The China Vortex

This is pretty self-explanatory.

Investors who bought notes due February 2018 on March 17, just after the Fed helped arrange the bailout of Bear Stearns Cos., have lost 6.2 percent, according to Bloomberg data.

The 10-year note, at 4.25 percent, yields no more than the inflation rate, leaving investors with real returns near zero. Consumer prices have exceeded 10-year yields by an average of 36 basis points since December, Bloomberg data show. In 1980, inflation reached a 33-year high of 14.8 percent and yields averaged 11.4 percent.

`Out of the Bottle’

Yields on 10-year notes had dropped to an almost five-year low of 3.28 percent on March 17, after the Fed cut the discount rate at an emergency weekend meeting and backed JPMorgan Chase & Co.’s deal to buy Bear Stearns Cos. Rates on three-month bills plunged to 0.39 percent, the lowest since the 1950s, the same day as investors sought the safety of the shortest maturity government debt.

Consumer prices advanced 4.2 percent in May from a year earlier, the Labor Department said June 13. The rate was above the median forecast of 3.9 percent in a Bloomberg survey of economists, and the highest since January.
Economists at New York-based Morgan Stanley say inflation will reach 5 percent to 5.5 percent this summer, the highest since 1991.

“The global inflation genie is out of the bottle,’’ Morgan Stanley analysts led by Joachim Fels, co-head of global economics, said in a June 11 report. Even if the pace moderates in coming months, “we are likely to see higher average inflation rates,’’ they said. Inflation averaged 3.1 percent during the past two decades.
`Unsustainable Levels’

Inflation is also eliminating the rewards of owning U.S. stocks. Standard & Poor’s 500 Index shares yield 0.2 percentage point more in profits than the interest on 10-year notes, the smallest advantage since 2004, data compiled by Bloomberg show. The last time corporate earnings returned less than bonds, the index posted its biggest monthly decline in five years.

“What did you say? You wanted us to buy more US assets?”

Oh, and I forgot to mention, this is in straight dollar terms only. You need to also figure in how much the US dollar is going to depreciate against other currencies in the coming ten years.

“Ouch!”

I wonder how the Chinese government is going to explain this to Chinese citizens, since it is their official responsibility to protect Chinese investments and assets? And that the situation, particularly re inflation, is going to get much worse before it gets better?

And it really doesn’t matter who becomes US president either, at least with regard to this set of issues.

Not even a US president can do anything about this.

Seeking Alpha has an interesting article The Power of the Market: 600 Million People Lifted Out of Poverty Since 1981. The article comes with two graphs, one of which is above.

This shows that there has been a gradual fall in numbers of poor since 1981, but there was a bump in the years from about 1988 to 1994, when the numbers of poor stubbornly resisted to fall. This was a time of high inflation in China.

Do I need to tell you what happened in China in 1989?

This graph gives a rough indication that as long as the Chinese government is able to show a descending line that poverty numbers are going down in absolute terms, then the government’s position is safe. If inflation should pick up and the number of poor goes up, then they have something to worry about.

So far, developments on the economic front have been going well in China, with the noted exception of high inflation in China, much of which is due to higher commodity costs (food and energy costs) and capital inflows. Much of the capital inflow into China is due to investors who want to get out of the US dollar, and see China as the most attractive growth market for their money.

Rising inflation is usually an early indicator of other economic and social problems to come.

A few years ago, investment money coming into China was welcomed with open arms, but now times have changed, and the government doesn’t see them nearly as favorably as they did just one year ago. Capital inflows which are liquid can come into China, and also leave it very quickly, leaving the country’s economy and society in a lurch, just as it did during the Asian financial crisis of 1997 for the countries of Southeast Asia.

With the US economy heading for the dumpster, and Europe showing signs of weakness due to rising energy prices, that is not something the Chinese government wants. It is more than likely that the Chinese government will do anything to keep those poverty numbers going down in China, regardless of what it means for the rest of the global economy.

The need for social stability in China trumps everything else. Including commitments to globalization and the WTO.

Fasten your seat belts.

The very dramatic unwinding of Bear Stearns and the purchase of its shares at a fire sale price by JP Morgan Chase has raised some very interesting questions.

Put simply, American assets are going to have to go at fire sale prices. We’re not talking about the Japanese buying Rockefeller Center, I mean real valuable and sometimes tangible assets. Remember that? And they will be denominated in US dollars, which most American banks still take. So this means a bargain on America for buyers smart enough to move quickly and take advantage of America’s double troubles on the banking and currency levels.

