Systemic Risk Posed by Democrat-led Congress?

``The difference between death and taxes is death doesn't get worse every time Congress meets." – Will Rogers

The election, which was coincidentally timed with the latest trade data, where US trade deficits with China have reached uncharted record highs, according to the LA Times, ``The deficit with China set a record of $23 billion in September. It is running at an annual rate of $228 billion this year, on pace to surpass last year's $202 billion, which was the all-time high for any U.S. trading partner” appears to have provoked an immediate response from the Chinese government as the Democrats dislodged the Republicans in both houses of Congress, ``Zhou Xiaochuan, governor of the People's Bank of China, said at a conference in Frankfurt that China has very clear plans to diversify its reserves, which now stand at more than $1 trillion. A wide range of instruments are under consideration, Zhou added” notes Wanfeng Zhou reporter for CBS Marketwatch.

One must not forget that a (Schumer-Graham) Bill filed in the US Congress by New York Senator Charles Schumer, a Democrat, and South Carolina Republican Lindsey Graham intends to slap 27.5% tariffs on imports from China, if China remains recalcitrant to allow its currency [Yuan] to appreciate, where Treasury Secretary Henry Paulson persuaded the senators to delay the vote which had been initially scheduled last September 27.

In essence, the bill is nothing but a political blackmail aimed at a wrong but highly popular target. Why? ``While the US imports lots of Chinese goods, China is not our biggest supplier of foreign goods. China soared past Japan in exports to the US in 2002 and surpassed the Eurozone last year, but the US still imports twice as much from Canada and Mexico than from China (emphasis mine)” notes Dr. Yardeni. Yes, another case of barking at the wrong tree.

Figure 2 US Dollar Index: Making Another Downside Breakdown Attempt on Diversification Talks

Let us put things in proper perspective; the US Dollar has been on a downtrend since 2002. Over the interim, following its short-term rebound or since its mid-October high, the US Dollar index has been on a decline. It has however formed a bearish Head and Shoulder pattern. Note too, that Friday’s test to break the neckline coincided with the aftermath of China’s Diversification Talks.

This is one highly trenchant comment from currency analyst Jack Crooks, whom has largely towed the line of the US Dollar bulls until Friday (emphasis mine)...

``Before US Senator and leading US-China trade/currency critic Chuck Schumer even finished his joyous celebration of Democrat victory in the Senate yesterday, Chinese central bank governor Zhou Xiaochuan launched the first salvo it what could be the upcoming US-Chinese currency battle.

``Effectively the diversification comment made by Zhou, and the dollar and metals market reaction, shows that China has some heavy artillery that it’s not afraid to use should Mr. Schumer turn his threats into legislation now that he and his party are in a position to do so.

``This is scary stuff for the dollar, and all financial assets in general, if indeed a real battle were to break out between the US and Chinese over trade and yuan.”

As I have argued in many instances, it is inherent in most politicians and their ilk (globally) to act on palliatives or motion on the whims of the popular, without giving second thoughts on the possible unintended consequences of their actuations.

This bill is ominously reminiscent of the Smoot-Hawley Act in 1933 which according to wikepedia.org, ``raised U.S. tariffs on over 20,000 imported goods to record levels, and, in the opinion of many economists, protracted or even initiated the Great Depression. U.S. President Herbert Hoover signed the act into law on June 17, 1930.” To paraphrase Spanish philosopher George Santayana, those who do not remember the past are condemned to repeat it.

The same interventionist fiasco is currently being exhibited by the Canadian government on its declared war via increased taxation against Income trusts leading to massive losses or exodus of capital. As always, politicians presume to know better even when they stake the least.

In my opinion, the Chinese government would unlikely be bullied into submission from a myopic suicidal bill which could do more harm to the US and to the world economy more than uplift its domestic [US] welfare.

Figure 3: Yardeni.com: China’s Foreign Currency Reserves tops $1 trillion!

Further, with China’s forex reserves believed to have topped the US 1 Trillion mark, USD 987.9 billion in September and growing by about USD 20 billion per month see Figure 3 courtesy of yardeni.com, gives them incredible amount of ammunition against any legislated blackmail.

In addition, China holds an estimated USD 339 billion in US Treasuries, as of August according to CNN, the second largest following Japan’s estimated $640 billion, which is in itself an economic and financial equivalent of a “nuclear bomb” that could force US interest rates to soar and the US dollar to crater, if and when they decide to retaliate against any trade sanctions. And to consider the US economy is heavily levered on a mountain of debt, and rapidly rising rates could simply be catastrophic.

Since China’s yuan has been allowed to be revalued last July 21, 2005 it has climbed by about 5.2%, which has also spearheaded the appreciation of most of the currencies in the Asian region (including our peso).

My view is that China could persist on appreciating its currency by a measured pace which they would be comfortable with. And these actions may be “timed” as part of their “compromise” or diplomatic efforts to stave off any potential conflicts.

And with the equally “saturated levels” of foreign exchange reserves in Asia, the region’s central banks may be least motivated to intervene in the markets and be impelled to keep the pace of its respective domestic currencies’ appreciation at acceptable or modest levels in line with China.

However one must be reminded that any belligerent approach by the incoming leadership in dealing with the controversial trade or currency aspects essentially translates to systemic risks. This leads your analyst to even be more bullish on gold and on Asian currencies.