Why China’s Currency Regime Shift Is Bullish For The Peso

``In essence, China is saying it thinks its currency will do a better job than the US dollar of retaining its value over time. Put another way, China is committed to having lower inflation than the US and China seems willing to deal with the natural consequences of that strategy, which is a currency that gains value. Previously, China was hesitant to allow its currency to gain value versus the dollar. From the early 1990s until mid-2005, despite a combination of rising trade surpluses with the US and growing attractiveness for global capital investors, the yuan-dollar exchange rate was fixed by the Bank of China. In other words, China was willing to import US monetary policy.” Brian S. Wesbury - Chief Economist and Robert Stein, CFA - Senior Economist, China Rising

The gap in the performances of the equity markets between ASEAN and western economies has apparently been widening (see figure 1).

Figure 1 Bloomberg: Signs of ASEAN-US Decoupling?

AS the US markets fumbled (signified by the S&P 500 in green, which was down by 3.65%) this week, ASEAN markets has remained surprisingly resilient, as shown by the Philippine Phisix (orange), Thailand’s SET (red) and Indonesia (yellow). The signs above possibly points to “decoupling”.

Since charting in Bloomberg allows for only four variables, other countries as Malaysia and South Korea had been excluded. Nevertheless, these bourses likewise registered modest gains for the week.

But such buoyancy has not been reflected on the regional currencies. Contrary to my expectations, Asian currencies lost material grounds this week, with the Philippine Peso suffering from the largest decline--down 1.2% to 46.45 against the US dollar. The asymmetric price developments in the marketplace seem to exhibit short term volatility or more “noise” than “signals” from the general trend.

In short, falling Asian currencies and strong stock markets appear in conflict with each other, where one of the two markets will likely be proven wrong.

ASEAN Divergence: Signal Or Noise?

Yet such dissonance is hard to relate to the performance of the euro. The euro declined marginally (-.16%) this week to 1.2371 vis-a-vis a US dollar. This comes in spite of the record surge in the CDS spread of Greece[1], where in the past, an upsurge in default risk translated to an accompanying collapse of the Euro, this time around the Euro appears to be holding ground (see figure 2).

Figure 2: stockcharts.com: Consolidating Euro And Resurgent Commodities

And another part of the picture of mixed actions has also been the advances in the commodity markets particularly, gold, copper and oil.

Seen from a conventional “demand” perspective, rising commodities should exhibit improvements in the global economy. But again, this would be inconsistent with the infirmities manifested by the sagging developed economy equity markets.

Of course, the alternative perspective is the monetary aspect, where rising commodities and weakening major equity benchmark could be exhibiting symptoms of stagflation. Though this would seem consistent with the strength in ASEAN, once known as major commodity producers, this hasn’t been the case today given transformation of the global trade configuration into a supply chain platform (figure 3).

Figure 3: Economist Intelligence Unit[2]: ASEAN Exports

Nevertheless, the significant share of high value (technology based) exports makes ASEAN nations susceptible to the vicissitudes of the global economy. Thus, ASEAN won’t be immune to a recession in the developed world.

Meanwhile, the unexpected picture is that the Philippines had been ranked first among high value exporters. But according to the EIU, what you see isn’t what you get and that’s because internal developments has skewed trade statistics.

Anyway the EIU clarifies, ``In our “high-value exports indicator”, the Philippines ranks first, with about 77% of its total exports made up of high-value goods. This places it well ahead of other individual ASEAN countries, as well as China and India. On the surface, this result might seem surprising, given that the Philippines is by no means a technology leader. However, one explanation for this ranking mined or exported. The industry desperately needs foreign capital and technology, but government policy for many years has kept out foreign investors. As a result, low-value exports from the Philippines have been depressed. It was only in December 2004 that the Supreme Court ruled that foreigners could again get involved in the mining sector. As the consequences of that ruling start to filter through, and as low-value exports pick up, so the Philippines may well slip down the high-value exports ranking.” (emphasis added)

From the above we learn that statistics are not reliable indicators of actual events because many factors influence an outcome, and second, the Philippines made it to the top of the list because the government has suppressed trade activities which pumped up the share of high value exports.

Alternatively, while the increased participation of the low value share is likely to erode the Philippines’ standings as measured by the above statistics, more trade should equate to more output and economic benefit.

Bottom line: Strong performances of ASEAN stocks and commodities defy the bearish outlook suggesting of a double dip recession in the world economy.

The Yuan Factor In The ASEAN’s Divergence

This brings us to the next factor which is likely to influence the ASEAN trade and market dynamics.

It’s the Chinese Yuan.

China’s government has announced last weekend that the Yuan will return to a managed float from the de facto US dollar peg[3].

In 2005, China went into a managed float but the recent financial crisis had forced China to re-peg the Yuan back to the US dollar[4] as a defensive move.

While a parcel of China’s action may have been in response to ease global political pressures aimed at pressuring the Yuan to revalue out of the perceived “overvaluation” and to “rebalance” the global economy, the geopolitical aspect seems to overstate the case. Instead, for me, China’s response has been due to its serial failure to combat internal inflation which continually flies in the face of government’s tightening policies.

As we wrote in March of this year[5],

``China has attempted several times since last late year to arm twist several industries to stem credit expansion which has led to inflation. Lately she has threatened to nullify loans granted to local governments and has similarly instructed 78 state owned enterprises (SOE) to quit the real estate market leaving 16 SOE property developers.

