It is well known that we are not enamored by China. For in spite of its large population, China punches under its weight in economic terms. We have been critical of China’s policies which created real estate and stock market bubbles, as well as the intervention to attempt to artificially prevent corrections. However, we cannot criticize the Chinese government’s decision to devalue its currency in an attempt to reinvigorate, or at least halt the slide of, the Chinese economy.
Although its methods might differ, its desires and goals are not all that different from what the Fed did following the housing bubble, what Japan has been doing for approximately two decades and what the EMU is doing today. Add to this group a number of smaller economies which took steps to weaken their currencies and it is difficult to blame China for doing the same.
Besides currency devaluation, there is something else most of the aforementioned economies have in common; population decline. China, Japan and Europe are all experiencing population contraction. All economies are being affected by globalization and technology.
Competition and technology (which tend to blunt wage growth and, in some cases, job growth) are threatening to make the so-called “welfare state” untenable. As political leaders and their constituents are reluctant to change their lifestyles and give up entitlements, monetary policy has been the preferred weapon to combat sluggish economies and deflation/disinflation.
As we stated yesterday, currency devaluation might not produce the desired results if most of your trading partners are doing the same. This is like building a racing car which can go 200 MPH to beat your competitors. However, when they make similar adjustments, your absolute speed no longer matters.
It is relative speed which always matters. When most of an economy’s trading partners/competitors are going the same speed in the same direction, increased monetary stimulus might provide little advantage in terms of relative speed.
Looking at absolutes rather than relatives is where we believe much strategy is misguided. We have heard many times that low rates and weak currencies should provide a boost to economic growth. The reality is that it is the relative level of interest rates and currency exchange rates which matter. If mortgage rates were at 6.00%, would that be considered conducive to mortgage borrowing? It depends on where rates were previously.
If mortgage rates were previously at 7.00%, 6.00% mortgages would probably stimulate housing demand. However, if mortgage rates were previously at 5.00%, 6.00% mortgages would probably crimp demand. This is something which pundits and strategists either do not understand or refuse to acknowledge as it is inconsistent with their preferred story.
Will China’s is weakening of the yuan boost its economy? Maybe, but it depends on what other economies do. If China’s move to devalue the yuan causes the EMU, Japan, South Korea, etc. to devalue further in response, then the yuan’s devaluation could fail to have the desired results. In fact, the yuan could “revalue” versus those currencies.
What is going on here is that countries which are devaluing have the same goal. This goal is to increase exports to the U.S. and other economies which are recovering. They are fleas fighting over the same dog. This harkens back to our views of China published during our Citi days.
Several years ago, investors and market participants were concerned what would happen to the U.S. economy when China developed internal demand and did not need to export to the U.S. as much. Our argument was and still is: As the largest consumer of goods (with few protectionist policies), the U.S. could easily find a replacement supplier of cheap goods. This is what has happened during the past decade.
Although China’s imports to the U.S. have fallen, prices in the U.S. have not soared, nor have long-dated U.S. interest rates. U.S. consumers were able to source goods from alternative sources, including domestically, thanks largely to the energy renaissance and technology which lowered the cost of production. In global economics, the fleas cannot become healthier than the dog off which they are feeding.
About Thomas Byrne
Thomas Byrne brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets.