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CURRENCY CURRENTS

Tuesday 30 July 2013

A free global-macro & market newsletter

John Ross (aka JR) sent me a piece of research this morning from Trading China, titled, China risks following Japan into economic coma. The first paragraph of the piece read: After decades of emulating Japan's export-driven economic miracle, China appears in danger of following it into the same kind of economic coma that Japan is trying to wake up from 20 years later. Well, I couldnt agree more. And in fact I would like to share with you more detail on the possibility China follows down the path of Japan by re-printing an article I wrote three years ago, titled, The Japanese-China Parallel: Eerie and Scary Combined. This piece was published in the Forex Journal in the August 2010 edition. Its interesting how history rhymes. I think I did a decent job of laying out the major macro rationales for the Japanese-China parallel; many are still in play today. So when we see arguments of whether or not China can continue to grow above 7%, etc., think about the prospect of a Chinese recession instead. An interesting mind game still, but in this strange macro-world in which we live the last few years have proven we can no longer say it will never happen with any degree of confidence.

Jack Crooks Black Swan Capital www.blackswantrading.com 16 July 2010 The Japanese-China Parallel: Eerie and Scary Combined
If you do not change direction, you may end up where you are heading. Lao Tzu I think most everyone thinks they know where China is headedworld hegemony and the most vibrant large economy is the usually the answer. But whenever we project from the recent past, we are usually disappointed. There are many obstacles along the way before China rules the economic world and one of them is what we have dubbed The Japanese Parallel. It would be a game changer and major implications for all global asset markets, especially currencies. Before we get into the parallel, lets first take a look at the US current account deficit, what it means, and why it is linked arm and arm with the worlds reserve currencythe US dollar. This will help you better understand the role of a world reserve currency and why the current account is an important indicator of global macro money flows and central to the story. Mr. Triffin and the world reserve currencys dilemma

The US dollar as the world reserve currency simply means that most of the worlds transactions across borders that are related to the trade of real goods (oil, food, cars, computers, etc.) and capital flows (major financial deals and movement of large pools of funds) are denominated in US dollars. The reason it came about is because the US became the dominant world economic and political power after the demise of Great Britain and has maintained that role in the world ever since. This role is very important for the US government because the reserve status affords more political and economic power to the US accordingly. Unfortunately, it allows the US to spend more freely than other nations. Why? Remember, other nations have to hold dollars in order to transact international trade. They dont have to hold British pound or euro or Japanese yen, per se. So as you can see, the reserve status is quite important for the US sphere of influence and for the dollar. If countries didnt have to hold dollars to trade, the dollar would likely be even lower based on the sharp rise in US debt and decline in overall economic position relative to rising competitors such as China and others. The problem is: the very nature of a world reserve currency is a flawed concept. This was first discussed by an economist name Robert Triffin. And his suppositions became known as Triffins Dilemma. Seemingly apparent to most people lately is the critical role the US dollar plays in global growth, precisely because it is the world reserve currency. Remember that during the credit crunch the dollar soared in value; this represents the proverbial risk bid. The reason for this was that dollar-denominated credit escaped from the world economy very fast. Thinking in these broader terms of how the dollar provides growth for the rest of the world is where Triffins Dilemma comes into play. In 1960, Mr. Triffin wrote a book titled Gold and the Dollar Crisis: The Future of Convertibility. In this book, Mr. Triffin identified the problems for the US economy if the dollar became the principle reserve currency in place of gold. He really nailed it. Triffin said that if the US dollar replaces gold in the global monetary system (as it has), the United States would incur large trade deficits in order to provide the rest of the world with the liquidity they needed to grow efficiently and keep the wheels of the global financial system greased. What is interesting is the fact that biggest dislocations we have witnessed in the global financial markets--the stock market crash of 1987, the Nasdaq market crash of 2000, and the global credit crunch were all proceeded, or coincident with, a decline in the dollar credit throughout the world, i.e. dollar-denominated reserves started to shrink, evidenced by an improvement in the US current account balance. You can see this clearly in a long-term chart of the US current account balance (a measure that takes into consideration both US trade and capital flows); notice that each time weve seen an improvement here dollar-credit receding from the globewe have had major market troubles:

Black Swan Capitals Currency Currents is strictly an informational publication and does not provide personalized or individualized investment or trading advice. Commodity futures and forex trading involves substantial risk of loss and may not be suitable for you. The money you allocate to futures or forex trading should be money that you can afford to lose. Please carefully read Black Swans full disclaimer, which is available at http://www.blackswantrading.com/disclaimer

