This week The Wall Street Journal's Opinion section had an interesting article outlining the unsustainable Chinese monetary policy that is impacting world markets. In the article, the Journal outlines the monetary policy of "sterilization," a specific combination of monetary and exchange policy in which the government attempts to peg its currency while maintaining price stability. Since economic theory argues the difficulty of perpetually maintaining both price stability and a fixed exchange rate, a trade surplus persists and grows with productivity gains and pressure builds within the monetary system.
The market mechanisms work basically as the following: To keep the yuan pegged to the dollar the Chinese government has been selling yuan to buy dollars. As of the end of June China had foreign reserves of $2.5 trillion, up 15% annually. In order to offset the upward pressure on Chinese prices as a result of selling yuan, the government has been selling securities and increasing the reserve requirements of banks. A recent article highlighted that the Chinese may increase the reserve requirement to 15% in 2012 from 11.5% currently, which is more aggressive than even the levels outlined in Basel III for world banks. This in essence requires the banks to hold a larger percentage of their deposits in liquid cash, reducing the amount of loans the bank can offer and offsetting the growth the money supply by reducing the money multiplier.
Despite these restrictive monetary policies the Chinese inflation rate increased to 3.5% in August, above the stated long-term goal of 3%. To offset the rising inflationary pressure there have been some opinions that the Chinese central bank may increase its one-year yuan lending rate at 5.31% and one-year yuan deposit rate at 2.25%. Raising the interest rate should apply greater pressure to the brakes of the economy. Between the rising reserve requirement, selling of securities, and potentially increasing central bank one-year rates; it would appear the Chinese government is pushing hard on the brakes. The problem is that the pegged exchange rate is acting like accelerator, which is increasing inflationary pressure as productivity and the economy grows. Thus the Chinese government is effectively driving with both feet. The policy also encourages over-investment in export industries, driving mini-bubbles within China's economy to the determinant of longer-term profits and domestic consumption.
The actions by the Chinese have exasperated the situation in the U.S. by driving down interest rates and encouraging consumption of Chinese goods due to their relative price advantage. It has also, I would argue, applied deflationary pressure in the U.S. since demand for dollars (purchased by the Chinese) has outpaced the 6% CAGR over the past 13 years in supply. The Chinese demand for dollars combined with the raised reserve requirements for U.S. banks, stricter U.S. bank regulations, and economic slowdown has created the environment in which the Federal Reserve could shower trillions of dollars into the market without creating inflation, for now.
Upcoming catalysts to change an unsustainable situation, or bubble, are appearing on the horizon. In the previously mentioned opinion article, The Wall Street Journal highlights that Chinese reform to boost domestic income is increasingly discussed by top officials. This reform likely involves some combination of increased worker benefits, monetary policy and exchange policy. The U.S. Congress is considering acting to punish China for the perceived currency manipulations, which depending on how carefully legislation is written and administered could nudge China to move faster or lead to a trade war hurtful to both sides.
So does the bubble go out with a bang? Or, a fizzle? A lot depends on how coordinated the U.S. and China act on these issues. If Congress tries to win cheap political points with voters by casting China as the villain and decides to punish the country too harshly, it could get ugly. If monetary policies on both sides are not careful, releasing the pent-up pressure could produce a surprising spike in U.S. inflation and recession in China. The one trend I do foresee is rising interest rates within the U.S., either as a sudden pop or a long 10-30 year cycle. Just as China's currency policy possibly provided deflationary pressure during a pegged time period, a loosening of the fixed exchange rate likely causes inflationary pressure as the demand for dollars moderates. This moderation coupled with the Fed's aggressive monetary policies potentially creates an inflationary period, increasing interest rates and therefore lowering treasury prices.
How to play it?
I will establish a relatively large position (5-15%) in an inverse leveraged Treasury ETF. I have been debating with myself as to whether to wait until October and a potential stock market drop, coupled with strengthening treasury prices, or to not get too cute and do it now. Given I think the position should pay-off in the next year, and likely continue to work for 5+ years, I'm inclined to establish the position and deal with any short-term rises in treasury prices associated with recovery concerns.
Other potential positions include net long yuan versus dollar, industries catering to domestic China, short-term (<1 year) long positions in exporters to Asia, and long positions in agriculture and other commodities imported by China.
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