THE AMPHORA REPORT

Vol 2/1, 1 January 2011 www.amphora-alpha.com

IN THIS EDITION

THE YEAR OF THE SILVER HARE

Whereas much of the world follows a solar calendar, with the year beginning and ending around the time of the winter solstice, there are those that follow a lunar calendar instead, including of course the worlds most populous country, China. Their new year is still one month away and, this time round, will be that of the harein the 12-year cycle of their zodiacand also that of yin metal, or silverin the cycle of the five elements. While we are not astrologers, we nevertheless appreciate the meaning of these cycles for the Chinese, who currently face unprecedented, potentially destabilising economic circumstances. According to tradition, the hare is not comfortable in such situations, in which its behaviour becomes unpredictable and potentially dangerous.
THE YEAR OF THE SILVER HARE Those of us who recently celebrated the New Year are now returning to work or preparing to do so, hopefully following a nice holiday with family and friends. But the Lunar New Year is still one month away. The Chinese calendar follows the lunar cycle and also contains multi-year cycles. One of these is a twelve-year cycle corresponding to the Chinese zodiac of animals, including the legendary dragon. The other cycle, called Wu Xing in Chinese, is less well-known outside of China and corresponds to the five elements: Fire, Earth, Metal, Water and Wood, with each element having a yin, or female aspect, and also a yang, or male aspect. 2011 is thus not only the Year of the Hare, following the 12-year zodiac cycle, but also the year of yin metal, following the Wu Xing. As yin is associated with the feminine and the moon, the most prominent yin metal is silver. 2011 is thus not only the Year of the Hare but the year of silver. It should therefore be no surprise to find Chinese jewellers currently offering a range of commemorative silver pendants of hares or of the Chinese language symbol for hare, as shown here. Not coincidentally, the Mandarin Chinese word for silver is yin. Another interesting fact about yin metal, or silver, is that the Chinese symbol for silver also means relating to money or currency, which should be no surprise given that, through the ages, silver rather than gold has been the predominant monetary metal in China, with gold,

although more valuable by weight, being used primarily for decorative or artistic purposes. The Chinese symbol for silver as metal is shown here on the left; that for silver as money is shown on the right. While we are not followers of astrology, we do appreciate the importance the Chinese place on their zodiac and also the Wu Xing. Even for those not particularly religious, these concepts might guide or at a minimum inform Chinese thinking on a wide range of issues, in much the same way that a secular, agnostic European might nevertheless draw extensively on the core concepts of the JudeoChristian tradition. As the New Year is naturally a time to reflect and consider what, if anything, one might wish to change in life, so it is instructive to consider how China, arguably the greatest rising economic and political power in the world, might be thinking about the rapidly approaching Year of the Silver Hare. As with all creatures in the Chinese zodiac, the hare has a well-developed personality, some key aspects of which are: Hares tend to be friendly yet generally keep to themselves; They are conservative, insecure and generally pessimistic and dont welcome change or conflict; As such, they undertake nothing without a thorough weighing of all pros and cons; They tend to be peaceful and occupy themselves with commerce and domestic affairs, unless confronted with an exceptional situation, a dramatic turn of events or an insurmountable obstacle, in which case their behaviour can

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become unpredictable, erratic, desperate or even dangerous At first glance, the qualities above would seem to be somewhat characteristic of modern China generally, which has not been an aggressive, expansionary power; which has generally resisted dramatic change, both political and economic; which has been focused primarily on commerce and domestic affairs; and which has not been easily provoked. Yet consider the final bullet: Just as there are circumstances under which the hare might suddenly behave in unpredictable or even dangerous ways, so this might also be the case with China. Consider: It was almost exactly 60 years ago, the last time the Year of the Hare was approaching, when China, confronted by crumbling North Korean resistance to a rapidly-advancing US-led military force, decided to pre-emptively attack the US by secretly crossing the Yalu river in huge numbers. Yet despite supposedly reliable intelligence and also nonstop aerial reconnaissance, this came as a complete surprise to the US forces, commanded by General MacArthur, who was forced to watch his seasoned troops beat a hasty, demoralising retreat in horrible winter conditions, suffering massive casualties in the process. At one point, MacArthur became so desperate to regain the initiative that the requested permission to use the atomic bomb. President Truman refused and, in defiance, MacArthur went public with criticism of the decision. Notwithstanding his legendary reputation and huge popularity he was considered a serious potential presidential candidate at one timewithin weeks he was relieved of duty, never again to return to command. Now we dont mean to imply that we think China is at risk of acting unpredictably in military fashion as China is not currently being so provoked. Yet arguably China is nevertheless faced with