The Japanese in the eighties thought that real estate prices could only go up. Sound familiar? They learned that that wasn’t true in the nineties; it’s called “The Lost Decade” in Japan. Then US mortgage lenders sold the same crock of shit to Americans in 2002-2006 while the US Fed and Treasury passively looked on. Maybe someone can explain to me why there should not be at least a “Lost Couple of Years” in the US. Anybody who is thinking about buying US real estate now before the market has hit rock bottom needs their head examined.

Tom Foremski’s Silicon Valley Watcher has a very interesting article about how the investment banking crisis will freeze Silicon Valley M&A deals. According to the article, the Bear Stearns debacle means that many of the recent startups will run out of financing, which is now done by US investment banks, and may even go belly up because they are unable to obtain funding.

This represents an excellent buying opportunity for cash-rich Chinese corporations, venture capital firms and private equity firms to buy companies which have good intellectual property and/or business/sales relationships at very good prices. It would also be a good release of all that capital floating around in China, and is mostly going into real estate and other junk investments in China which don’t offer good ROI, especially with rising inflation.

There are three ways to do this: Chinese VC and PE firms could set up shop in SV and do the due diligence and offer term sheets and see what they come up with. So far, I have not seen any Chinese firm which has the people with the kind of capability to pull this off. There is a strong cultural component in dealmaking and most Chinese who have grown up and worked in China don’t have a feel for US dealmaking.

Or, they could partner with SV VCs, set up joint funds which the Chinese would fund, and which the American partners would do the due diligence on.

The third way would be if China Investment Corp. got really smart for a change and decided to buy several of the top-tier Sand Hill venture capital firms, funded them up, put in Chinese general or limited partners and/or board members, and started hearing pitches from entrepreneurs. The current crop of SV startups will start getting really desperate in 6-12 months, and that would be the best time to offer term sheets at favorable terms for the VC firms. (I’m willing to bet that even the leading US social networking sites will be going at low prices because they have not been successful in generating meaningful ad revenue even in fat times.)

To complete the M&A/IPO cycle, the Chinese would have to have partial ownership, preferably with a board seat/s, of one investment bank.

With all the mess on Wall Street, all they have to do is wait until the time is right.

Everything comes to he who waits (and has cash when nobody else does).

JP Morgan Chase has just purchased Bear Stearns at $2 a share, an investment bank which was valued at $150 a year last year. Equity and capital markets are poised for a volatile week. The US Fed is set to make another rate cut, a desperation move, on Tuesday. This is likely to push the US dollar into free-fall, and set the stage for inflation in the US and later worldwide. More and more companies and individuals will choose to distance themselves from the US dollar.

Some time ago, I talked about why globalization, at least in its current form, would fail. Globalization has been oversold, especially in the US, where it was seen as leading to some growing kumbaya world where everyone just got along. That is not happening, and will not happen.

There is a strange resemblance between the way globalization was sold and the way real-estate was sold up until last year in the US. Up until 2007, Americans were told that real-estate prices would never go down, they only leveled off in bad times. When the bad times passed, then real-estate prices would climb again. Globalization was sold the same way.

It didn’t matter if American factories were relocated to China because Americans would find something else to do which would add greater value-added. Guess what? Americans haven’t found where that new value-added is, which in turn is leading to higher unemployment, and a generally angry population. We will see how their anger is channeled when the November elections come up.

In the meantime, Chinese government policy, through its VAT policy, encourages local governments to set up factories which waste energy to make products with very little value-added which Americans have bought on credit. Calling this real growth is just a fantasy, to use polite language.

This is why inflation is already flowing through the Chinese economy, first with food prices, and is now working its way through the system. It is likely that the situation will become much worse, and will soon hit the Shanghai and Shenzhen bourses.

The _real_ globalization where value is _really_ created is about enabling people to work productively in different regions with little or no damage to the environment, and enabling them to use their skills in a productive manner without having to travel great distances which previously took a lot of time. But that is not simple to explain, is it?

The business valuation models for these new productivity tools do not yet exist. Ironically, the valuation models for hocus-pocus subprime-mortgages did exist. It’s just that they got turned upside-down in a short time.

So what have all the risk consultants been measuring lately? I’d say that they’ve been out to lunch. That’s why, in these times, the Chinese approach to measuring risk makes more sense.

It’s beginning to look like the snowstorms and US economic slowdown can help the Chinese government to do something government controls could not do: cool down the Chinese economy and maybe, even damp price inflation.

The greatest worry for Chinese government economists over the past year has been the very real rise in price inflation, especially food prices. In spite of repeated rises in interest rates, the Chinese government was having trouble putting a damper on inflation, something which Chinese leaders have traditionally viewed as a huge threat to social stability.

Now though, there are early signs that the slowdown in the US is welcome news for the Chinese government in its struggle to cool prices down.

Gold prices are going up.

