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92110465 Hugh Hendry Download Able

92110465 Hugh Hendry Download Able

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Published by: totti_the_great on May 05, 2012
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 Mark 3:27I have not written to you at any great length since the winter of 2010. This is largely because not much hashappened to change our views. We still see the globaleconomy as grotesquely distorted by the presence of fixed exchange rates, the unraveling of which is creatingfinancial anarchy, just as it did in the 1920s and 1930s.Back then the relevant fixes were around the goldstandard. Today it is the dual fixed pricing regimes of the euro countries and of the dollar/renminbi peg.
The former is common knowledge
everyone wonders
 whether the Greeks have a political economy that can work with the euro. The second system is lessunderstood. But I believe we might soon come toquestion whether China is going to be able to maintainits currency peg with the dollar. It has long seemed tous to be the case that this economic crisis would start inthe US and make its way to Europe. That has happened.However, we also think it will end in Asia.This might be the year everyone else notices this; the year panic over Chinese economic growth comes toreplace the market's morbid fascination with the
travails of the European continent and the year in
 which we see that the US is not giving way to China interms of global economic leadership. There is a nearconsensus that China will supplant America thisdecade. We do not believe this. We are more bullish onUS growth than most. The momentous nature of recentadvances in shale oil and gas extraction and America'sacceptance of the unpleasantness of debt and labourprice restructuring looks to us as if it is creating yetanother historic turning point. By embracing hisinadequacies and leaping on his luck, the strong manmay have finally broken the binds that had previously held him back. We are also more pessimistic on Chinesegrowth than ever. This makes us bearish on most Asianstocks, bearish on industrial commodity prices,interested in some US stocks, a seller of high varianceequities and deeply concerned that Japan could becomethe focal point of the next global leg down. On the plusside we also believe that we are much closer than beforeto the beginning of a bull market of perhaps 1982, if not1932, proportions. We just need the last shoe to drop.
US First, EU Second, China Last
economic growth is unsteady, imbalanced,uncoordinated, and unsustainable.
 Premier Wen Jiabao, March 2007 press conferencefollowing the annual meeting of the National People'sCongress.Let us start with that final shoe, China. For a decade the bureaucrats in Beijing attempted and managed theseemingly impossible, keeping their currency undervalued and maintaining domestic price stability.How? From the mid 1990s to 2005 the renminbi waspegged one-for-one to the dollar. For most of thisperiod the greenback was strong (the dollar appreciated
 by roughly 3.5% p.a. through 2001). Investors were
infatuated with American TMT stocks and China was yet to mount its assault on the rest of the world. Thedynamic meant the US current account surplus washeld in check (around 2% of GDP). Dollar strength worked to keep a lid on Chinese inflation.Soon after several things changed. China got acceptedinto the WTO, America set a course for a weakercurrency post the NASDAQ crash and the dollar's realtrade-weighted value took a nose-dive. This wasinitially great news for the Chinese. Net exports as apercentage of GDP doubled in the two years from 2005.
Then they doubled again. The overseas sector
contributed less than 5% of GDP growth in the four years to 2004 but 20% between 2005 and 2008. At thesame time the current account surplus reached itszenith at almost 10% of GDP. According to the rights of economic principle at thispoint the renminbi should have appreciated
 Manager Commentary, April 2012
Samson Sleeping
n fact, no one can enter a strong man's houseand carry off his possessions unless he first tiesup the strong man. Then he can rob his house.
The Eclectica Fund
 Manager Commentary, April 2012
considerably. This was not allowed to happen. The scaleof Chinese FX interventions became legendary as bureaucrats sought to maintain the cheap currency. Thelevel of FX reserves rose to unprecedented heights forany country at any time in history. China was on a roll.However the boom came at a cost. The Chinesegovernment had effectively printed money to purchase vast amounts of Treasuries. This was akin to shortingtheir own currency. In time the new money began tooverwhelm the domestic money supply. The Americaneconomy was three times the size of 
economy  yet Chinese broad money exceeded that of the US. Andof course waves of credit such as this are not just aboutmoney, they are about temptation as well. In any othereconomy that would have meant runaway inflation. InChina it did not. Instead, the rate of consumer priceincreases averaged just 3% p.a.
How Did They (Almost) Get Away With It?
 The Chinese did it with a cultural revolution; they did itthrough financial repression on a gigantic scale. Thecentral bank kept the deposit rate low, incredibly low.On February 21
, 2002 the monetary authorities set theinterest rate that banks could pay on demand depositsat just 0.72% and then kept it unchanged for aremarkable six and a half years. By the first half of 2008, inflation was running at 7.9% and the real rate of return on demand deposits had fallen to -7.2%. This
appalling rate of return on bank deposits probably 
accounted for 20% of the decline in householddisposable incomes as a share of GDP over the period1992 to 2008 and significantly contributed towards theconsequent collapse in consumption relative to GDP.Having averaged more than 50% of GDP during the1980s, consumption had fallen to just 34% by 2010.This was a record low for any nation and, to my mind atleast, a very potent sign of the disequilibrium created by the currency peg and the repression required tomaintain it.
Unintended Consequences