Global Credit Crunch 1987 stock market crash and 1990 recession

2000 Nasdaq stock market crash

Declining in dollar credit global comes about then dollars rush back to hide in US capital markets, when it is destroyed, and when US consumers pull in their horns. Prior to the credit crunch of 2008 the world was awash with liquidity US dollar liquidity. Because of the large current account deficit being maintained, thanks much to China as the hub of global trade, the US was effectively funding global growth through the recycling of Chinas trade surplus. We coined this: The US-China Symbiotic Relationship and put together our representation of this relationship in flow chart form, as you can see below:

US-China Symbiotic Relationship


Single Currency Zone Argument

Black Swan Capitals Currency Currents is strictly an informational publication and does not provide personalized or individualized investment or trading advice. Commodity futures and forex trading involves substantial risk of loss and may not be suitable for you. The money you allocate to futures or forex trading should be money that you can afford to lose. Please carefully read Black Swans full disclaimer, which is available at http://www.blackswantrading.com/disclaimer

The credit crunch changed this game and exposed the flaws in Chinas growth model that was highly dependent on pure export and Mr. US Consumer.

US-China Symbiotic Relationship Game Over?


Single Currency Zone Argument
Chinese Government Explicit Stimulus
Forcing Asian Trade Partners to Adjust [China surplus up, but exports to West down]

Cap Invest @ 45% GDP

X X X

US Consumer Wealth Fading

X
Crunch Seemingly costless Chinese capital?

X X

Money Locked Inside the System

Property & Stock Bubbles

The credit crunch took the US consumer out of the game and drained a lot of dollar credit out of the global system. The Chinese government has had to step in with direct stimulus in a very big way to keep the music playing. And here is where the seemingly eerie parallel with Japans global macroeconomic history comes into play. The Parallel in Play During the 1980s it appeared Japan as the Creditor Superpower was going to gobble up the world with their powerful export machine and massive current account surpluses rolling in. Then a little thing called the US stock market crash in 1987 changed the game. Dollar credit flowed from the global system triggering an improvement in the US current account balance (first gold box left in chart below) which was followed by a US recession. This came as the Japanese yen was appreciating in value, thanks to the G-7 Plaza Accord to pressure the yen higher because of all those Japanese exports. The litany: 1) Japans very hot stock market broke in 1989. 2) Then its extremely overpriced real estate bubble started its collapse(remember when the Imperial Palace in Tokyo was worth more than the entire state of California). 3) Japanese authorities did all they could in the form of stimulus to try to keep air in the bubble
Black Swan Capitals Currency Currents is strictly an informational publication and does not provide personalized or individualized investment or trading advice. Commodity futures and forex trading involves substantial risk of loss and may not be suitable for you. The money you allocate to futures or forex trading should be money that you can afford to lose. Please carefully read Black Swans full disclaimer, which is available at http://www.blackswantrading.com/disclaimer

a.

They pumped more money into the stock and property markets in order to revive the wealth effect for domestic consumers b. They subsidized export companies to keep exports flowing (but the worlds major consumerthe US economywas entering recession and not there to buy). c. They lowered interest rates to zero d. They continued massive fiscal stimulus by building infrastructure across the country

But, it didnt work. The massive dislocations caused by artificial channeling of credit within the Japanese economy in order to focus almost entirely on building a global export machine created the malinvestment that has taken years to work off precisely because the Japanese economy was so imbalancedproduction versus consumption. Attempts to change this model were scant at best; instead they kept morbid companies alive, and forced its consumers to save thanks to artificially low interest rates. Fast forward to China todayand you can witness the parallels Instead of the US stock market crash being the triggering event, we have the credit crunch in its place arguably a much bigger and more powerful global event. Secondly, global leveragedebt in the systemwas massively larger in 2007 than it was in1987 i.e. the world was hooked on massive dollarbased credit spewed out by the trillions of dollars in derivatives production. Mr. US consumer has pulled in his horns much more quickly and to a greater degree than he did back in 1987, taking much more global demand for goods out of the marketdemand that China was and still is so highly addicted to. And interestingly, now we also have the Chinese currency starting to rise in value, albeit at a much slower pace than the Japanese yen did in the last 1980s. So what has China done to overcome this sea change in the global economy evidenced by the improvement in the US current account? They have done many of the same things Japan has done and we are seeing a replay of events to a degree The litany: 1) Chinas very hot stock market broke October 2007 and is now 59% off its old high (that is a major drag on the so-called wealth effect). The Chinese government owns or controls most of the stocks on its exchange and has still been unable to keep them pumped up. 2) Chinas real estate prices started falling in June for the first time in sixteen months. But Chinas real estate market, especially on the commercial side, is extremely over built. A massive amount of speculative credit has poured in here that could come rushing out. [Interesting point here too: The change in Chinas currency policy, which has now made it clear there will not be any type of one time ramp up revaluation, means a lot of the hot money that poured into China, and headed into real asset investment to position for this one off, might now quickly come rushing back out as real estate prices start to turn over. a. They pumped more money into the stock and property markets in order to revive the wealth effect for domestic consumers; it hasnt worked, as it didnt in Japan. And just as Japan found out, because of pursuing a pure export policy for so long, there is no fall-back to local demand if international demand disappears for their exports.

