Dealing with "manipulation" of the yuan

I have been reading many reports on the pressure from the US and the EU on China to revalue its currency to reflect "market realities". How should the US and EU deal with Chinese currency "manipulation"? I think the US and EU should just sit tight and do nothing.

China has had a significant trade surplus over the last many years (over $800 billion in just the last four years). China's trade surplus peaked last year at around 9% of GDP. In 2009, it is expected to be around 5% of GDP. China's huge trade surplus and its rising economic power has increased pressure on elected officials in the US and EU to act on China's "currency manipulation". Chinese premier Wen Jiabao rejected the calls for currency revaluation as "unfair". "Their measures are restricting China's development" Wen Jiabao said.

There is no evidence that revaluing the yuan will have a positive effect on the unemployment statistics in the developed world. Former Federal Reserve Chairman Alan Greenspan mentioned in 2005 - "I am aware of no credible evidence that ... a marked increase in the exchange value of the Chinese [yuan] relative to the dollar would significantly increase manufacturing activity and jobs in the United States." I agree with Greenspan. There is not much of an overlap between the exports of China and the US and EU. If China revalues its currency, the US and EU imports will move from China to some other country (say India or Taiwan or Vietnam) or increase inflation in the developed world instead of creating jobs in the developed world.

Even if we assume that there is a correlation between Chinese currency appreciation and jobs in the developed world, the US and EU cannot do much. The WTO does not have too many rules against currency manipulation. There is no consensus that the China's pegging of yuan to the US dollar (which many people think is currency manipulation) would qualify as a "subsidy" under the WTO treaty. Hence it would be difficult to force China to revalue its currency under WTO rules.

Market forces will eventually force China to revalue its currency (when it revalues is anybody's guess). Today, People's Bank of China keeps its currency artificially low by absorbing dollars from the market and investing them in US Treasuries. This increases yuan in circulation, increasing inflation in the process. The central bank has to then remove these additional currency in circulation by issung bonds (at an interest rate much higher then the interest rate on US treasury securities). The cost of doing this is very high - the interest rate differential of around 5% would amount to over a $100 billion per annum on a $2 trillion reserve! This process of running huge trade surpluses and accumulating reserves will become increasingly unsustainable.

Bottomline - there is neither a need nor a way to force China to appreciate the yuan. Sit tight and leave yuan revaluation to market forces.

It's the deleveraging process stupid

I read an impressive article on Bridgewater Associates (the world's biggest hedge fund) and its CEO Ray Dalio, in the Fortune magazine. His flagship fund has clocked an annual return of 15% over the last 18 years – a very impressive performance indeed. The fund never imploded during the many crises the financial markets have seen over the last two decades. Also, when 70% of the hedge funds lost money last year and the average hedge fund was down 18%, Dalio's fund returned an impressive 14%.

The article claims that over the last two years, the hedge fund industry in aggregate terms has been closely correlated to the S&P 500 and had even reached a 75% correlation. I am not able to digest the fact that hedge funds had such a big bias towards growth even though signs of strain in the economy had begun to surface 2 years ago.

I liked the way Dalio put the current economic woes in perspective:
“Most people think that a depression is simply a really, really bad recession. But in reality, the two are distinct, naturally occurring events. A recession is a contraction in real GDP brought on by a central bank tightening monetary policy, usually to control inflation, and ends when the central bank eases. But a D-process (deleveraging process) occurs when an economy has an unsustainably high debt burden and monetary policy ceases to be effective, usually because interest rates are close to zero, and the central bank has no way to stimulate the economy. To compensate, the value of debt must be written down (risking deflation) or the central bank must print money (a trigger of inflation), or some combination of both.” In recent years the level of debt as a percentage of GDP in the U.S. has skyrocketed past previous highs last seen in the early 1930s. And the Federal Reserve's benchmark rate is now hovering just above zero. "It seems very likely that stocks will get materially cheaper," he says. "We have to go through an important debt restructuring process, and a lot of assets are going to be for sale, huge numbers of assets. And there's going to be a shortage of buyers."

If Dalio’s predictions come true, the expectation that the markets have bottomed out could be short-lived.

Jon Stewart vs Jim Cramer

Jon Stewart, host of The Daily Show, recently interviewed Jim Cramer, the host of CNBC's Mad Money. Jon takes a dig at the business news channels that failed to educate viewers on what was happening in the financial markets and Cramer is defenseless.

The interview has had a huge fan faollowing in the US. The Washington Post reports White House Press Secretary Robert Gibbs saying "I Enjoyed It Thoroughly", when asked about the show.

When the equity markets were in a bullish phase, CNBC's Indian unit - CNBC TV18, made the mistake of celebrating (literally) every additional 1000 points on the Bombay Stock Exchange, knowing very well that the market was frothy. The reporters wore colorful dresses, cut cakes and decorated the studio with balloons! Why did they do all that? The TV channel has a stake in the market going up all the time and small investors feeling gung-ho about it. So it was just an act of playing to the gallery. One wondered whether CNBC TV18 is a business news channel or an entertainment channel.....

Watch Jon Stewart's interview here:

I hope shows like this highlight and encourage debate on the important issue of an inherent conflict of interest that the news media faces these days - the quest for profit versus the duty of quality reporting and investigative journalism. If the issue of conflict of interest is not resolved, news media risks failing in its role as a pillar of democracy.

Overdose of Statistics

This cartoon, published in The New Yorker in the year 1977, is quite relevant even today!

Black Swan Fund gains 236% amidst capitulation in financial markets

Bloomberg reports that 36 South Investment Managers, a New Zealand based hedge fund, gained 236% in the last 12 months. This is a terrific record in a year where hedge funds lost 19% on an average.

How did 36 South manage to put up such an impressive performance? It has to do with the trading strategy. 36 South buys long-dated options it considers cheap - in currency, bond, equity and commodity markets, betting that rare and unforeseen events would generate unusually large profits. The premium it pays on those options are relatively small - but when the direction of the bet is right, the pay-off is huge.

36 South had profited from bets on interest-rate cuts in Australia and New Zealand, and the purchase of put options on major stocks around the world, including BRIC nations. The fund had also bought put options on commodities.

The risk premium on most of the financial instruments has risen significantly over the last few months, making such a trade not so lucrative these days. Volatility indices have risen substantially and consequently the options premia have shot up. So, a trade similar to what 36 South entered into last year, is unlikely to be lucrative this year.

What is 36 South going to do next? It will start a fund that will bet on inflation around the world going up significantly. With governments around the world planning to tackle recession by printing money and pumping it into their economies, 36 South is likely to make a killing once again.