China buying more JGB

In an attempt to diversify from the USD, China bought more JGB in June.

China purchased a net 456.4 billion yen ($5.3 billion) of Japanese debt in June, following net buying of 735.2 billion yen in May that was the most in records dating from 2005, according to a report released today by the Ministry of Finance in Tokyo.

This is expected as the nation switched to a soft peg referencing to a basket of currencies.  Although Japan is the 4th largest export market of China, making up about 10% of its exports, the trade is more or less balanced. As such China’s trade surplus against Japan was only about USD20bn in 2009.

Since China has so far bought about USD20bn JGB this year, has it used up its quota then? Not likely. China has been under-weighting JGB in its reserves since 2006. If China does indeed intent to bring its currency to be trade weighted, there’ll be more JGB to buy, at the expense of US Treasuries naturally.

A side effect of buying more JGB is pushing up the Yen and Japanese Finance Minister Yoshihiko Noda commented yesterday that he’s watching the matter. But this may be a price that Japan has to paid, as it becomes increasingly relying on foreign lenders. Savings rate tumbled in  to a mere 2.2% in 2007 from 11.4% of a decade earlier, as economic stagnation and an aging population takes it toll.

The real Chinese revaluation story

The media has been busy propagating and debunking the RMB revaluation story, but I think both narratives are off-target. Yes, China is having a significant revalution, just not with its currency.

Instead, China has chosen an aggressive program of internal revaluation, i.e. raising costs for the exporters internally, by inducing wage-led inflation, cutting export subsidies, and stiffening environmental regulations etc.

Most of the recent coverage of China’s labor disputes have focused on the workers’ being simply more demanding in sharing the spoils. But one should also note the subtle, and very important, support that the Chinese government is giving them. Besides rallying behind the workers in state media, labor activists have been allowed to organize freely (rare for China’s pro-capital government), so long that they train the target on wage demand only. Raising the minimum wage is also a cue for the workers that their action is being sanctioned by the state.

Why is China going this route instead of currency appreciation recommended by the developed economies? Well, this is simply a better way of adjustment for China. With currency appreciation, the losses to Chinese exporters become gains for exporters in other countries, i.e. a net loss of wealth for China. With internal revaluation, the benefits go towards Chinese workers, i.e. only a redistribution of wealth within China. This later approach also helps in building up a middle class and reorient the economy towards more consumption.

Another way to achieve internal revaluation is by cutting export subsidies. China has announced cutting export rebates on over 400 types of products deemed energy-intensive or polluting. This allows the government to target only industries deemed inefficient and force them to upgrade, and helps soothing trade relations with the West as a bonus.

The implementation of environmental regulations has also been tightened, to the benefits of future generations of Chinese. Again, this is an area that simple currency appreciation may not be as effective.

At the end of the day, although China has decided to bite the bullet and pony up for rebalancing its economy, it still seeks to minimize the costs and maximize the benefits. It’s just that their preferred method may not be the most desirable one from the POV of the developed economies.

Impact of higher Chinese wages

The successes of workers at Foxconn and Honda, coupled with tacit support from a Chinese government determined to build a domestic market, have predictably embolden workers elsewhere. What’s surprising is the speed and ferocity of the spread of the labor unrest.

Besides a second strike at Honda, there are many copycat strikes in Guangdong and in the Yangtze River Delta to the north. To the dismay of many foreign investors, the unrest has even touched provinces like Jiangxi and Shaanxi,  inland areas that previously were considered as possible sites for relocation in order to lower costs. Now they are investigating opportunities at other countries. Foxconn is looking at India, and Vietnam is already a hot destination for lower end manufacturers.

So, does this mean China’s days as world’s factory is numbered? Not likely, as labor make up only a small portion (7% by some estimate) of total costs. The lower end manufacturers are likely going to move elsewhere, and the rest simply are going to move up the value chain, following the same path of Asian tigers like Taiwan and South Korea.

Is iPod going up in price? I doubt it. Foxconn and other manufacturers are just going to eat up the wage hike. Low end manufacturers have slimmer profit margin for cost absorption. But I think they will eventually opt to move out of China to the next low cost mecca rather than raising prices collectively.

Is this going to be a boom to workers in the developed economies? Hello! What have you been drinking? The Chinese are moving UP the value chain, which means that they are going to compete head-to-head with the developed economies which have already reached peak productivity. Feel free to ask Siemens whether the rise of Chinese high-speed train manufacturers is good for their business or not, or quiz Japanese car manufacturers on the impact of Kia and Hyundai.

