Contrary to our prediction, shares of the Commonwealth Bank fell yesterday. A $2 billion profit was not enough to please everyone. But mostly it was the bank’s $1.20 dividend that appeared to disappoint the crowd, even though it was a six percent increase.
Outside Australia, all eyes are on Greece. According to Bloomberg, Germany and France want the Greek government to make concrete budget cuts before organising a bailout. Of course it’s not just the Greeks that have a lot to lose if a deal isn’t found. A lot of bondholders (banks) will lose too.
But the biggest loser of all is Europe’s common currency itself. Monetary union in Europe was always an experiment. It got rid of all the old colourful paper currencies in Europe and replaced them with impressive looking new paper notes. It also made the euro a reserve currency to rival the dollar.
It now looks, though, like Europe’s experiment with paper money may go up flames even faster than the U.S. dollar, which is an impressive achievement. Twelve economies, one interest rate policy, high government deficits as a matter of course….it’s a mess. It makes high-yielding commodity currencies like the Aussie dollar and the Canadian loony look downright sexy.
One perverse irony of the Euros woes is that it might be good for the U.S. dollar. Still, the bond markets are telling us that the world is fed up (or over-fed) with U.S. debts. Dow Jones newswires reports that an auction of $25 billion in 10-year U.S. notes “did not go particularly well.” It doesn’t bode “particularly well” for an auction of $16 billion in thirty year bonds set for later this week.
Even though the 10-year auction was over-subscribed, this kind of action suggests higher yields (borrowing costs) ahead. That’s an ominous sign if you have or plan to have large structural deficits. It’s also a bad sign given that the Fed hasn’t even begun its “exit strategy” from the bond markets. It’s still supporting prices and suppressing yields.
If the mere indication that it’s going to exit the market lessens demand for Treasuries, what will it’s actual exit do? Come to think of it, what will happen when the Fed stops buying and the Chinese start selling? We reckon the Fed will have to a quick about face. More on that in second.
Further to yesterday’s point about debt as a very bad habit, check out the chart below. It shows the large spike in gross and net interest paid to Australia’s overseas creditors. By today’s standards, paying out $30 billion in interest to your creditors (half of whom are in the U.S. and the U.K)seems like a fairly small price to pay for such an extravagant increase in house prices across the nation.
Just one small point, though. According the date, 37% of Australia’s debt is denominated in Aussie dollars and 39% of it matures in 90 days or less. This makes the debt sensitive to exchange rates and extremely interest rate sensitive too. A spike in rates and/or a fall in the Aussie dollar makes paying back and servicing the debt much more expensive.
Perhaps this is one reason CBA is keeping more of its cash.
In any event, the net interest on the debt doesn’t look back-breaking at these levels. But if the debt continues to accumulate or interest rates rise, it does start to get heavier. And at bottom is a simple financial point: interest paid on your borrowings doesn’t increase your capital. It’s just money sucked into a giant black hole.
You had better hope the capital goods or investments you made with your money compensate you for the cost of servicing your debts. In Australia’s case, that means the country needs higher and higher house prices. By the way, the ABS reported yesterday that housing finance approvals fell by 5.5%. The question is begged: when housing finance slows down, will housing prices follow?
Yesterday we claimed that borrowing your way to national prosperity is a sure-fire way to servitude and political instability. Today, we aim to prove it. To do so, we cite this article from Reuters. It suggests that China is using or should use its large holdings of U.S. Treasury bonds as a cudgel with which to bludgeon the United States its strategic adversary/ indispensable economic partner.
Figures in the People’s Liberation Army want the financiers to sell U.S. bonds as a way of punishing Washington for selling arms to Taiwan. Mind you this might not seem like such a good idea if the bond selling triggers a run on the dollar and swift devaluation in China’s forex reserves. But maybe China’s arsenal of U.S. bonds is a like a pile of bullets – they’re no good unless you fire them.
Of course what we’re suggesting is that China accumulated U.S. debt as both a by-product and a weapon. The huge stock of U.S. government securities was by product of China’s trade strategy. That strategy was to keep its currency low and gain global manufacturing market share through low labour and production costs. The result was a blizzard of U.S. dollar trade surpluses that were reinvested into U.S. bonds.
You could say it’s China that’s paid for the wars in Afghanistan and Iraq.
But why is this bundle of bonds now a weapon? We think China’s export-driven growth strategy is on its last legs. Labour unions in Europe and America given today’s political climate and high unemployment – will have the ear of politicians. And they will be saying something like this, “Make the Chinese pay!”
What they’ll mean is that China will be pressured to give up its main economic weapon – currency manipulation. This has kept Chinese exports cheap all over the world and led to the gutting of American manufacturing jobs. It’s made it pretty tough on exporters in Europe too. As a result of China’s dollar peg, European exporters suffered doubly from a weaker U.S. dollar. American goods were cheaper in Europe. But European goods were not cheaper in China.
So the unions and the politicians will probably not tolerate another leg of the global recession in which China gains more market share by keeping the currency peg and exporting its way to more growth (if growth is to be had). It brings us to the end-game of China’s export-driven development.
It also brings us back to one of the great monetary questions of the day: when will China de-peg? The answer has always been simple: when it is in China’s interests to do. To us, that means China will de-peg when the benefits of increased purchasing power in the currency are more important that dwindling export profits.
In other words, we think China is close to a new phase of growth that’s driven by consumer demand, domestic consumption, and more mature Chinese capital markets open to foreign investment. A de-pegging of the currency would see a much stronger Yuan. This would give Chinese savers a lot of spending power on global markets. They would also be able to buy more Chinese goods, which might lead to higher wages in China too (and more stoking of consumer demand).
This is all a theory, of course. And we could be way wrong. But there will come a day when Chinese customers are worth more to Chinese producers than American customers. De-pegging the currency will bring that day forward. And it could be sooner than you think.
This means that the accumulation of forex reserves was never really meant to protect China from external trade shocks, although they would be handy in that event. It means they were a side effect of a trade strategy whose ultimate objective was to gain as much global manufacturing market share as possible.
Now, you might wonder why China would damage its own interests by “punishing” the United States and selling bonds. But it depends on what China’s interests are. If China’s interests are in fundamentally weakening an economic competitor and strategic adversary, then selling U.S. bonds is in China’s interests.
China’s ultimate interests are in regaining Taiwan. And we’d suggest it try and use its bond leverage to weaken U.S. resolve about defending Taiwan. And selling U.S. bonds or crashing the dollar wouldn’t just weaken U.S. resolve. It would expose the loss of strategic influence that occurs when you are a chronic debtor nation.
Mind you the U.S. still has a lot of aircraft carriers, strategic bombers, and nuclear weapons. It’s not like its bereft of tools of persuasion. But the basis of all those tools has always been a strong economy, a strong industrial base, and sound finances.
The question now is, if the base of military strength has been eroded, how long will the U.S. maintain its military advantage? Can America afford it? And when push comes to shove, will American voters demand that an American President defend Taiwan? Hmmn.
for The Daily Reckoning Australia