A View from the Trenches, October 21st, 2010: "China's message"
Please, click here to read this article in pdf format:october-21-2010
If you’ve been following the markets since our last piece, you know by now that the People’s Bank of China has increased its 1-yr lending rate by 25bps, to 2.5%. The reaction was a sell-off in risky assets on Tuesday, recovering some yesterday.
So, what’s the big deal?, you may ask. A 25bps increase in the lending rate? Here’s our view:
China did what it did because it is trying to curb inflation. Why does China have inflation? Because China seeks to keep its currency as undervalued as possible through a simple mechanism: When foreign exchange arrives to China as payment for their exports, the People’s Bank of China buys it and takes it out of circulation.
What does the People’s Bank of China pay with to take foreign exchange out of circulation? With Yuan, which is deposited in Chinese banks. The Yuans multiply thanks to the credit multiplier, and are used to buy goods produced in the country. However, the rate at which the supply of Yuan grows, both by the central bank’s interventions and by the credit multiplier is higher than that at which the supply of goods, for internal consumption, grows. Therefore, in the end, Chinese find that they have plenty of Yuans available to purchase a limited supply of goods. Prices then rise. Inflation sets in.
How could China stop this? It’s very easy: They have to stop buying foreign exchange. China could have done that yesterday, but it preferred not to. That was an important message and we took proper notice! Let’s rephrase it: On Tuesday, the news wasn’t a 25bps increase in the lending rate. On Tuesday, the news instead was that China let the rest of the world know that it will not let its currency appreciate and will distort its credit markets as much as it is necessary to address the inflationary problem. The message is that the export lobby is stronger than the financial lobby or the wishes of the average Chinese consumer. The message was also that such moves can and will be done without prior notice to other central banks, which means that policy coordination is out of the question.
What wisdom can be found in raising the lending rate? None, for it only throws more fuel to the fire. In the context of falling yields, it will only encourage to bring more capital to China, beside that which enters as payment for their exports. This will leave the People’s Bank no other alternative but to interfere the “distribution channel”, either by raising rates or reserve requirements, or even causing a market segmentation, whereby payments on exports do not enter the country. At “A View from the Trenches”, we had anticipated this back in January, where in a series of letters, we reviewed the intervention efforts by the People’s Bank of China, on the “distribution channel”. Back on January 21st (refer: www.sibileau.com/martin/2010/01/21 ) we wrote:
“…We would quickly see that there would be segmentation in the credit market, where exporters borrow offshore and internal consumption is financed onshore…(…)…. No central bank can simultaneously sustain a fixed exchange rate regime and control the local rate of interest…”
On this note, yesterday we came across a Bloomberg article titled” Banks’ Yuan Debt Costs 30% Cheaper in Hong Kong” (http://www.bloomberg.com/news/2010-10-19/banks-yuan-debt-costs-30-cheaper-in-hong-kong-china-credit.html ). This was exactly the point we made way, way earlier, before anyone else would examine this possibility.
In conclusion, we think this is only going to get worse and as readers know by now, unilateral policies will continue to support gold. The intervention can be easily seen in the price of the Yuan yesterday (see chart below, source: Bloomberg). The reaction was textbook classic: The currency appreciated at open, and then the intervention started bringing its price down. We are far, far away from reaching a solution to the global monetary mess. That can only be bullish of gold.
Martin Sibileau
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