``And economic overheating presents as a real risk. There has been an acute shortage of labor where factory wages haverisen by as much 20% as the inland now competes with the coastal areas and reduced migration in search of jobs.

``We are now witnessing a classic adjustment in trade balances as taught in classical economics. As Adam Smith once wrote, ``When the quantity of gold and silver imported into any country exceeds the effectual demand, no vigilance of government can prevent their exportation.” (emphasis added)

``In short, this leaves the Chinese government little or no option but to allow its currency to rise as a safety valve against a runaway inflation.”

And faced with the predicament of recession risks from further credit rollbacks and the intensifying inflation, China has indeed resorted to the currency safety valve.

A stronger yuan allows relatively cheaper imports, which many in the mainstream mistakenly thinks that this will translate to economic “rebalancing”.

Yet in a world of paper money system, the international currency reserve, which essentially expedites the global trading activities, has NO automatic mechanism for adjustments. This implies that aside from adjustments mostly due to political preferences, the higher costs from the attendant currency adjustments simply mean that investments get shifted to the trading partners (see figure 4).

Figure 4: IMF[6]: Savings-Investment, WEF[7]: ASEAN Exports By Destination/

Alternatively, this means that “rebalancing” concept is an illusion, which fundamentally disregards the function of money as a medium of exchange and where an international currency reserve is the politically preferred “medium of exchange.”

The upshot to this is that a firmer yuan would induce the growing number of wealthy Chinese to buy more stuff abroad [provided the government allows for this]. And this should extrapolate to a boon to the major trading partners.

Considering that the share of the China-ASEAN trade has been ballooning (lower window of the ASEAN Export Destinations) at the expense of Japan and the US, the underinvestment seen in Emerging Asia (upper window) exhibited by yawning gap between savings and investment is likely to see significant improvements as a consequence to both a rising yuan and the deepening of intra-region trade. [Note: the Asian Crisis was clearly a result of malinvestments as shown by investments overtaking savings, which obviously was funded by inflated money from domestic and foreign sources.]

Of course, currency valuation is just one of the many factors that influence trading dynamics, yet one of the most important forces is the political desire to accommodate free trade.

Apparently, the process to integrate economically by regionalization has already been set into motion by the China-ASEAN Free Trade Agreement (FTA)[8] in late 2009 and secondarily, by China’s attempt to introduce the yuan as the region’s reserve currency[9].

The negative facet is that the use of the currency valve triggers more political rather than consumer based distribution which leads to accretion of internal imbalances and an eventual bust.

We are reminded that China’s 9.8% appreciation in 2005 did little to make any dent in the so-called “rebalancing” of trade and that the revaluation of the Japanese Yen through the Plaza Accord[10] in 1985 (15 years ago), had also little impact on Japan’s trade surpluses (Japan remains mostly in the trade surplus position).

Instead, the corollary of the Plaza Accord was that it fueled a massive real estate bubble in Japan which culminated with a colossal bust that lasted for more than ten years, popularly known as the Lost Decade[11].

However, if China is indeed truly determined to make the avowed currency regime shift, then one can’t help but put into picture how the Philippine Peso has responded to China’s revaluation via the shift to a managed float in July of 2005 (see figure 5).

Figure 5: yahoo finance[12]: USD-China Yuan (top), USD-Philippine Peso (down)

The Peso has strengthened in near conjunction with China’s yuan!

Although China ranks fourth among the largest trading partner for the Philippines, in terms of exports, and ranks third in terms of imports in 2009[13], China projects that the recent FTA will pole-vault China’s position as the Philippines’ 2^nd largest trade partner[14].

Thus, China’s ascendant “free trade” dynamics combined with the Yuan’s appreciation should lead to a shift in the current trading framework which will likewise be reflected on her trading partners as the Philippines.

Of course, the growing role of China’s trade relations will also redound to the political spectrum. So we should expect to see more of Chinese representation in local politics overtime.

And we should expect all these to be eventually reflected on the region’s financial markets. (see figure 6)

Figure 6: US Global Funds: Indonesia As Prime Beneficiary

The last time the Yuan was revalued in 2005, Indonesia massively outperformed.

However, as noted above, almost every Asian currency profited from this, including the Peso.

According to US Global Funds[15], ``Indonesia remains one of the major beneficiaries of an appreciating Chinese currency, thanks to the commodity-heavy nature of its exports to China. Coal and palm oil are key categories. During the three years from mid-2005 to mid-2008, when the yuan was unpegged from the U.S. dollar and saw appreciation, Indonesian equities more than doubled in U.S. dollar terms, making them the second-best performer in Asia after Chinese equities. In addition, the government’s improving fiscal status highlights a prudent Indonesia where public sector debt declined to 31 percent of GDP in 2009 from 102 percent in 1999, a confidence booster in a world of apprehensions over sovereign indebtedness.”

Today, Indonesia is once again at the top in terms of equity performance on a year to date basis.

Ingredients Of A Bubble: Pegged Currency And Lack Of Convertibility

None the less, this isn’t 2005.

Then, the US dollar weakened as global growth surged behind the US centric housing mortgage bubble. This means the Yuan appreciated on the back of weak dollar.

Today, the US dollar has emerged as safehaven from ongoing credit prompted woes in Europe, hence, the Yuan’s appreciation arises out of the US dollar strength. Besides, in contrast to 2005 where global economy was running on full throttle based on a US bubble, today, emerging markets and Asia has reportedly done most of the weightlifting of the global economy out of the recession[16].