Jim Rogers has long been a bull on China, to the point where his daughter’s first language is Mandarin, and is betting on a rise in commodity prices because of demand from China. He highlights this point in his new book A Bull in China: Investing Profitably in the World’s Greatest Market.

The recurring theme is not so much demand from China, but that people in Asia are turning to gold as an investment, safer than property. In my previous article, I mentioned that gold is often an investment of last resort which is safe when all the other investments have gone down the tubes. Obviously Vietnamese and other Asian investors have the same belief and affinity for the metal as Chinese do, and as I’m sure Jim Rogers does.

The astute investor will notice that it isn’t so much that they believe in gold, as it is that they are rushing to get out of US dollars.

When Jim Rogers talks about the commodity demand from China, the flip side of the story (which he is not talking about so much) is that he is using US dollars to buy those commodities.

When you have too much of a currency in circulation, you get inflation and the currency loses value until a new floor is found and supply and demand reach equilibrium. Right now, Asian investors do not feel that they know where this new floor will be; that explains the rush to gold and gold futures.

That is what’s going on now.

Yesterday, the new national aquatics center was unveiled in Beijing. This will become the venue for the leading water events of the Beijing Olympics. After the Olympics are over, it will be converted to a shopping mall for Beijing’s masses.

Beijing is now the site for some of the most exciting architecture in the world. For many Chinese though, there is an underlying uneasiness. Is all this dramatic futuristic architecture the beginning of a new and exciting future of wealth and prosperity which Chinese have never experienced in their long history?

Or is this instead a blip of prosperity, and will the future be much less bright, and will their children and grandchildren look back and see the Beijing Olympics as the apogee of what has since become a downward trajectory? And will this architectural marvel become dirty and dusty and seedy?

China has seen prosperity before, only to have its dreams shattered. Westerners today see China as a rich, prosperous and growing power, but it has run into the wall before, and on many different points in history. The first Chinese industrial revolution, when Chinese factories started making goods for the Chinese market started at the end of the nineteenth century, with textile mills and flour processing factories spouting up in the Yangzi river delta, mostly started and financed by entrepreneurs from Shanghai and Wuxi. Then China went into political chaos in the period following the revolution which overthrew the Qing dynasty in 1911.

Another period of short-lived period of prosperity came in the early 30s, this was cut short by the Japanese invasion of China in 1937.

Then, in the period following the end of WWII, China fell into civil war between the two leading political parties, with the Nationalists losing and retreating to Taiwan. Following the establishment of the PRC, China was very poor, and then made even poorer by the Cultural Revolution. In 1978, the Chinese government essentially decided that they were tired of being poor and moved ideology off the national agenda. From now on, it would be about making money.

Even today though, with all their savings and comfort, Chinese feel that it can all change and all go away. That is why they save and sit on their cash.

Americans are the opposite. Until very recently, most Americans believed that the future would always be brighter, that although there were things that they did not understand, America was the strongest and most prosperous country in the world, and that there would always be a way. This is why theyspent their savings, and when their savings were gone, they would take loans on easy credit terms, promising to repay the loans and credit when they had income again. It led to a bigger and bigger mountain of debt. And now, Americans are much less sure about their ability to repay the loans.

This is a way of thinking which is completely foreign to Chinese, and makes no sense at all to them. For Chinese, the only real money is cash. And when money goes bad in times of high inflation, they don’t even believe in cash.

They believe in land, and if the politics becomes unstable, they go to gold.

Runaway inflation is something the Germans experienced in th 1920s, then again in the postwar period. Japan experienced it too in the postwar period. China also experienced it in the postwar period when the Nationalists had to change national currencies three times in the period up to 1949. With the runaway inflation in the cities, people had to carry their money in paper sacks to do their shopping. They would go to the markets carrying bags of money to buy their groceries, then they would use the same bags to carry their groceries back home.

When the Nationalists lost control of inflation, they lost the Chinese cities and the support of the business community. This paved the way for the establishment of the PRC in 1949. The first task for the government was then to stabilize the currency.

While China was very poor in the fifties, sixties and seventies, there was virtually no inflation.

Today in China, we are seeing the early signs of inflation again in food prices and property prices. For any Chinese government, and this government is no exception, inflation is the greatest single and most frightening enemy it faces. It may creep up slowly, but it unleashes forces which can easily spin out of control.

If a government cannot maintain the value of its currency, it cannot protect its citizens, and the people end up in the poor house. It’s that simple.

This is why the Chinese government will not easily revalue the yuan upwards, and why the government keeps such a tight control on credit.

One of the upsides for Chinese businesses investing in Africa is that although the people are poor, at least they pay cash. When times turn hard, you want to be paid in cash.

For most Chinese, you aren’t rich unless you own cash.

Credit is just a derivative and in tough times, no one wants derivatives.