exceptional economic provocations, brought about by recent US actions, including those of both the US government and Federal Reserve. Specifically, China is confronted by the glaringly obvious lack of US fiscal discipline and the aggressive monetary policy of the Fed, both of which threaten to destabilise not only the US economy but, by implication of the dollar being the worlds reserve currency, the global economy. The sudden, surprising decision in Washington late last year to extend both tax cuts and unemployment benefits may have been labeled a political compromise by the interested parties but, as is evident to the rest of the world, including China, it was in no way an economic compromise, in that nothing was given up. Indeed, you could just as well say that the US has sent a message to the rest of the world that it will NOT compromise in its pursuit of artificial, fiscally-engineered stimulus. Some weeks previously the Fed had already made its latest move, announcing the start of a programme of monetaryengineered stimulus, to purchase up to $600bn of Treasuries, known in the financial jargon as QE2. In previous Amphora Reports we have used the word pathological to describe the Fed s relentless pursuit of inflation at all costs. At this point, the word seems an equally apposite description of US fiscal policy. The Chinese are therefore faced with the prospect that the US will stop at nothing to stimulate economic activity, no matter how unsustainable, inflationary and destabilising. The US simply refuses to allow its economy to adjust and restructure naturally notwithstanding wide and growing global criticism. (In this respect, current US political behaviour is eerily reminiscent of the run-up to the Iraq war, even if it is economic rather than foreign policy that is at issue.)

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Global US Treasury holdings are soaring, fuelling inflation

Why does the increasingly pathological behaviour of the US with respect to economic policy present the Chinese with such an exceptional situation? As mentioned above, the US dollar is the world s primary reserve currency. As such, dollar assets comprise the bulk of global central bank reserves. The People s Bank of China and central banks the world over hold huge amounts of dollar assets (See chart above), including of course US Treasury securitiesclaims on the present and future US taxpayer. As current US economic policies are highly expansionary, they are stimulating activity all over the world. As an indirect result, consumer price inflation in many countries, including China, is now soaring, threatening economic and, in some cases, political instability. China has recently raised interest rates to try and dampen these pressures but it is highly unlikely that an incremental rate increase or two is going to maintain economic stability. More action is going to be required. How much? It is impossible to know. This is because no one can know exactly what impact US economic policies will have either on the dollar or on Treasury securities. As with all assets, there is no simple linear relationship between supply, demand and price. Whereas US Treasury and dollar money supply, at least in the short run, might be reasonably easy to forecast with accuracy, this cannot be said of demand, which can be fickle and unpredictable. Indeed, global investors confronted by the exceptional situation of a US government bent on creating inflation at all costs simply cannot be

expected to continue purchasing Treasury securities indefinitely. And neither can China. Is there a potential straw that breaks the dollars back, which results in a sudden drop in demand for US assets and thus sends Treasury yields sharply higher? We can imagine quite a few. For example, what of the deteriorating finances at the US state and municipal level and the growing risk that, at some point, Washington will have to craft some sort of rescue package, financed no doubt with US Treasury issuance? What of the continuing foreclosure crisis and associated lack of transparency of US bank balance sheets? And what of commercial real estate, more and more of which is now also being foreclosed upon? What of soaring commodity prices which, according to available data, are narrowing profit margins for US firms? If, as a result of these and other factors, the economy fails to respond as hoped to the above stimulus measures, what does this imply for US assets generally? We don t purport to know what China is going to do in response to increasingly pathological US economic policy and the global consumer price inflation it is fuelling. We suspect the Chinese themselves dont know. But one is naturally led to ponder whether this year, being that of yin metal, or silver in the Chinese elements cycle, is the year in which China considers implementing some major economic reforms. Perhaps they are going to raise interest rates dramatically. Perhaps they will revalue their currency by a substantial amount. Perhaps they are going to impose widespread wage and price controls. Perhaps they are going to escalate an

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already simmering trade war with the US. Any of these actions could have a large, quite possibly negative impact not only on the Chinese economy, which is at clear and present risk of a hard landing; but also, by implication, on global asset values and certain industrial commodities. There can be no doubt that the Chinese face exceptional, unprecedented economic challenges. It

may be 2011, not 1951, but the prospect of a Chinese surprise seems comparably high today. In any case, US authorities seem unconcerned about China, even complacent. Sure, they might be confident in their intelligence and in their reconnaissance. But they would do well to consider that the Year of the Silver Hare is about to begin.

AMPHORA: A lateral-handled, ceramic vase used for the storage and intermodal transport of various liquid and dry commodities in the ancient Mediterranean.
JOHN BUTLER john.butler@amphora-alpha.com John Butler has 18 years experience in the global financial industry, having worked for European and US investment banks in London, New York and Germany. Prior to launching the Amphora Commodities Alpha Fund he was Managing Director and Head of the Index Strategies Group at Deutsche Bank in London, where he was responsible for the development and marketing of proprietary, quantitative strategies. Prior to joining DB in 2007, John was Managing Director and Head of Interest Rate Strategy at Lehman Brothers in London, where he and his team were voted #1 in the Institutional Investor research survey. He is a regular contributor to various financial publications and websites and also an occasional speaker at major investment conferences.
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