In my view, the attendant underperformance of developed economies is likely to attract even more of hot money flows into China, Asia and the Emerging Markets.

In addition, the gradual appreciation of the yuan amidst the lack of convertibility is likely to prompt for more the same bubble predicament.

The problem isn’t China’s alleged “currency manipulation”, instead it is the lack of convertibility or the freedom to convert local currency to foreign currency and vice versa. The lack of convertibility means that the pricing mechanism via concurrent exchange rate or monetary policies (e.g. monetary base) has been severely distorted from which creates arbitrage opportunities. Speculative money sees this and gets “smuggled in” through unofficial channels, which causes “huge surpluses”. Naturally, such policy contortions lead to malinvestments throughout the country’s economic structure.

In addition, having both the exchange rate and monetary targets, likewise create mismatches from which imbalances will ultimately be expressed via a crisis. This characterises the pegged currency regime. Contrary to public wisdom, a pegged currency and fixed currency framework are different.

A fixed currency, according to economist Steve Hanke[17] is either established by a currency board which “sets the exchange rate, but has no monetary policy — the money supply is on autopilot — or a country is "dollarized" and uses a foreign currency as its own. Under a fixed-rate regime, a country's monetary base is determined by the balance of payments, moving in a one-to-one correspondence with changes in its foreign reserves.”

An example of the symptoms from imbalances of a pegged currency is China’s battle to control inflation and the subsequent reaction to appreciate the yuan following the failed attempts to arrest inflation.

Hence the lack of convertibility and the ramifications from conflicting goals of a pegged currency framework are likewise recipes to bubbles.

And one way to alleviate this dilemma is to engage in free market mechanism and to eliminate controls again, Mr. Hanke, ``Beijing should adopt a fixed exchange rate regime. This would force Beijing to dump exchange controls and make the yuan fully convertible. Such a "Big Bang" would muzzle the China-bashers and put Beijing in the driver's seat. After all, China would then have a stable, freemarket exchange-rate regime.”

Considering the earlier or previous bubble policies, this is not going to be a painless solution.

But the point is, free markets operating under a under currency regime with free market mechanisms and without exchange controls will reduce, if not eliminate, incidences of bubbles.

But this isn’t likely to happen under a central banking system.

Therefore, China’s regime shift isn’t likely to do away with the formative bubble in process.

Conclusion

To conclude, China’s purported regime change is likely to result in an appreciation of Asian currencies, including the Philippine Peso.

This would be further amplified by the ongoing region’s trade integration. And the possible decoupling signs we seem to be witnessing today could likely be the evolving repercussions from China’s currency shift.

So unless we see further deterioration in the economic conditions of developed markets which would result to a liquidity squeeze, the effects of the China’s actions will likely be evinced positively in the region’s financial markets.

Therefore, like in our previous outlooks, the case of the China’s currency regime shift adds to why the Philippine Peso, Asian currencies and equity markets should a buy.

Nevertheless, China’s currency makeover doesn’t eliminate the ongoing bubble process.

Perhaps in the future we will deal with “buy what the Chinese buys, and sell what the Chinese sells” story.

---

[1] Businessweek, Greece Swaps Surge to Record, Signaling 68.5% Chance of Default, June 25 2010

[2] Economist Intelligence Unit ASEAN Exports Today, tomorrow and the high value challenge

[3] Wall Street Journal Blog, China Issues Statement on Yuan Exchange Rate Flexibility, June 19, 2010

[4] See Currency Values Hardly Impacts Merchandise Trade

[5] See Spurious Mercantilist Claims And Repercussions Of A Strong Chinese Yuan

[6] IMF, The Regional Economic Outlook, April 2010

[7] World Economic Forum, Enabling Trade in the Greater ASEAN Region

[8] See Asian Regional Integration Deepens With The Advent Of China ASEAN Free Trade Zone

[9] See The Nonsense About Current Account Imbalances And Super-Sovereign Reserve Currency

[10] Wikipedia.org, Plaza Accord

[11] Wikipedia.org, Lost Decade (Japan)

[12] Yahoo Finance, Currency Converter

[13] Economywatch.com, Philippines Trade, Exports and Imports

[14] Xinhuanet.com China to become 2nd largest trade partner of Philippines as recovery takes hold, December 30, 2009

[15] US Global Investors, Investor Alert, June 25, 2010

[16] See Another Reason Not To Bet On A 2010 'Double Dip Recession’

[17] Hanke, Steve H. The Dead Hand of Exchange Controls

The Model Curse Strikes Again!

The curse of Models have struck again! And apparently government based models has been alleged as a vital contributor to the massive oil spill in Gulf of Mexico in the US!

Here is the Wall Street Journal, (hat tip Russ Roberts)

``BP PLC and other big oil companies based their plans for responding to a big oil spill in the Gulf of Mexico on U.S. government projections that gave very low odds of oil hitting shore, even in the case of a spill much larger than the current one.

``The government models, which oil companies are required to use but have not been updated since 2004, assumed that most of the oil would rapidly evaporate or get broken up by waves or weather. In the weeks since the Deepwater Horizon caught fire and sank, real life has proven these models, prepared by the Interior Department's Mineral Management Service, wrong... (emphasis added)

As Friedrich Hayek once wrote, "The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design."

How true.

Malicious Propaganda- "Shocking News From The World BANK"

Many Filipinos simply adore political rubbish.

