Almost 18 months ago I wrote a blog in response to an Ambrose Evans-Pritchard piece in the London Telegraph. I think readers of NOTES will find it more than a passing interest. More importantly, Mr. Evans-Pritchard wrote a new piece in yesterday’s London Telegraph, “China Cannot Risk the Global Chaos of Currency Devaluation.” Evans-Pritchard stresses the deflationary shock from a significant Chinese yuan devaluation in response to the Chinese plague of overcapacity from an excess of capital investment for a Chinese effort to increase exports to ease the burden of excess production would weight heavily on an over indebted world struggling with falling prices.
This is the greatest fear for the world ‘s central bankers and why I always referred to Bernanke and Yellen as the ultimate 1937ers for Bernanke promised Milton Friedman that the FED would not repeat the errors of 1937 and allow deflation to become the major dynamic in the world economy and certainly not the U.S. Evans-Pritchard is hopeful that the recent weakness of the YUAN is not really a new policy:
“The slowdown in China is not yet serious enough to justify such a risk. True, the trade-weighted exchange rate has soared 22% since-mid-2012,the result of being strapped to a rocketing dollar at the wrong moment.The YUAN is up 60% against the Japanese Yen.”
Read the article and be aware that the Chinese are not targeting the dollar but are very concerned about the YUAN strength versus the rest of the world.
From April 24, 2014:
Pritchard Raises An Important Issue– Is China Exporting Deflation?
Making the rounds with the rumors of Russian troop movements was the talk about a London Telegraph article by a Notes From Underground favorite,Ambrose Evans-Pritchard[AEP]. The column, titled, “Suspicion Grows That China Is Exporting Deflation Worldwide By Driving Down Yuan,” is a very balanced piece as even the Evans-Pritchard maintains that he takes no view on “how far china intends to go with this” but is making his readers aware of the opinion of Albert Edwards of SocGen bank.
Mr. Edwards maintains that deflation is taking hold in China and in an effort to prevent a massive slowdown in its economy is seeking to drive down the value of the YUAN to protect its export markets. The operative process is that China is busy buying U.S. and European bonds to in an effort to weaken its own currency. The YUAN is 3.1 percent lower on the year, hardly an aggressive depreciation, but it is an issue that some U.S. politicians have also raised. For the global economy, it is the idea of exporting deflation that is the biggest POTENTIAL PROBLEM. Again, this a theory and not in any way proven conclusive but let’s play with the potential fallout from the Chinese exporting deflation.
“The true picture has been masked by unsustainable levels of investment.” China through its own savings and foreign direct investment (FDI) has developed enormous productive capacity and if the Chinese economy fails to make to the move to a domestic consumer-based economy that huge amount of productivity will have to find a way into the world markets, putting pressure on prices everywhere. Japan, Europe and the U.S. are all trying to create a “modicum” of inflation to reduce their own homegrown deflationary pressures. If Chinese goods are flooding the markets it will put great pressure on corporate profits and remember that the world is awash in high yield corporate debt that is anything but high yield and not priced at all to the impact of China exporting deflation.
The recent action in the U.S. yield curves may be the result of China’s efforts to buy huge amounts of long-term Treasuries easily supplanting the effects from the Fed’s tapering. For now, I don’t believe that the moves in the 5/30 are the direct result of China but reflect a trading battle between giants. However, if the 2/10 curve were to break decisively out of its recent range I would be more receptive to the “China exporting deflation” school of thought, which would justify a flattening of all the yield curves where there is not a solvency issue.
If the Chinese are exporting deflation, then the ECB, BOJ and Federal Reserve are going to have a more difficult time igniting the inflation they are trying so hard to create to help relieve their own debt-burdened economies. The boogeyman of Chinese deflation will also act to pressure politicians in the U.S. and Europe to raise the scepter of Chinese mercantilism as the chief cause of high unemployment and low wages. Fed Chair Yellen is very openly concerned about raising U.S. employee wages and downward price pressure from China will add to pressure on the Fed in how to resolve this dilemma.
If the issue presented by Mr. Evans-Pritchard proves correct then BUY GOLD. I know this will cause head scratching but it is not present inflation that is bullish gold but rather the fear of how CENTRAL BANKS WILL ACT TO DIVERT A DEFLATIONARY SPIRAL. It was interesting today that the GOLD/YUAN and GOLD/YEN both tested their 200-day moving averages before embarking on a violent corrective short rally. Again, nothing is proven with the Evans-Pritchard article but it does raise some important issues going forward.
***Quick Hit: The gaining popularity of Chancellor Merkel in the polls is a result of her firm stance in the Greek negotiations. Some talking heads are trying to spin this as a positive for the European Union. It is anything but and President Hollande of France needs to be very concerned as the German-French relationship is at a dangerous crossroads. I will discuss more next week.