Hey, Chinese workers with higher income are going to consume more, benefiting some international suppliers eventually, right? Right. But they also consume more natural resources, driving up the costs of practically every commodity. Plus the Chinese market is very difficult to penetrate and China runs explicit industrial policies to promote domestic companies. Japan is exhibit A of how powerful these non-tariff trade barriers can be.

Bottom line is, I just don’t get the euphoria of many western commentators.

What have the US-China talks achieved?

The so-called Sino-American Strategic and Economic Dialogue has been properly wrapped up, with a plethora of agreements signed. But what has it actually achieved? Probably not much, as usual.

Rmb revaluation has been relegated to the back burner, as expected. The two nations have agreed to:

1. Balance their respective economies, with the US increasing savings (you don’t really think this is going to happen, do you?) and China increasing consumption (even if they do succeed, this will be a decade-long project at best).
2. Fair trade. The US has promised to consider recognizing China as a market economy, and China is to give equal access to foreign companies (presumably in government purchases). This is potentially the most important result coming from the talks, and I’ll come back to this later.
3. Some sort of vague cooperation in the financial field.
4. blah, blah, blah
5. They agree to talk some more in the future.

That’s about it in trade related results. There are some other stuff regarding new energy and geopolitics etc.

On the fair trade agreement, what the US has promised potentially has important impact on many anti-dumping cases where “Chinese real wages” are often imputed from other economies as China is currently not considered a market economy. If this is to be implemented, Commerce Dept. will have much higher burden of proof in anti-dumping cases that it initiates. Is this likely to happen? I’m not holding my breath. The current economic environment really is not exactly conductive to lessening trade tensions. Unless the US is thinking about imposing overt tariff, it is not likely to weaken the power of its anti-dumping mechanism. The keyword in the agreement is “promised”. It’s going to be a long and convoluted way to actual implementation, if at all.

On the Chinese front, it’s all promises as well. US companies have protested vehemently about China’s “indigenous rule”, devised to promote domestic technologies. Since China has never signed up to the WTO treaty that gives equal access in governmental access, the US has to use other leverage. China has since modified the rule, but the devil is in the details. Since China sees creativity, or rather the lack of which, as a national, strategic issue, I doubt it’s going to backtrack on the core pieces of the new rule. An official has clarified earlier this week that only value-added portions carried out within China by a foreign company will be considered as national in doling out governmental purchases. In other words, if you want to be considered a domestic company, you need to manufacture and carry out key R&D in China.

Runaway inflation in China

China is to release April CPI today and the consensus is about 2.7%. While this seems well within the 3% target, actual inflation on the ground is quite another story. One telltale sign is that PPI is forecast at a scary 6.7%. How long will it take for this to be transmitted downstream, or should we look for the factories bellying up instead?

The inflation story is so worrisome that even the PBoC has repeatedly cautioned against “heightened inflation expectation,” which it sees as a result of excess domestic and global liquidity, raging commodity prices, and rising wages and other domestic costs.

Since China’s growth relies heavily on investment, i.e. capital intensive, it is more sensitive to commodity price swings. The trade figures released yesterday largely confirmed this. Although China reported a surplus in April, as opposed to the slight deficit expected by many economists, it’s still down 87% YOY, despite decent recovery in global demand. The main culprit was surging imports, especially of commodities. Iron ore import was up 27% YOY, soya beans was up 13%…you get the picture. Considering the massive hikes in wages I blogged about earlier, unless China succeeds in reigning in its economy, commodity-induced inflation will eventually be transmitted to CPI, as early as May according to the pessimists.

And CPI may breach the 3% threshold even if  China succeeds in its endeavor. This is because China is mainly relying on policy measures to surgically cool down the property market, which is seen as the main problem, instead of truely mopping up liquidity. As such money squeezed out of property market simply flows to other sectors of the economy like farm produce. After a 40x (!!!) run up in price last year, garlic has gone from RMB9 per kilo in Q4/09 to RMB12.2 in April. 80% of farm produces monitored by the National Bureau of Statistics are seeing similar price increases and this is causing great consternation among the general public. Yes there are climate issues, but speculation definitely plays a significant part.

I had thought that China would hold off interest rate hike for much longer given the uncertainties in the global economy. I’m still of this belief but the Chinese government is now having rapidly diminishing room for maneuver, and might actually be forced into an unilateral hike in Q2, especially now that the ECB has entered into the competitive printing business as well.

From Bloomberg: Europe Rescue Lets China Tackle Asset Prices, PBOC Adviser Says

The European initiative will enable Chinese leaders to “focus more on containing risks in the domestic economy instead of worrying too much about the global risks,” said Li, appointed in March as one of three academic advisers to the People’s Bank of China.

He’s being nice. Helicopter Ben x2 means that China will be submerged in a tide of liquidity if it doesn’t act decisively.