Since this is the 3rd time that I received this silly propaganda called the "Shocking News From The World BANK - MUST read by all Filipinos" might as well expose it for its fraud.

Yes, google search reveals of 7,900+ related post, which means many have thought this as pertinent to unfortunately publish it (how nonsense can be so pervasive).

The message goes:

The Financial Analyst of World Bank would like to inform each and everyone of you that the present currency exchange rate of US Dollar to Peso is actually $1 = P52. Your government is manipulating the exchange rate for some years now. It is very much improbable and impossible that the Philippine Peso is appreciating compare to Euro, British Pound, Rials, and any other foreign currency. Even your ASEAN neighboring countries are suffering from the Global Crisis. Singapore , a developed country is affected by depreciation of their currency what more of your country?

We admire you for your hard work but we also pity you for having such a very corrupt government that is taking advantage of your hard earned money.

The ARROYO ADMINISTRATION is blatantly milking each and every OFW's all over the world of billions of pesos for its own greedy, selfish ends. Investigations reveal that this milked money from OFWs will be spent to BRIBE not only PGMA's pet CROCODILES in CONGRESS but some in the SENATE as well for her to PERPETUATE IN POWER BEYOND 2010. The rest would be deposited to the family's SECRET ACCOUNT in Switzerland .

Another money-making scheme is the LOTTERY DRAWS. Filipinos should be aware that all LOTTO DRAWS are orchestrated, and big money goes to the two sons of the lady president. Recent example is the SUPER LOTTO 6/49 draw, where supposedly two individuals from Luzon won. Do you know WHO these individuals are? It's Mikey and Datu, who else? One might ask how can the draw be rigged when it is being televised in front of millions of viewers. The answer is simple. As you all know, all bet combinations are being entered into PCSO's main data base as it is on-line, therefore, it is easy to determine which combinations were NOT betted upon. If they want to raise big money, no winners will be declared until the JACKPOT reaches sky-high because they could dictate the outcome at will. When it's "HARVEST TIME", viola, there would be "winner or winners" and the process repeats all over again. One might ask how this is being done. One insider told our investigators that actually the "DRAWN BALLS", six balls to be exact, are the only set which could fit into the transparent tube which sucks the balls up. All others are slightly bigger than the diameter of the tube which could not be distinguished by the viewers, therefore, there's no way they could be drawn! You Filipinos are being skinned alive, fried in your own fat and lard by your own government.

Outside the toxicity of personality based politics (or the vile focus on the past administration), the disinformation campaign represents a menagerie of fallacies.

We will just deal with the allegation of the Peso and Lotto.

1. like all markets, currency pricing is subject to demand and supply

2. all governments have been "intervening" in the currency markets (directly or indirectly-e.g. fiscal policies). Remember supply or currency issuance is monopolized by governments.

3. on intervention: currencies are being manipulated to "depreciate" and NOT to appreciate.

Around the world, mainstream thinking and politicians abhor 'strong' currencies. The main reasons are that weak currencies reflect on the continued financing of political activities, unsupported by the laws of economics (inflationism), by the political leaders.

Second, but of lesser importance is "export competitiveness"-the mistaken notion that the only way to grow an economy is by exports. We call this "mercantilism".

4. By appreciation, you'll have to unduly restrict supply of money in the markets. And this would create artificial mayhem or what is known as deflation (confiscatory deflation or government confiscating private property to collapse money supply). By doing so, such translates to a deliberate restriction in government expenditures, which ironically, would only cause an uproar among politicians and their cohorts.

Hence what is improbable and impossible is not for the Peso to appreciate, instead it is for politicians to refrain from inordinate spending!

5. Meanwhile, a currency is depreciated by means of printing money or increasing government financial liabilities relative to goods and services.

6. Peso appreciation is largely a global phenomenon-as the US dollar, the world's currency standard, is being debased- from quantitative easing, massive bailouts and deficit spending.

7. Since currencies are valued in pairs, or in terms of the other currencies, the strengthening of the Peso vis-a-vis the US dollar, suggest that the US government is manipulating their currency more than the Peso, by engaging in more printing money (inflationism).

8. For the paper money system, as history would show, is a race to oblivion. And we go by what I would call the Voltaire rule: Paper money eventually returns to its intrinsic value-ZERO.

9. Lotto has little (or insignificant) relevance to the strengthening of the Peso. Pagcor earns about $29 million a year a smidgen compared to the Philippine economy is $324 billion (PPP) or $160 billion (official exchange rate) according to the CIA.

From Pagcor's annual report

Therefore, Pagcor is a "state" business, whose income is derived from monopolistic revenues of gambling and gambling related activities less liabilities due to the winners (minus other related charges) --regardless of the personality/ies involved.

If there has been any shenanigans in the operations they are too minute to influence the Peso's activities.

10. Obviously, such unintelligent highly disoriented message isn't from a qualified financial analyst or importantly from the World Bank.

Beware of misleading mendacious politically colored missives like this.

Incredible Day In Sports

At Wimbledon. The longest (and the closest) ever 11 hour+ epic match in tennis (played in 2 days):

John Isner (USA, seeded 23rd) over Nicolas Mahut (France)

6-4, 3-6, 6-7 (7-9), 7-6 (7-3), 70-68

Incredible feat. See Here

Unintended Consequences Of America's Foreign Policy: Hydra Of Warlordism

Given the recent political controversy which resulted to the resignation of General Stanley A. McChrystal as commander of the US and coalition forces in Afghanistan, we came across an interesting insight which reveals of the unintended consequences from America's Afghan policy...the hydra of warlordism has been a product of American policies!!!

