Renminbi Rebalancing Webinar

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Renminbi Rebalancing WebinarSince Marco Polo's time, the West's perception of China has been composed of equal parts fantasy and reality. Nowhere is this dichotomy better captured than in the modern financial markets. The Chinese economy breathed fire into commodity prices and emerging markets for much of the last decade, sending many exchange rates soaring upward. But now, the dragon's tail is whipping through the markets as the economy decelerates, driving prices downward, and creating a new surge in volatility.

This video is from Proformative webinar "The Dragon's Tail: China's Rebalancing: Renminbi Risk and Opportunity" held on October 3, 2012. The webinar features a presentation from Karl Schamotta, Senior Market Strategist, Western Union.

 

Renminbi Rebalancing Webinar

"Thanks for joining our event today, Renminbi Rebalancing Webinar.

We've spoken a number of times over the last year and a half. I believe we spoke about six months ago. Since then a lot of water has flowed under the bridge. Very much in line with our expectations, we've seen a sharp shift in sentiment on the Euro area itself, as the likelihood of collapse has actually receded. At the same time we've seen a growing sense that the developed world will continue to muddle through the problems that its facing without experiencing growing shocks.

Volatility levels are relatively low right now, despite a growing belief that the central banks cannot continue to support the economies in the long run. We are feeling fairly calm out there. But, the fact is, traders are suffering from a form of attention deficit disorder we might call it. They are continually on the lookout for a new crisis, a new source of volatility, or more charitably a new form of entertainment.

Conveniently China is providing this right now. This is very much along the lines of what we've been talking about for the last year and half or so. After breathing fire into everything from commodity prices to luxury goods demand for the last decade, the Chinese economic dragon now appears to be changing direction. It's tail is now knocking asset values sideways. This is causing turmoil across the entire global economy.

I have to kind of to make personal note here that this is somewhat gratifying in a sense because I spent many years, very lonely, wandering in the wilderness, as something of a China bear. I am now being joined by a majority of the market watchers. There is a lot more caution and concern about what's happening in China.

I have to say here that I'm not really a China bear. I've often been very cautious about things in China, not because they're really terrible in the grand scheme of things, but really because Western perceptions have so often been completely unrealistic. We've had a very, very limited understanding of what's happening in China, and also greater hopes than was necessarily realistic to have.

We are now seeing a change. This shift in sentiment has profound implications for the future of the global economy itself.

Today I'm going to start off by providing broad overview of the historical forces behind what is happening in today's business pages. Today, I'll start off by talking about the historical forces from ancient times through to the two major phase transitions, or new equilibria if you will, that China has gone through over the last four years. Then we'll discuss the impact that today's changes might have on the financial markets. In particular, the opportunities that are being created as China evolves.

Before we get to any of that, I'd like to talk about why this is actually so important. I've watched China for many, many years. I've always been struck, not just by the fact that the West doesn't understand China, but by the fact that it often just doesn't want to. Time and time again, Westerners have been content to imagine that China is a mysterious, unknowable, alien place.

This has really meant that we have often suspended our sense of disbelief. This goes back millenia. It really imposes real cost, both on the West, and on China itself. For example, 3000 years before the common era, China learned how to cultivate silk. For the following 3500 years, the West was largely content to imagine that it was produced via magical processes unknowable by mere mortals.

Even in Roman times, it was believed that silk grew on trees. This meant that we paid exorbitant amounts to transport the cloth across the planet through some of the world's most dangerous territories. Wars were fought over the material, and the emergence of Victoria's Secret was set back for an incredibly long time.

The next thing that the Chinese invented, something very, very major, was paper-making. This time around we'd gotten smarter. It had only taken us about 1120 years to learn the trick.

When you put this into perspective, you have to think about all the novels and other masterpieces that we'd have if we had developed a stronger understanding of China at the time, and if we'd been able to share information more efficiently 2000 years ago, how much more farther the human race would be ahead today. Now, that's enough  about the West.