It must have all seemed devilishly clever to theauthorities. Unfortunately they failed to take intoaccount the law of unintended consequences. Chinesehouseholds mounted a rearguard offensive actionagainst this repression. Instead of accepting low rateson their money in the bank, they became a nation of property speculators. There was temptation in all thatnewly printed money after all and the populace gave into it. Investment in residential real estate averaged only 2.4% of GDP back in the years before the financialrepression. As deposit rates became more and moreunattractive and the
Bank shorted more andmore of its own currency domestic speculators lit thetorch paper under residential real estate investment. Itgrew to 9.1% of GDP by H1 2011. Chairman Mao musthave been turning in his grave.
The Mother of All Housing Booms?
  At first the scale of this speculation was hidden under
the guise of an entirely plausible argument based on
mass urbanisation. China, we were told, was merely investing as peasants moved en-masse to the coastalcities. Perfectly plausible. But perfectly wrong. Duringthe period 2000 to 2003 mass migration to the citiespeaked at 24 million people per annum. At the sametime residential investment expanded to 4.1% of GDPand housing starts rose from 240m sqm per year to440m. After that the urban population growth ratedecelerated (to an average of only 19 million people per year) but residential development did not. Instead,housing starts went crazy, rising from 490m sqm in2004 to 1,290m sqm six years later.It is also worth noting that by the time all thishappened the sharpest rise in home ownership hadalready passed. In 1983 the home ownership rate inChina was a mere 10%. By 1998, thanks to theauthorities' commendable privatisation of the housingstock in the mid 1990s, it had reached 80%. Its growthsince has been, by comparison, unspectacular.
30%35%40%45%50%55%60%1970 1975 1980 1985 1990 1995 2000 2005 2010
Household Consumption (% China GDP)
Source: Bloomberg/EAM Research
 Manager Commentary, April 2012
So it was not urbanisation that drove residentialinvestment. And it
levels of home ownershiprising from a low base. Rather, it was house priceappreciation. Before 2004 bank deposit returns hadexceeded average house price gains across the country. After that money printing and financial repressionpropelled house prices higher and higher. Annualreturns from residential investments beat term deposits by a whopping 5% p.a. in real terms. At the same timefirst time buyers found they could borrow at a discountof 15% to 30% to the benchmark rate for the life of amortgage. There was no property tax so the carryingcost of owning an empty flat was modest. Housinginvestment was a no-brainer.The market went ballistic. On official numbers,households raised their borrowing by $400bn and then$460bn in 2009 and 2010. That was an annual average
increase 4x the increase seen in 2008. By 2009,
individual mortgage borrowings where growing 6xfaster than the year before as banks lent out a third of the total mortgage stock outstanding. By mid-2010, theshare of residential properties purchased acrossChinese cities as an investment hit an extreme peak of 40% and even the central bank estimated that 18% of households in Beijing owned two or more properties.Many of these lay vacant. It should not be surprising tolearn that as a result of all this the ratio of householddebt to income rose by almost 20 percentage points between the end of 2008 and the end of 2010. This wasan incremental change greater than the one witnessed
during the wilder years of the US boom. China has
spent twice as much as the US relative to the size of itseconomy on its property bubble. Given that Americanmortgage underwriting standards completely collapsedduring the bubble, that is quite an achievement.The scale of the surge is, we think, without precedent inemerging markets. Consider Taiwan. It is an islandnation with land in short supply and, like the UK, it issusceptible to housing bubbles. But when Taiwan hadits China moment of rapid growth and massurbanisation, investment in residential housing peakedat just 4.3% of GDP (in 1980). In other words, half of  where it was in China last year.
The Chinese Buy in Cash? Nonsense
  You do not read as much about a residential bubble as you should. China's banks are instructed to demand40% down-payments on new mortgages and officialnumbers have China's household debt-to-GDP ratio atthe end of 2007 as just 20%. Ergo, Chinese householdsare thought to be unleveraged so there can be no bubble. This just does not fit the facts.To really understand what is going on we must look tothe shadow-banking system and how the financially repressed, caught in the tyranny of negative realinterest rates, use it. These underground lending andinvesting networks are estimated to total $1.3 trillion.This rivals the size of the U.S. government's budgetdeficit. I suspect that we will also find in time that it hasfinanced a large number of the deposits apparently prudent investors have put down on new build flats. 
 Want a House Deposit? Ask a Shipbuilder
 This is just the beginning. All this might have started
 with informal loan desks at underground train stations
in Wenzhou but, as ever, it was not long beforeeveryone wanted a piece of the action. SocieteGenerale's Yao Wei estimates that China's entireshadow-banking system totals $2.4 trillion, so aroundone-third the size of the official loan market and equalto the entire stock of US consumer debt. Wei's largerfigure includes $1.1trn in outstanding "wealth
products from the official banking sector.These products enjoyed a three-fold increase in 2010alone as banks and other corporates desperately soughtto compete against the black-market loan flyers on thestreets promising to pay as much as 0.5% a day. The
 banks responded by offering 2 to 31 day term deposits
 with annualised returns of 8%. But perhaps with toomuch zeal. China's Banking Regulatory Commissionrecently had to insist that they refrain from selling such"wealth" products (I use this term in its loosest possiblesense) which are not based on market analysis, have norisk measurement and cannot be independently appraised.

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