Wrong Problem, Wrong Solution Mr. Krugman

Nobel prize winning economist Paul Krugman had commented in his recent New York Times article that the world should indeed be worried about China's currency policy. Krugman quotes Paul Samuelson to argue that China has stolen jobs from other countries through its currency policy.

I agree with Krugman on his comments so far, but Krugman also argues in favor of protectionism and "trade confrontation" by the developed world to get China to revalue the yuan.

I think there are a couple of flaws in Krugman's argument:
a) Currency is not the only factor which makes China competitive. Speak to companies that import stuff from China - they would tell you that currency is important, but one cannot ignore factors like labor availability, infrastructure and to some extent regulatory (health / safety / working conditions / minimum wages etc) arbitrage which makes China’s manufacturing competitive.

b) Krugman, through his "back-of-the-envelope calculation", has pegged the extent of job loss in the US because of China's currency policy at 1.4 million. I think Krugman has overestimated the ability of the US and other countries to competitively manufacture most of the goods that are currently imported from China. What might happen with yuan appreciation is just a rise in inflation and inflationary expectations in the world and not job creation. At a time when unemployment is high and economies are growing at a slow pace, high inflation can cause a lot of trouble.

c) Protectionism and trade confrontation are easy to recommend but extremely difficult to implement. I had argued in my earlier post that under WTO rules it would be difficult to force China to revalue its currency. The only way out would be to bypass the WTO and erect trade barriers against China. However, the US and the EU will be shooting themselves in their foot if they undermine the WTO.

This takes us back to the question - How should the US and EU deal with Chinese currency "manipulation"?.... My answer is still the same - China 's currency policy is clearly unsustainable and market forces will eventually force China to revalue its currency. The developed world should leave the timing of yuan revaluation to market forces.

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.

Where is the global economy headed?

Where is the global economy headed? People will kill to get a definitive answer to that question.

There is so much panic, skepticism, and fear among not just investors but also laymen who are wondering whether they will get to keep their jobs, be able to feed their families and pay their mortgage. The scenario is so anti to how it has been over the last few years when words like optimism, confidence and euphoria defined the mood.

Not everyone has realized yet that the turmoil in credit markets will affect the real economy. The freeze in credit markets is bound to have a ripple effect on economic activity. People must be naïve if they think the credit crisis would affect only the financial markets. The crisis would push CEOs make preserving cash the objective, rather than chasing growth. Jeffrey Immelt, the Chairman & CEO of GE recently commented (not quoting him verbatim here) "for every dollar of economic activity, there is 10 dollars of financing involved in the entire supply chain. So if credit market freezes, economic output is bound to be affected."

Now back to the question - Where is the global economy headed?
A recent Reuters poll of economists showed that “the global economy will likely shudder to recessionary levels in 2009 as developed nations' woes damage emerging countries' economic prospects”. The IMF has also projected sharply lower growth for 2009. My take is that we should consider ourselves lucky if we can escape a deep and prolonged recession.

One bright spot in the economy right now is the fall in commodity prices. Oil prices have fallen 50% from the peak and prices of industrial commodities have crashed as well. Oil prices are likely to remain soft if OPEC does not become too greedy. Lower commodity prices will ease the pain many economies are facing.

The demise of Bear Stearns

Bear Stearns has been absorbed by JP Morgan for just $2 per share – reportedly valuing the company at $236 million. It has been a dramatic collapse of a Wall Street Firm that was the darling of employees and stock markets. The employees seem to own nearly 30% of the company (though a significant chunk is likely to be owned by the top few executives) and it has been a terrible loss of personal wealth for them.

I feel sorry for Bear Stearns employees and investors. But I think such incidents tend to make the market healthier by weeding out excesses.

It is apt to be a little philosophical at times like these. Incidents like these reinforce our belief in the laws of Systems Thinking and Behavioral Economics

a) In my post of 30th March 2007, I had discussed how the ballooning asset bubble was threatening to push the financial markets off a cliff and the events that are unfolding now were not so hard to predict even a year earlier.
b) Students of Game Theory know about “Prisoner’s Dilemma”. To cut a long story short, it says that every individual acts in his own interest, thereby causing systemic failures. This failure ends up harming the individuals’ interest which they thought they could protect by acting in a “selfish” manner. Run on banks follows the same principle. When everyone is in a hurry to withdraw their assets from a bank (to protect their own savings, and in hurry to withdraw the asset before the neighbor next door does so), the bank collapses. It does not require erosion in the value of assets of the bank to trigger a crisis like this – it requires just erosion in confidence in the bank.
c) “The law of unintended consequences” is playing catch up: The last few moves of the Fed have had quite a few undesirable effects. Excessive rate cuts by the US Fed have always created asset bubbles – Nasdaq, Subprime, and now a short lived bubble in emerging market equities. Despite the rate cuts, the mortgage crisis is only gathering pace and the economy does not seem to stop sinking into a recession.