This from CATO's Malou Innocent. (Bold highlights mine)

The New York Times reports that congressional investigators have found mounting evidence that “American taxpayers have inadvertently created a network of warlords across Afghanistan who are making millions of dollars escorting NATO convoys and operating outside the control of either the Afghan government or the American and NATO militaries.”

The Financial Times broke this story back in March. But their most startling discovery was that after nearly a decade at war in Afghanistan, Washington still has no clue as to who its true enemies (and allies) are.

Many Americans would be surprised to learn that some prominent Afghan officials are in fact saboteurs of America’s presumptuous and dangerously quixotic nation-building endeavor, instituting policies that feed the insurgency’s momentum in order to get more economic assistance from the coalition. America’s Ambassador to Kabul, Karl W. Eikenberry, said as much last November. Eikenberry warned (of course, to no avail), that Afghan President Hamid Karzai, “continues to shun responsibility for any sovereign burden. . .He and much of his circle do not want the U.S. to leave and are only too happy to see us invest further.” [Emphasis added]

Karzai knows very well that once the conflict ends, his open aid spigot will dry up. Indeed, Karzai has become notorious for replacing and undercutting people in his government who become too well-liked and “clean,” fearing these officials will become more popular than himself. Such double-gaming leads us to Karzai’s younger half brother, Ahmed Wali Karzai.

I guess the US haven't learned from their regrettable experience with Osama Bin Ladin who allegedly had been an erstwhile ally of the CIA.

Maybe learning isn't the right word or phrase, maybe promoting vested interest is.

The huge amount earmarked for military expenditures seems like a compelling incentive for vested interest groups and the political bureaucracy to sustain such 'imperialist' policies in spite of the tremendous costs (needless deaths and corruption of society). As these signify political control over money and power.

Yet we are reminded of former US president Dwight Eisenhower's warning in his farewell speech, where he said,

"we must guard against the acquisition of unwarranted influence, whether sought or unsought, by the military-industrial complex. The potential for the disastrous rise of misplaced power exists and will persist. We must never let the weight of this combination endanger our liberties or democratic processes. We should take nothing for granted. Only an alert and knowledgeable citizenry can compel the proper meshing of the huge industrial and military machinery of defense with our peaceful methods and goals, so that security and liberty may prosper together."

Global Price Earnings Growth (PEG) Ratios

For enthusiasts of financial ratio fundamentals here is a nice table depicting on the country price earning growth ratios (PEG), courtesy of Bespoke Invest.

The methodology, according to Bespoke Invest,

"The PEG ratio is used for individual stocks as a valuation measure that factors in growth rates. It is calculated by dividing the company's P/E ratio by its growth rate. Many investors would rather own a company with a high P/E ratio and an even higher growth rate than a company with a low P/E ratio and an even lower growth rate. A PEG ratio of one or less is typically viewed positively.

"A few years ago, we decided to apply the PEG ratio to various countries by dividing estimated GDP growth into the P/E ratio of the country's main stock market index. Many developed countries have low P/E ratios, but they also have low GDP growth, while developing countries may have higher market valuations as well as stronger GDP growth. Investors may find PEG ratios more useful than simple P/E ratios when determining asset allocations for various countries.

And Bespoke's outlook,

``Russia and China have the lowest country PEG ratios at 1.86 and 1.90, respectively. Russia has a very low P/E at 8 and decent estimated GDP growth at 4.3%. China, on the other hand, has a rather high P/E ratio at 19.24, but its GDP growth is also very high at 10.10%. The US is right in the middle of the pack with a PEG of 5.07. Our neighbors to the south rank just above the US with a PEG of 3.85, while our neighbors to the north rank just below the US at 5.67.

``The US does have the best PEG ratio in the G-7, so US investors looking for developed country exposure might be better offer staying right at home. European countries have exceptionally high PEG ratios because of their mediocre valuations and low growth rates. Australia and Spain both have negative PEGs -- Australia because it has a negative P/E and Spain because it has negative GDP growth."

Here is Asia's country financial metrics equivalent based on the table from ADB's Capital Market Monitor.

The table was updated last April, however with little changes in the marketplace (this view is based on the Philippine setting) the estimates should be relevant.

And here is the expected annual economic growth for Asia, again based on ADB's estimates.

Applied to the Philippines, since the estimated GDP number is 4.6% for 2011, then at 14.7 PE ratio as of April, thus PEG is at 3.2.

Since PEG is a relative measure, this makes the Philippines 'pricier' relative to her Asian peers but more 'affordable' relative to developed economies. Therefore, cheap or expensive depends on which country is used as basis of comparison. In behavioral finance, this is called the "contrast principle".

Currency Values Hardly Impacts Merchandise Trade

In the eyes of the mainstream the only way to generate export growth is to devalue a currency or impose punitive tariffs on trade partners whom are deemed as 'currency manipulators'.

Yet, facts belie these misguided conventional beliefs.

Referring to the above charts, analyst Howard Simons argues, (bold highlights mine)

``First, three-quarters of the import weights and two-thirds of the export weights derive from five sources: China, Canada, Mexico, Japan, and the eurozone; the others will be aggregated for visual clarity. Let’s take a look at the imports first.

``The most prominent development over time has been the seizing of market share by China from Japan and Canada. Mexico’s share expanded after the passage of NAFTA, but it has stagnated in recent years as maquiladora plants have become uncompetitive with Asian exports. In economic terms, Mexico now is exporting labor, a factor in production, as it has lost a competitive advantage in the production itself.

``On the export side, China is displacing Japan as a customer of the US. Exports to both Mexico and Canada expanded after the passage of NAFTA, as have exports to “all-others;” this category includes important growing customers such as Brazil, India, the Middle East, and the Asian periphery.

``What is or should be striking in the pictures above are the rather constant weights for the eurozone. Given the euro’s prominence for financial flows and for traders, and given its outsized 57.6% weight in the dollar index, you might think all of the changes over the years in the rates between the dollar, the euro, and its predecessors would lead to substantial changes in trade weights.

``The US and the eurozone have structurally similar economies and factors of production. As a result, we trade in similar goods where differences in customer tastes and small quality differentials mean more than price. Moreover, much of the trade between the two zones is inter-subsidiary and represents a transfer."

True enough, (chart courtesy of netdania) despite the Euro's 5 year uptrend, this has hardly affected the trade weightings of the Eurozone vis-a-vis the US.

In addition, many other factors also seem to impact trade more than currency values, such as Free Trade Agreements, differentiation of goods, transfer pricing from inter-subsidiaries, and etc...

In other words, currency values hardly is the major factor that influences trade balances.

I'd like to interpose another perspective--how did the Euro become an export giant, in spite of the currency's elevated valuation levels?

Analyst Martin Spring enumerates the strength of Germany as the Eurozone's driver: (all bold emphasis mine)

-Germany is a hugely powerful exporting power, only recently overtaken by China, and still a far bigger exporter than the US or Japan. This year it is forecast to have a foreign trade surplus of $187 billion, not far behind China’s $219 billion.

-Despite some of the highest labour costs in the world, it has high productivity to match them.

-Due to the cohesion that comes from good employer-employee relationships, manufacturing industry has the flexibility to meet adverse circumstances. In the global recession it has kept growth in unemployment to just half a percentage point through measures such as pay cuts and state-subsidized short-time working.

-Instead of looking to currency depreciation to ease its problems, it survived the period of a strong euro by meeting competition head on. The OECD, in its latest economic survey, says the nation used the adversity to spur innovation, make allocation of resources more efficient, and invest strongly in advanced production techniques.

-Its companies have diversified internationally and outsourced to low-cost countries – about half the added value of exports is now produced abroad.

-Although Germany does, like so many countries, have a problem of high and growing public debt, it is at last addressing that problem decisively. Over the 2008-2012 period, despite the biggest stimulus programme in Europe, its debt is forecast to grow by only 17 percentage points, compared to 22 per cent in France, 33 per cent in Greece and the US, 34 per cent in the UK and 39 per cent in Japan.

-The Economist says Germany “no longer suffers from an arthritic labour market, an obese state or a suffocating tax burden.”

-At the core of the engineering sector that is the cornerstone of the nation’s industrial economy are thousands of dynamic Middelstand enterprises (small and midsized firms, often family-owned) that export almost 80 per cent of their production, selling not only highest-quality machines, but also the panoply of expert support services that go with them.

-Germany is a world leader in fields such as automotive technology and renewable energy. It can sell machinery in China at four times the cost of Chinese competitors’.

All these can be summed up into competition, division of labor, competitive advantage and high level of entrepreneurship. In short, Germany's export powerhouse came about from fundamentally embracing free market principles and not from devaluation and closed door isolationist policies.

This bring us to the surprise announcement by China to gradually allow her currency to rise. Will these alleviate the so called global imbalances?

In 2005 the yuan appreciated by 9.8%, yet there has hardly been any improvements in the trade balance (deficit) standing of the US vis-a-vis China, as shown in the above chart.

And the narrowing of the trade gap in 2008 can't be attributed to the rising Yuan, because the world suffered from convulsions of the 2008 financial crisis, which had been a far larger factor.

Besides, China then repegged her yuan to the US dollar at the onset of the crisis (also shown above-chart courtesy of Northern Trust).

So the answer is a NO--the appreciation of the yuan is unlikely to make a significant dent to the US deficits. Moreover, for as long as the US dollar is the de facto medium of account "currency standard" for global trade, the US is likely to maintain huge deficits.

However for China it could be a different story.

China's surpluses could narrow, not because of the appreciating yuan, but because of policies aimed at shifting internal dynamics.

According to Northern Trust's Paul Kasriel,

``Now, I do believe that the rate of increase in China's trade surplus will be slowing in the coming years, but not primarily because of an appreciating renminbi. But rather because rising incomes among Chinese households will lead to increased discretionary spending by them. Also, in order to keep the population relatively happy, Chinese politicians will re-allocate government spending more toward services and infrastructure spending to benefit households rather than export industries."

Bottom line: currency values signify only as one variable out of the many that influence trade activities. Therefore tunneling on the "currency" valve as means to rebalance trade by indirect (inflationism) or direct protectionism is not only fallacious and deceptive but also unwarranted.

Borrowing Howard Simons conclusion, ``the world’s protectionists are better at making noise than making sense".

Does Macro Economics Matter?

