Distortions and Imbalances


–Yesterday’s Daily Reckoning left off with the claim that BHP’s strategy of growing earnings through its energy assets may not be enough. Enough what? Enough to make up for the loss of earnings from falling iron ore and coal prices when China’s property bubble deflates.

–Whether China has a property bubble and whether that bubble is about to deflate are matters of debate. But the People’s Bank of China (PBOC) is sure worried about inflation. The PBOC again raised reserve requirements at Chinese banks. The wrinkle this time is that margin deposits are included in its requirements. So what?

–This is the off-balance sheet or “shadow banking” problem we’ve referred to in the past. Beijing’s central planners are trying to stamp out off-balance-sheet lending and credit creation. They are trying with all their regulatory might to rein in house prices and cool consumer price inflation. Reserve requirements – the amount banks must hold back in its vaults as a percentage of deposits – are at 21.5% for China’s big banks.

–UBS economist, Tao Wang told the Financial Times that this latest move is, “A signal that the government intends to deal with the recent rapid growth in off-balance sheet activity, which has complicated and compromised the liquidity management of the central bank.” In other words, banks are finding a way around the rules restricting credit growth.

–We should back up from the details for a second and focus on the big picture. The big picture is that China has enjoyed a structural advantage over its economic competitors for the last 20 years. Several structural advantages, in fact. One advantage is lower labour costs. The other big advantage is its fixed currency regime – or ‘a managed floating regime’ as the Chinese have called it.

–The currency peg to the US dollar – currently around ¥6.38 for every one greenback – allows China to always keep its exports to America cheap, in dollar terms. The US dollar may fall against the AUD, since the Aussie floats freely. But the value of China’s currency is pegged to the dollar.

–The result of the currency peg is another structural problem for China. The problem is inflation. The currency peg boosts Chinese exports to America and generates a trade surplus. That trade surplus can be seen in the chart below. It shows annual figures in US dollars. In July alone, China ran a $26.7 billion trade surplus with America. China’s trade surplus for 2011 is on pace to set a new record.

China’s accumulating imbalances

China's accumulating imbalances

–This is where the uncontrollable trouble begins for the PBOC. A trade surplus generates a stream of dollars headed back to China. To prevent those dollars from creating massive inflation, the PBOC buys them up from Chinese. Those businesses, and Chinese investors, are forbidden to invest those US dollars overseas. They don’t mind selling. But to buy the incoming trade surplus dollars, the PBOC must create more of its local currency, renminbi.

–As you can imagine, the larger the trade surplus, the more renminbi the PBOC must create. This quite literally expands China’s money supply. That wasn’t a problem when China’s economy was growing double digits, year over year. The new money found its way into capital investment. It did not generate inflation. But it’s a problem now.

–In order to prevent newly created renminbi from expanding the money supply and causing inflation, the PBOC “sterilises” the money. It does this by issuing renminbi bonds, which banks must buy. The banks get the bonds. The PBOC removes the renminbi from circulation. Inflation problem solved.

–Only the problem isn’t solved. Chinese banks are finding ways to create credit outside official channels. Banks are loaning to local government financing vehicles (LGFVs) for elaborate and extravagant property development projects. Many of these projects will not generate sufficient cash flow to repay the loans, we reckon.

–So China has come to a structural crossroads. It’s accumulated massive foreign currency reserves via its trade policy, over US$3 trillion. It’s created more renminbi than it can effectively sterilise by issuing bonds. Asset price inflation is the result.

–We’ll leave off with the mechanics of the currency management and bring it back to the big picture. In the big picture, China is likely to manage its inflation problem by allowing its currency to appreciate. This is what would happen naturally if the PBOC didn’t intervene. This is what we’re discussing in the next issue of Australian Wealth Gameplan.

–In the meantime, it means that China may be at the tail-end of some of the big structural advantages it’s enjoyed over the last 20 years. The currency will rise relative to its global peers. The trade surpluses will fall. Wages will rise. All of which could challenge China’s manufacturing dominance globally.



