``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’ 2nd 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