In an article, "What's the Point of Macro?" Societe Generale Dylan Grise remarked,

``So my advice to anyone about to embark upon Einhorn's path of using macro to "actively manage your long-short exposure." is to think long, hard and honestly about what your sphere of competence actually is." (thanks to my dear friend Mr. Laird Smith)

If importation of product X is my business, and suddenly our government prohibits the imports of this item and its related lines, then what's the effect to my business? Obviously I'd have to either shift to other products where imports are allowed or close shop! [yes my dad suffered from this predicament nearly 30 years ago]. In short, business conditions respond to macro policies.

Thus my corollary: The more the government intervenes in the marketplace, the more macro perspective becomes relevant, and vice versa, in determining the viability of investments.

Put differently, the usefulness of the macro perspective relative to risk-reward tradeoff depends on the expected level or degree of government interventionism or inflationism.

As a caveat, while macro does matter, we shouldn't ignore the micro developments. Importantly, we should NOT depend on mathematical formalism to make macro appraisals.

Thought Of The Day: The Keynesian Circular Thought Process

This quote from Professor William Anderson

"In the world of Keynesian economics, there really is no individual behavior that is purposeful. People don't "spend" because they believe that the purchase of a specific good or service will make them better off, but because they are "buying back the product" they have produced as workers.

"This is what one might call circular logic, and it reminds me of the imaginary exchange that Professor Israel Kirzner used to explain the circular flow of Keynesianism:

"FIRST PERSON to SECOND PERSON: Why do you eat breakfast?

"SECOND PERSON: So I can go to work.

"FIRST PERSON: Why do you go to work?

"SECOND PERSON: So I can eat breakfast.

The Road To Serfdom In North Korea

Max Borders at the Washington Examiner enumerates the "vital concepts" from Friedrich Hayek's legacy "The Road To Serfdom" which most recently hit the top spot in Amazon (due to Glenn Beck's promotion).

From Mr. Borders:

Spontaneous Order - Complex society and open markets cannot be planned. Period. Human beings just ain’t smart enough. Instead, the extended order emerges - unplanned and undesigned - due to humans interacting in complex ways according to simple rules. These rules do not specify certain social ends, but rather bring order to the diverse ends of billions of people pursuing happiness.

The Knowledge Problem - It is impossible for a single mind or group of minds to predict, plan or control the innumerable inputs, outputs and actions in a market. Instead, knowledge is dispersed among billions of people. Entrepreneurial opportunities are seized by individuals with particular, local insights, and/or expertise in some specific area the bureaucrate cannot possess.

Price System - Entrepreneurs also respond to information flows communicated through the price system. Bureaucratic control of an economy is impossible due to the loss of information communicated through prices, and due to the inability of one to gain the right kinds of information at the right times and right places. “Prices are signals, not marching orders.”

Competition as a Discovery Procedure - The circumstances of time and place are critical to the success of competitive market actors. The idea that we can aggregate economic data - like macroeconomic data - in order to say something meaningful about how things should to be coordinated is, well, a bad idea. Competition among market actors looking for opportunities to offer a previously unnoticed value to consumers is basically crowd-sourcing value creation. Innovators compete, you win."

And a fantastic example of how a society operates without or with little of these elements is North Korea.

This from the Washington Post, (all bold highlights mine)

Bowing to reality, the North Korean government has lifted all restrictions on private markets -- a last-resort option for a leadership desperate to prevent its people from starving.

In recent weeks, according to North Korea observers and defector groups with sources in the country, Kim Jong Il's government admitted its inability to solve the current food shortage and encouraged its people to rely on private markets for the purchase of goods. Though the policy reversal will not alter daily patterns -- North Koreans have depended on such markets for more than 15 years -- the latest order from Pyongyang abandons a key pillar of a central, planned economy.

With November's currency revaluation, Kim wiped out his citizens' personal savings and struck a blow against the private food distribution system sustaining his country. The latest policy switch, though, stands as an acknowledgment that the currency move was a failure and that only capitalist-style trading can prevent widespread famine.

"The North Korean government has tried all possible ways [for a planned economy] and failed, and it now has to resort to the last option," said Koh Yu-hwan, professor of North Korean studies at Dongguk University in Seoul. "There's been lots of back and forth in what the government has been willing to tolerate, and I cannot rule out the possibility of them trying to bring back restrictions on the markets. But it is hard for the government to reverse it now."

Because North Korea operates in secrecy and isolation, outside observers rely on informants and accounts from defectors. In this case, experts agree that the food shortage is dire. Several analysts who monitor and travel to North Korea said that in recent weeks, Pyongyang has abandoned almost all its rules about who can spend money and when. That would seem to indicate that Kim -- who once equated free-market trading with "egotism" and a collapse of social order -- now wants to rehabilitate the markets damaged in November...

``In the mid-1990s, amid a total collapse of the central planned economy, somewhere between 3 and 5 percent of the population -- perhaps 1 million people -- died of starvation. Meanwhile, North Koreans increasingly turned to small markets for trading and buying supplies."

Bottom line: The Road To Serfdom is about shortages, death and poverty. Even the North Korean leadership now recognizes that they can't subvert economic laws.

(hat tip Greg Ransom)

What Gold’s Latest Record Prices Mean

``The struggle against gold which is one of the main concerns of all contemporary governments must not be looked upon as an isolated phenomenon. It is but one item in the gigantic process of destruction which is the mark of our time. People fight the gold standard because they want to substitute national autarky for free trade, war for peace, totalitarian government omnipotence for liberty.” Ludwig von Mises

A major trait of bullmarket is, whatever assets we sell today will climb higher tomorrow. This implies that the most regrettable course of action in a bullmarket is to sell.