The US Fed is blamed by many for taking no action to prvent the crisis. It is interesting to read the comments of Alan Greenspan, the former Fed Chairman, as gathered by Paul Krugman, a columnist with the New York Times

What Greenspan said: “The current financial crisis in the US is likely to be judged in retrospect as the most wrenching since the end of the second world war. It will end eventually when home prices stabilise and with them the value of equity in homes supporting troubled mortgage securities.
Home price stabilisation will restore much-needed clarity to the marketplace because losses will be realised rather than prospective. The major source of contagion will be removed. Financial institutions will then recapitalise or go out of business. Trust in the solvency of remaining counterparties will be gradually restored and issuance of loans and securities will slowly return to normal.”

What Keynes said: In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.

Debunk the Decoupling Theory Atleast Now

My comments on January 20th (read post on this link) have all come true !!!

Just a day after I posted the comment, the Indian stock market fell 10% on an intraday basis. The next day it fell another 14% on an intraday basis. Though stock markets recovered a bit, they have been on a down-trend ever since.

It takes a brave man to voice opinion against the wisdom of the crowds and the events over the last few weeks make me feel vindicated.

What were those predictions and how have they markets shaped up against these predictions ?

a) During a downturn, money flows into the home market
There have been huge outflows from emerging markets. Indian and Chinese stock markets have been the worst performers this year.

b) If there is a recession in the US, no country can fully decouple itself and maintain its growth rate

There are signs of sluggishness in the Indian economy. Reports indicate that India’s Industrial Production grew by only 5.3% in January. Bank of China estimates Chinese GDP growth to slow down. Decoupling theory has now given way to Recoupling theory !!!

c) Reckless rate cuts will only stoke inflation rather providing a real impetus to growth (China is currently witnessing inflation of over 6% and the authorities have committed themselves to fight it through a tight monetary policy). Despite the heavy fall in short term interest rates in the US, the long term interest rates have refused to budge, indicating bullishness on inflation trends.

Just look at Gold and Oil. Gold has reached $1000 and oil has crossed $110 – close to a 100% gain in the last 12 months.

How do you position yourself ?

a) Act like a hedge fund; have a long-and short strategy. Immediately switch out of stocks that are dependent on discretionary consumer spending in the US. You can buy into emerging market equities on dips, but buy into those stocks which have lower export component and are fairly valued. Don’t buy stocks whose valuations are can be justified only by a great growth story.
The Indian and Chinese markets have fallen 25% from the peak and people who bought into “growth stocks” have burnt their fingers very badly.

b) If you play commodities, play agri-commodities – the switch from food to fuel is unlikely reverse in a hurry and will help maintain an upward bias on prices.
Soybean, Corn, and Wheat futures have gained around 25 percent from the time I posted the message two months back.

c) If you are currency trader, short the dollar and the pound and go long on the Chinese Yuan. The Chinese government is not answerable to its people and will not mind paying the cost of holding a huge forex reserve (the reserve is already worth about $1.6 trillion – over 50% of its GDP). The government is in NO mood to let the currency seek its natural level and China's trade surplus is not going to disappear in a hurry
Dollar is at an all time low versus a basket of currencies and the Yuan has gained further ground against the dollar. A short position on the dollar and long position on the yuan would have given handsome rewards.

Bangalore - the new home to IBM's Chief HR Officer ??

The Economist carries an interesting article:
Hungry Tiger, Dancing Elephant - How India is changing IBM's world

The article analyzes how IBM is changing its business strategy to take advantage of the talent-pool available in India. India is fast becoming the country that houses the maximum number of IBM employees. IBM's business in India is growing @ 40% to 50%. IBM has realized that to compete with top-tier Indian companies it needs to leverage the global service delivery model (pioneered by Tata Consultancy Services - India's largest IT services company) - the model comprising of onsite, offshore and nearshore business development centres.

People who have worked at some point in time in the Indian software industry would know that TCS has a much better and robust business model when compared to the other top-tier companies. Its clientile, focus on innovation and creation of knowledge assets, best-in-class processes, and a deep talent pool have placed it in a strong position to leverage the opportunites that globalization creates, without eroding its short-term competitiveness.

IBM's chief procurement officer John Paterson moved office to China. (Read http://av.blogspot.com/2007/04/offshoring-corner-office.html)

I would not be surprised if within the next couple of years, IBM's Chief HR Officer moves office to Bangalore...

Offshoring the Corner Office ???

The link below leads you to an excellent article. It explains how Globalization is creating a shift in the country from which senior management operates

http://www.cfo.com/article.cfm/8834573?f=related

Though the article discusses the phenomenon of senior management team operating in different locations to capitalize on business opportunites, the idea of moving decision making jobs to low-cost locations is increasingly debated in mainstream media.

George David, Chairman of United Technologies, a Fortune 50 company, had earned $88 million in compensation in 2005. He had jokingly suggested outsourcing his own job to India.

The advent of KPO as a business model has increasingly made analytics based decision making "outsourceable". Technology has reduced distance. Travel has become faster and easier.

In such a scenario, it may not be long before boards demand outsourcing management jobs to the country with a vast pool of high quality managers - India.