b. They subsidized export companies to keep exports flowing (but the worlds major consumerthe US economywas entering recession and not there to buy). China has managed to push its domestic adjustment off on to its trade partners thus far. But if the US
Black Swan Capitals Currency Currents is strictly an informational publication and does not provide personalized or individualized investment or trading advice. Commodity futures and forex trading involves substantial risk of loss and may not be suitable for you. The money you allocate to futures or forex trading should be money that you can afford to lose. Please carefully read Black Swans full disclaimer, which is available at http://www.blackswantrading.com/disclaimer

consumer does not materialize, trade frictions will grow for China, not just in the West, but from its Asian-block competitors also.

c. Chinas interest rates are not at zero, but they are extremely low for a country supposedly growing that fast. This low interest rate policy is similar to what Japan did. It leads to forced savings and smothers local consumer demand at a time it is most needed. d. They continued massive fiscal stimulus by building infrastructure across the country. Chinas infrastructure development is legendary. It has led to massive overcapacity across many sectors. If global demand is not there to take the final goods all this capacity can produce, then much of that capital will be wasted. This is what happens when government determines investment policy instead of letting the market do the job. Officially, China sports quite a low debt-to-GDP ratio. But if you consider that Chinese banks are effectively government conduits, some have estimated debt to GDP in China is somewhere between 70-80%.

The credit crunch is the markets way of starting to rebalance a very imbalanced global world that has at the heart of it: 1) A flawed world reserve currency system; 2) inordinate demand and depth of capital markets concentrated in one place (US); and 3) a beggar they neighbor export policy (Asia) leading to massively suppressed relative currency values. The Japanese-China Parallel is truly eerie. The next chart displays this, what I discussed above:

China
US Stock Market Crash

Japan
Creditor Superpower

Creditor Superpower

BOJ formula as US Current Account Improved


1. 2. 3. Boost stock & property market Give buffer for export companies to turn inward Stock & property trigger wealth effect

Credit Crunch

Black Swan Capitals Currency Currents is strictly an informational publication and does not provide personalized or individualized investment or trading advice. Commodity futures and forex trading involves substantial risk of loss and may not be suitable for you. The money you allocate to futures or forex trading should be money that you can afford to lose. Please carefully read Black Swans full disclaimer, which is available at http://www.blackswantrading.com/disclaimer

This potential global macro replay shows that policymakers have either learned little, or are unwilling to do the heavy lifting of real global monetary reform. If the Chinese economy plays out as Japans did when its credit bubble burst, the implications for the global economy would be dire, as we are still in the midst of massive private deleverage, which is already overwhelming the public debt being poured into the system, which has created the nasty byproduct of shaky sovereign credits across all Western nations. Asset market impact if the parallel continues: 1) Grinding global deflation impacting many asset classes: a. Commodity prices plunging b. Commodity currencies tanking c. Stock markets predicated on China/Asia growth leadership hammered d. US government bonds rally as US based credit leaks out of the system and hide in the worlds deepest capital markets e. The world reserve currency rallies on the demand for cash f. The euro disappears, as this conflagration would end the single currency poorly structured experiment So, we continue to watch as China ticks off the historical markets that crushed Japans growth and economic leadership and hope that part about history repeating in another form is wrong. ----If you wish to learn more about our forex service, please click here. We also offer a global macro trading service that might be of interest. You can find more information about that service here. Thank you. Jack Crooks Black Swan Capital www.blackswantrading.com info@blackswantrading.com

Black Swan Capitals Currency Currents is strictly an informational publication and does not provide personalized or individualized investment or trading advice. Commodity futures and forex trading involves substantial risk of loss and may not be suitable for you. The money you allocate to futures or forex trading should be money that you can afford to lose. Please carefully read Black Swans full disclaimer, which is available at http://www.blackswantrading.com/disclaimer