And one great example would be the gold market. Gold just set a new record in terms of nominal high (see figure 1).

Figure 1: Netdania.com[1]: Gold’s Stairway To Heaven

The monthly chart reveals that gold prices have been in a bullmarket since 2000. While true enough, there have long periods of consolidation, the general trend over the last decade has been up.

And importantly, contrary to those who allege that gold functions as safehaven during recessions or during the “deflation-symptom” crisis similar to the Bear Stearns-Lehman episode of 2008, evidence has shown otherwise—gold fell during the previous two recessions of 2001 and 2008 (see black channel lines)!

Alternatively, the most recent record run only implies that the fresh milestone high, established last week, DOES NOT presage of any forthcoming market crashes or “double dip” recessions. And if gold serves as a lead indicator as previously discussed[2], then the likelihood is to see reanimated activities in global risk markets.

At the start of the year, we were told that gold wouldn’t generate investor appetite as the menace of “deflation” continues to lurk around the corner. We even read predictions stating that gold would fall back to the $800 levels[3] way until last month[4].

However, as we have always been saying--in a world of central banking, deflation is no more than a bogeyman to rationalize more inflationism, which central bankers are likely to accommodate. After all, inflation is ALL about politics. And central bankers, in spite of their supposed “independent” role, have been the main conduits in financing government expenditures. Thus all talks of “independence” are mostly demagoguery. Fact is, global banking regulations, as the Basel Accords, have all been skewed to accommodate government expenditures[5].

Of course, one major bullish factor about gold is that mainstream STILL doesn’t get it; gold isn’t just an inflation hedge, nor is it about alternative assets[6]. It’s also been starkly misguided to impute ‘conventional’ financial valuation metrics to gold when this doesn’t apply. It’s even myopic to calculate or value gold prices premised on commodity usage. And it is also faulty to appraise gold based on global mining output. Since gold isn’t being consumed, incremental additions to the above ground supplies by existing mines hardly determine the pricing model (see previous discussion[7]).

In a decadent world of fiat money, where money printing to fulfil specific political agenda have been the most convenient route resorted to by political leaders everywhere-for the simple reason that the ignorant masses hardly understands how such surreptitious redistributive activities influences their lives- gold seems to be re-establishing its role as ‘money’.

Therefore, gold’s ascendant trend in ALL currencies have simply been manifestations that demand for gold has been transforming from mere “commodity” (jewelry and industrial usage) to “money”.

Gold is being held as reserve asset not just by the central bank, but importantly by the general public. Gold’s increased function as “reservation demand” is what usually the mainstream sees as “speculation” or “speculative hoarding” or “investment demand”.

Otherwise said, money’s “store of value” is increasingly being factored into gold prices (unit of account). Hence, relative to gold pricing, this implies that reservation dynamics or the reservation model (and not consumption model) determines gold valuations or that the exchange ratio or monetary valuations relative to fiat currency applies-- where valuations are determined by the expected changes in relationship between the relative quantity of, and the demand for, gold as money vis-a-vis paper currencies.

And possibly one day, such transformation would include the deepening of “exchange demand” or gold as ‘medium of exchange’ (see previous discussion[8]). Proof of this has been the emergence of Gold ATMs in Germany[9] and in Abu Dhabi[10].

All these, of course, are ultimately dependent on the stimulus-response and action-reaction of global political leaders on the swiftly evolving political, economic and financial sphere.

And thus, periods of weaknesses, whether from recessions or from consolidations (in technical or chart lingo the “energy fields”), has served as buying windows rather than selling opportunities.

Yet for those whom have remained sceptical and or earnestly drudge to market “timing” gold’s prices, they usually end up chasing gold prices higher-- buy high and sell low.

And this is especially brutal to those in constant denial of gold’s ascendancy; they have entirely missed out the rally for ideological reasons, and vent their frustrations by continually disparaging such developments. The odd thing is that this has already been a 10-year market process.

Yet since gold rise has been threefold, all errant attempts to “time” the market has resulted to lost or missed profit opportunities.

As the legendary trader Jesse Livermore expressed by Edwin Lefevre in the classic must read for any serious investors, “Reminiscences of a Stock Operator”,

``Disregarding the big swing and trying to jump in and out was fatal to me. Nobody can catch all the fluctuations. In a bull market your game is to buy and hold until you believe that the bull market is near its end. To do this you must study general conditions and not tips or special factors affecting individual stocks.[11]”

In short, the best returns emanate from long term investments.

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[1] Netdania.com, Forex charts

[2] See Why The Current Market Volatility Does Not Imply A Repeat Of 2008

[3] Yahoo. Finance, Gold Is "Fairly Expensive," Could Fall to $800 If Fed Moves, Midas Fund Manager Says, January 22, 2010

[4] CNN.Money, The coming gold bust

[5] See The Myth Of Risk Free Government Bonds

[6] Reuters.com, US gold sets record, ends strong as alternate asset

[7] See Gold As Our Seasonal Barometer

[8] See Financialization of Commodities: Boon Or Bane?

[9] See Creative Destruction: Electronic Payments Over Cash And Checks

[10] Financial Times Blog, Abu Dhabi’s gold ATM machine a sign of more opulence to come, May 13 2010

[11] Lefevre, Edwin, Reminiscences of a Stock Operator p.76 John Wiley and Sons