China’s Logical Reaction to the Global Currency War


What is it with Australian institutions right now? First, the cricket team gets humbled in India by an innings and 135 runs. Next, while the Dow Jones celebrates a new all-time high, the All Ordinaries lingers nearly 25% below its October 2007 high of 6760. What will it take for Australia to catch up?

In cricket, the answer is elusive. Australia became the first Test team to declare in the first innings and lose by an innings. That’s a statistical and historical novelty. But in the share market, it really comes down to just two sectors: the banks and the miners.

We’ll leave the banks aside because, frankly, their recent death-defying run only makes sense when you realise they are the objects of global yield hunters. Even so, it’s hard to imagine the banks rallying enough from here to pull the whole index to a new all-time high. If that DOES happen, by the way, it will be the last big rally before the mother of all bear markets.

That leaves us with the miners. And today, in the spirit of Sherlock Holmes, we will speculate on how it might be possible for the resource boom to re-ignite and take the stock market on another wild ride. Granted, yesterday’s evidence from the Australian Bureau of Statistics that the terms of trade fell 2.7% in the fourth quarter – despite higher iron ore prices – suggest that the resource boom is already…less boomy.

Also, GDP growth of 0.6% for the quarter and 0.1% decline in net national income confirm what we already know: the resource boom is generating less ‘profit’ and national income for Australia. The government knows this now. It’s already blaming lower commodity prices for what are sure to be larger annual deficits. It hasn’t mentioned new spending, which probably has something to do with the deficits as well.

But let’s focus on the economic, not the political. How do we turn this boom around and get it going in the up direction? Well, you have to know your limitations. And it’s not within Australia’s power to single-handedly turn things around with the right policy. For that, we’re going to need China’s economy.

And perhaps the central planners of China, like their spiritual brethren around the world, simply can’t resist the call of more spending and even bigger, grander plans. ‘We are in the process of rapid urbanisation,’ National Development and Reform Commission (NDRC) chairman Zhang Ping told a press conference in Beijing yesterday. ‘Urbanisation is the biggest potential force driving China’s domestic demand in the years ahead.’

Zhang is not telling the world anything it didn’t already know. China’s great internal migration, from the farm to the factory, is the single biggest factor in Australia’s commodity boom. When China builds, it shops for raw materials in Australia first. This was the story we all counted on until 2007.

Consumption makes up just 35% of China’s GDP. Real estate makes up about 25%, by the way, according to the official statistics. China hopes that its migration and urbanisation will lead not only to more consumer spending as a percentage of GDP, but also more immediate investment that will stimulate growth. ‘It is estimated that this mass migration will require US$6.4 trillion worth of investment,’ according to Angus Grigg in today’s Australian Financial Review.

We don’t know where that $6.4 trillion estimate came from, but it’s a lot of money either way. And in the age of the printing press, where central banks are willing to buy any debt the government issues, money is no object. Well, literally, it might be paper. But objectively, it’s just digits on a spread sheet.

The point is, the NDRC is China’s leading long-term central planner. If its chairman is calling for trillions in investment to boost China’s on-going urbanisation, then we have a leading suspect for the cause of a bull market that could take Aussie resource stocks higher. And if we follow the thread, a money-printing binge the world will never forget may indeed be China’s logical reaction to the global currency war.

Follow closely: the Bernanke Fed devalues the dollar by lowering short-term official US interest rates. It says its goal is to save the housing market, boost stocks, and lower unemployment. But the net effect also weakens the US dollar against its major reserve currency competitors like the Yen and the Euro. US stocks (the Dow) make an all-time high as investors shift out of fixed income.

In response, Japan elects a new Prime Minister who then nominates an extremely dovish central bank governor. Their mutual goal: weaken the Yen, to boost Japan’s export competitiveness. Do so by any means necessary.

Both currency strategies (the US and the Japanese) are manipulative in every sense of the word. And they are driven purely out of national interest, as they should be. They make a weak currency someone else’s problem. That someone else is now China.

China doesn’t want a currency war with Japan and has now said so. ‘Treating the neighbours as your garbage bin and starting a currency war would not only be dangerous for others but eventually be bad for yourself,’ said Gao Xiqing in an interview with the Wall Street Journal on Wednesday. ‘I would hope that it doesn’t do that as a responsible government.’

Gao is the head of China Investment Corp. That’s the centrally planned sovereign wealth fund, responsible for making investments abroad. Gao was referring to the possibility that China might become a dumping ground for cheap Japanese goods because of Yen devaluation. This, of course, is what currency wars are all about, and it’s why this type of growth is often referred to as ‘beggar thy neighbour’ growth.

China may not want a currency war with Japan. But it may have one anyway. And in the same article, Chen Yulu, an advisor to the People’s Bank of China, admitted this. ‘The currency war situation is quite severe,’ Chen said. ‘China is definitely a victim.’

Uh oh.

What are China’s options? Well, geopolitically, it can exert economic pressure on Japan by exerting military pressure in the East China Sea. This steady pressure on Japan is really economic warfare by other means – a gentle reminder that the context for every economic argument is military force. But let’s leave armed conflict out of the equation for now.

China cannot invest more in factories to win a currency war. NDRC Chairman Zhang points out that China already has over-capacity in its steel, aluminium, cement, and coking coal industries. He says those sectors are running at just 70% of capacity. ‘In a normal market these usage rates should be 80 to 85 per cent…These industries are having huge difficulties.’

CIC has a problem too. It has $500 billion to invest. And it’s probably a bit wary. It bought stakes in Morgan Stanley and Blackstone Group in 2007, during the height of the financial crisis, and got burned. Where will it look next?

Well if CIC follows the lead of the China National Petroleum Corporation, China’s largest oil company, it may look to shale gas assets abroad. Bloomberg reports that China National Petroleum is set to spend $40 billion in cash on US and Chinese shale gas companies. This follows a $1.02 billion investment by China Petrochemical Corporation in one of the Oklahoma fields belonging to Chesapeake Energy Corporation.

Whether China will be able to actually make larger shale gas investments in the US is another question. Energy is increasingly deemed a ‘strategic asset’. National governments have been wary to sell off prized energy resources to countries they consider strategic rivals. Which of course, opens up doorways for other nations… such as… Australia.

Dan Denning
for The Daily Reckoning Australia

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Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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3 years 7 months ago
A good, backgrounding article that pulls up short of making any predictions but in this environment, I don’t blame Mr. Denning. I’m trying to prognosticate the future myself as I sit in one of the biggest bubbles I’ve ever seen (Perth) after 15 years in Japan watching endless, remorseless decline. With rental prices rising monthly and pub lunches costing $35, my eyes grow like saucers in wonder at where this will end. Anyone who says the CPI is 4% is a liar. And unemployment here is rocketing up. Tens of thousands are ineligible for dole so they don’t show up.… Read more »
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