When China was first unified, roughly 200 years before common era, the country generated an estimated quarter of all economic activity on earth.It largely maintained this for the next eighteen centuries.

When the [Ching] emperor took the throne in 1644 he controlled roughly 22% of the world's GDP. Gradually, step by step, China began to close itself off from the outside world. Barriers to trade were raised. The merchant class was persecuted. Economic rules and regulations multiplied by the day and by the year.

Ultimately, this meant that the flow of new ideas into the country was gradually cut off. As a result, by the time the Ching dynasty began to collapse in the late 19th century, the country's share of global GDP had fallen to 11%.

It only got worse. After Mao seized power in the late 40's, he launched The Great Leap Forward and the cultural revolution and further isolated the country. This utterly destroyed what was left of the Chinese economy.

By the 70's China generated less than 4% of global GDP. It was one of the poorest countries in the world to the extent that tens of millions of people were dying of hunger and famine.

After his death a new generation of leaders took power. They understood that a clear pattern had emerged. Whenever China isolated itself and tried to impose too many economic rules on its own citizens, it paid a terribly high price. They knew that China needed to abandon its strict adherence to dogmatic economic principles in order to regain its place as one of the world's most powerful countries.

As Deng Xiaoping put it, "It doesn't matter if the cat is black or white, as long as it catches mice." What did he mean here? He meant that he intended to put into place a set of policies that we've now come to know as capitalism with Chinese characteristics.

In essence, the government sought to achieve collective strategic objectives by harnessing the power and the motivation of individual citizens, to get individual citizens to work toward a set of strategic goals. Rather than simply telling people that they needed to work toward these common goals, as they did during the communist era, they used a number of incredibly sophisticated macro economic tools to engineer the economy itself.

Indeed, if you really need to understand modern China, always remember that the vast majority of central standing committee members or politburo members have  engineered by training, really since The Great Reforms began in the 70's. This really, really tells you how the Chinese policy making elite actually makes its decisions.

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These engineers structured the economy so that it would continually, subtly shift household income into strategic investment. How did they do this? They locked up the financial system firstly. They took control of all linkages with the outside world and only allowed citizens to deposit their savings within the official banking system. They then mandated that the banks channel these savings into strategically important investments, rather than into things like consumer lending.

At the same time, they created a number of enormous businesses that were controlled by the state, allowing the government to set prices across China. Meaning, for example, that electricity could be sold at a premium to households, while being sold below cost to steel mills.

These state owned enterprises also gained from direct subsidies and preferential lending. Meaning they could invest in huge infrastructure projects without being overly concerned about whether they would actually break even in the long run. Beyond this, interest rates were held at levels well below those seen in other growing economies.

I often look at the BRIC group of nations; Brazil, Russia, India, and China. Last year, Brazil's interest rate was the fourth highest in the world, Russia's was the 47th, India's was the 81st, and China's was the 164th. One of the lowest interest rates in the world.

In effect what this means is that China was subsidizing business borrowing, while it punished ordinary citizens that kept its savings within that official banking system. As we also know, the value of the Chinese won was kept way below market levels in the rest of the year.

The reality here is that we've tended to focus on the effect that this had on exports. It helped to make Chinese goods more, or artificially, cost-effective than the rest of the world. However, it also had an impact on Chinese citizens. It made imports from other countries more expensive. Meaning that they were less likely to consume them.

In the grand scheme of things, this entire structure meant that there were clear incentives at all levels of the Chinese economy to invest in infrastructure like factories, mines, and railroads, rather than to consume goods. This was incredibly successful.

China deployed almost 46% of its GDP into fixed investment last year, which is not just the highest in the world right now, but it's the highest in recorded economic history to my knowledge. Even the Soviet Union in its heyday was unable to achieve something like this. It's as if the United States were to somehow convince it's citizens to quit buying . . ."

End Partial: Renminbi Rebalancing Webinar
 

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