–This would be good news for Australia. Australia is currently in the grip of the realisation that its manufacturing base could be annihilated by the course of globalisation, unless that course shifts. The charts below from the US Bureau of Labor Statistics show what happened to the structure of America’s labour force, especially since 1978 when Deng Xiaoping’s “Socialism with Chinese Characteristics” led to economic reform and double-digit GDP growth in China. More after the charts.

Demise of the maker jobs, total manufacturing employment

Demise of the maker jobs, total manufacturing employment

Source: BLS

Rise of the McJobs era, total services employment

Rise of the McJobs era, total services employment

Source: BLS

The permanently unemployed, 6.1 million jobless for more than 27 weeks

Rise of the McJobs era, total services employment

Source: BLS

–The three charts from the BLS show the decline in manufacturing jobs since 1978, the increase in service sector jobs, and the spike in the long-term unemployed in America as a result of the GFC. These three charts show the structural impact of China’s emergence on America, and, to some extent, on the whole industrialised Western world.

–Over five million manufacturing jobs have disappeared from America in the last 30 years. But over 30 million lower-wage service industry jobs have been handed out. GM fell. Wal-Mart rose. This fundamentally changed the character of the American economy, and probably of American society.

–The spike in unemployment during the GFC is a side-effect of this structural change in the economy. A service-based economy is a consumption-based economy. A consumption-based economy is a debt-based economy. When debt loads – government, household, and business – are unbearable, consumption falls. Unemployment rises as people spend less money.

–The solution, of course, is not to borrow more money and give it to people to spend. That is not real wealth creation. It is just money shuffling. The solution is creating wealth by producing things of value that people want to buy. This does not include CDOs, RMBS, and synthetic ETFs.

–Easier said than done, though. It’s hard to compete when there are two billion new people entering the global work force. This creates global wage deflation. Wage deflation coupled with declining GDP and Welfare State promises is a recipe for a structural crisis in Western economies. This is precisely what we have.

–In Australia, China, Europe, and America, structural tensions have reached the breaking point. What will break first? China’s currency peg? Europe’s monetary union? Or America’s distorted, consumption-based economy? The answers tomorrow!

Dan Denning
for The Daily Reckoning Australia

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.


  1. What happened off the record at the Jackson Hole meeting that has relaunched the AUD carry trade? Someone knows something, and whatever that something is, it as loose as …..

    Doesn’t the “recalcitrant” Mahatir look smarter with every passing day. What would have happened if China had let the currency peg go when they are so culturally affixed to household savings? Imperial USD led rapacious and plunderous “foreign investment” (hot money carry) led asset inflation that would have made the eyes bleed as it disemboweled the Chinese state.

  2. Hoenig interview with Liesman of CNBC via prudent bear worth a read ….


  3. What policies could the U.S. government adopt that would expand its manufacturing base? Is that even possible? The rapid diffusion of knowledge and innovations would seem to make appropriating them for national benefit very difficult especially in a “free trade” regime.

    Tom Shillock
    September 3, 2011
  4. I read that interview Ross since it’s always interesting to see the men of power have to say. Granted the Fed bankers are acutely aware of the power their words carry and it is always hard to know how seriously to take what they say. Though Hoenig sounds good at face value. And then this…..

    “Mr. Liesman: Presidential candidate Rick Perry used the word “treasonous” to talk about Chairman Ben Bernanke and additional quantitative easing. What’s your response to that?”

    “Dr. Hoenig: I don’t have a response, but I think the best reply was from another individual who was a critic of the Federal Reserve, and that’s Ron Paul who said, “Well, I would never say you were treasonous. I have accused him of counterfeiting for some time now.” You know, everyone’s got an opinion. And I think we’ll see how it all plays out over time.”

    Ron Paul shows good measure, articulation and of course wisdom….I perceive from his words. Now where is the cloning machine? ;)

  5. Also reckon that AUD carry trade will break down again soon Ross. That initial leg down looked like the start of something to me and maybe 95cents coming soon. I still follow the inflation/carry/dollar dump scenario still for the longer term but just in the near term there has been a strong sell-off now a bounce and looks like a trend line around parity could be broken if she goes for another slide. Plenty of fundamental bad news to complement such a move…..US hit debt ceiling again, Spain and Italy, US banks solvency issue..BoA etc …nightmares everywhere Ross.


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