensible for China to import aluminium, even at the cost of lost jobs, to gain the benefits of saving energy and limiting pollution.

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Expectation of US Dollars (USD) printing creates an Australian Dollar (AUD) bubble?

Sunday, October 10th, 2010

Everyone on the streets know that the Australian Dollar (AUD) is rampaging towards parity with the US Dollar (USD). Joining the media circus, some forex pundits are even prophesying that the AUD could reach $1.20 against the USD. The masses in Australia are cheering because it is now cheaper to buy stuffs overseas due to the ?strong? AUD. Politicians (Wayne Swan) are cheering because it is a great excuse to brag about the ?strength? of the Australian economy under the stewardship of their political party. Businesses that has their costs paid directly or indirectly in terms of USD are cheering (e.g. retail import). Businesses that receive their revenue in terms of USD (directly or indirectly) are in pain (e.g. mining, tourism).

We wouldn?t be surprised if the next round of readings for consumer confidence in Australia will show a marked increase. We have no doubt that this in turn will add fuel to more cheering by politicians and the media circus.

But as contrarian investors, you have to understand the context and big picture behind the surging AUD. Do not be like the masses by being caught up with the euphoria. Instead, be prepared and even profit for what is to come.

Firstly, it is not just the AUD that is rising against the USD. The euro, yen, base metals, gold, silver, etc are also rising too. However, the expectation of more interest rate rises by the Reserve Bank of Australia (RBA) is acting like rocket boosters to the already rising AUD (see Return (and potential crash) of the great Aussie carry trade). In other words, it is more of the USD that is deprecating, not the AUD appreciating. As we wrote in What if the US fall into hyperinflation? on April 2008,

Now, in this age of freely fluctuating currencies, the currency?s value is a relative concept. For example, a falling US dollar implies a rising Australian dollar. Therefore, one way to ?maintain? the value of the US dollar relative to the Australian dollar is to devalue the Australian dollar. Perhaps this is the route that central bankers will concertedly take to instil ?confidence? in the US dollar in order to create the illusion that the US dollar is still a reliable store of value? Well, they can try, but growing global inflation and skyrocketing gold price relative to all currencies will be tell-tale signs of such a dirty trick.

Already, the Japanese central bank are cutting interest rates, taking token measures to intervene in the forex market to weaken the yen and even talking about buying government bonds (i.e. ?printing? money). Basically, the Japanese want to devalue the yen. For Australia, we would hazard a guess that one of the major contributing reasons why the RBA did not raise interest rates last week is because of the surging AUD (that was also the suggestion of one of the economists in CommSec).

To put it simply, the depreciating USD is creating a bubble-like conditions for the currencies of foreign countries. That is problematic, not the least because it is making their exports uncompetitive (just ask any Australian mining company). What is the solution for these countries? Devalue their currencies too (if it can be done without the masses being aware, all the better).

The next question is: why is the USD depreciating?

The reason is simply because of the expectation that the Federal Reserve is going to embark on a second round of massive money printing (see Bernanke warming up the printing press). What is the background behind the Federal Reserve?s money printing idea? To answer this question, we would refer to the late Professor Murray Rothbard?s book, Mystery of Banking:

In Phase I of inflation, the government pumps a great deal of new money into the system, so that M increases sharply to M?. Ordinarily, prices would have risen greatly (or PPM fallen
sharply) from 0A to 0C. But deflationary expectations by the public have intervened and have increased the demand for money from D to D?, so that prices will rise and PPM falls much less substantially, from 0A to 0B.

Unfortunately, the relatively small price rise often acts as heady wine to government. Suddenly, the government officials see a new Santa Claus, a cornucopia, a magic elixir. They can increase the money supply to a fare-thee-well, finance their deficits and subsidize favored political groups with cheap credit, and prices will rise only by a little bit!

It is human nature that when you see something work well, you do more of it. If, in its ceaseless quest for revenue, government sees a seemingly harmless method of raising funds without causing much inflation, it will grab on to it. It will continue to pump new money into the system, and, given a high or increasing demand for money, prices, at first, might rise by only a little.

Murray Rothbard wrote this book more than 25 years ago. Yet, it is pertinently relevant for today?s context. The US government?s budget is in great deficit. It will get worse as they have to spend even more money to prop up and stimulate the economy. The current environment of deflationary expectations is providing an excellent cover for Bernanke to print money (see Bernankeism and hyper-inflation).

But as Murray Rothbard continued,

But let the process continue for a length of time, and the public?s response will gradually, but inevitably, change. In Germany, after the war was over, prices still kept rising; and then the postwar years went by, and inflation continued in force. Slowly, but surely, the public began to realize: ?We have been waiting for a return to the good old days and a fall of prices back to 1914. But prices have been steadily increasing. So it looks as if there will be no return to the good old days. Prices will not fall; in fact, they will probably keep going up.? As this psychology takes hold, the public?s thinking in Phase I changes into that of Phase II: ?Prices will keep going up, instead of going down. Therefore, I know in my heart that prices will be higher next year.? The public?s deflationary expectations have been superseded by inflationary ones. Rather than hold on to its money to wait for price declines, the public will spend its money faster, will draw down cash balances to make purchases ahead of price increases. In Phase II of inflation, instead of a rising demand for money moderating price increases, a falling demand for money will intensify the inflation.

Given the large and exponentially growing debt of the US government, monetary inflation is the only path they can take as far as the eye can see.

There is a lot more in Professor Murray Rothbard?s Mystery of Banking if you want to learn how money and credit are related to each other through the banking system work. You can read a sample of this book here (at the right of that page, click on the ?Read First Chapter Free? button).

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