Sunday, April 26, 2009

China and the Reserve Currency

As mentioned in Part 2 of The Global Strategy of the Dragon, in late March, China raised the heated debate of substituting the dominant currency status of the U.S. dollar with a new reserve currency. China’s central bank governor, Zhou Xiaochuan, called for moving toward a super-sovereign reserve currency, or one that doesn’t belong to any particular country, by expanding the Special Drawing Rights (SDR) – a kind of synthetic currency whose value is determined by a basket of major currencies – of the International Monetary Fund by including the Chinese yuan and currencies from other economies. This debate mainly revolves around China, Russia and the U.S., illustrating their concerns from multiple dimensions.

It began in March 2009, when Chinese Premier Wen Jiabao voiced his concern on the fact that China was holding about $2 trillion U.S. Treasury in its foreign reserves. China bought so much U.S. debt without diversifying its foreign reserve because of the low default rate of the liquid U.S. Treasury market. However, since the U.S. government has been printing and pumping money into its economy in this financial crisis, an economic recovery will inevitably generate inflation, which will depreciate the value of the dollar. As a result, holding too much U.S. Treasury will be detrimental to its value, and thus China’s foreign reserve. Therefore, according to Zhou, moving to a reserve currency that belongs to no individual nation would make it easier for all nations to manage their economies better because it would give the reserve-currency nations more freedom to shift monetary policy and exchange rates.

The proposal also allows China to regain face, especially in response to U.S. Treasury Secretary Timothy Geithner’s criticism of currency manipulation, or the notion that China artificially keeps the yuan weak against the dollar (even after Mr. Geithner declined to cite China as the currency manipulator in April). Peter Gries’s book, China’s New Nationalism, states that “face is fundamentally political, involving a contest over power” (Gries 26). Currently, the SDR is only composed of four major currencies in the world (G4): the U.S. dollar, the euro, the Japanese yen, and the British pound. If the IMF SDR program includes the Chinese yuan, it will certainly enhance national pride in China.

As a consequence of rising Chinese nationalism, the Chinese will “altercast the relationship between China and the U.S. as teacher and student, respectively” (Gries 33). The U.S. government (as the student) is busy implementing different economic stimulus solutions to rescue its economy, while China (as the teacher) is slowly preparing itself to teach the student a lesson by attempting to overtake the U.S., the single economic superpower. According to The Economist, “the crisis would severely weaken the economic, political, military and diplomatic power of developed countries. This would create a “historic opportunity” for China to strengthen its position. To do this, China should export capital to South-East Asian countries to strengthen their economies. Doing this would help prevent political turmoil and win strategic influence in the region (The Economist 28).

On the other hand, China has been continuously opening up its economy to the world since Deng Xiaoping became the leader of China in 1978. After Deng set up four Special Economic Zones in China, namely Shenzhen, Shantou, Zhuhai and Xiamen, China underwent rapid economic development. When Jiang Zemin became the new Chinese leader in the 90s, he greatly favored Shanghai and the Yangtze River Delta to become the next big economic regions in China. When Hu Jintao became president in 2002, he led China to increase its participation in developing the domestic front such as the “Open up the West” policy, the completion of the Three Gorges Dam, and the international economics affairs. Consequently, these actions would contribute more to the Chinese economy during his tenure.

If China wants to expand the international use of the yuan, in addition to having a low inflation rate in its economy and a huge GDP and export figures, China still needs to broaden its financial markets by increasing the yuan’s usability and convertibility. Due to this, China has been taking great steps to strengthen the importance of yuan in the foreign exchange market, even though China is still proposing a reserve currency under the IMF. China has not only set up tens of billions of dollars in currency swaps with Hong Kong, Malaysia and South Korea, which enabled those regions to settle their trade accounts with China in yuan, but in late March 2009, China also entered a 70 billion yuan currency swap deal with Argentina. This deal effectively allowed China to settle the trades with yuan, which further enhanced China’s influence in Argentina’s economy while strengthening China and Argentina’s geopolitical relationship. Hence, we can see China is slowly bypassing the dollar to settle its bills on the international trade platform.

Recently, on April 9, 2009, China picked five cities (Shanghai, Shenzhen, Guangzhou, Zhuhai, Dongguan) for the yuan settlement program. This program allows foreign trades to be conducted wholly in yuan rather than in conventional U.S. dollars in those cities. This is an innovative move, as the yuan settlement program not only reduces the risks of exchange-rate fluctuations for the Chinese companies, but also promotes the development of China’s currency investments products.

From China’s view, all these recent currency policies have shown that even if the Chinese yuan failed to be included in the reserve currency by the IMF, China’s new currency policies and political positioning are preparing the yuan to become an increasingly important global currency with implications for reducing the use of the U.S. dollar in the future.

Russia’s reaction may be a good implication on the strategic importance of China’s recent decisions. Once China released its reserve currency proposal, Russia echoed its terms and proposal change. Before the G20 meeting, Russia’s President Dmitri Medvedev supported the creation of strong regional currencies as a basis for a new reserve currency and the consideration of backing this currency by gold. According to Reuters, Russia said that the new international reserve currency, which dislodges the dollar, could curb the volatility of foreign exchange markets. In April 2009, the Kremlin’s chief economic adviser Arkady Dvorkovich also asked the IMF to study the risks and possibilities of the new global currency. These actions reflect how anxious Russia is to remove the primacy of the U.S. dollar.

In comparison to China, Russia’s economy is less export-oriented and Russia’s currency, the ruble, has been devalued by more than 35% since the commodity bubble burst in the summer of 2008. If the U.S. dollar is no longer a dominant currency, the ruble should appreciate against the dollar, which will increase its currency reserve.

In addition to Russia’s own benefits, Russia supports China because of their geopolitical relationship, since Russia and China share the same border and both countries have serious currency concerns over the potential depreciation in the value of the U.S. dollar that they are currently holding. In addition, Russia and China have important economic relations. China has been invested in Russia’s natural resources, such as the deal with the China Development Bank in February 2009, which I have mentioned in Part 1 of The Global Strategy of the Dragon.

From the U.S. standpoint, the U.S. does not want to lose the dominant status of its currency. The use of a country’s currency as an international store of value allows the country issuing it to benefit from seigniorage (the net revenue derived from the issuing of currency), and lower borrowing costs. In response to the reserve currency proposal, the U.S. President Barack Obama said the U.S. dollar still remains the primary global currency and there is no need for a new global currency. At the same time, since many commodities are denominated in dollars globally, changing the current system would take a lot of effort and time for a worldwide adaptation to occur.

On the other hand, even though a move towards global currency reform may detract from the dominance of the U.S. dollar in the foreign exchange market, it may not necessarily be a bad thing. Since China is an export-oriented country, if the U.S. dollar is no longer a dominant currency, the Chinese yuan will surely appreciate against the dollar and make Chinese exports relatively more expensive than those in other emerging markets. Moreover, as most of the Chinese exports are shipped to the U.S., Chinese goods will become more expensive than U.S.’s goods, which the U.S. will import less from China and consume more domestic goods. If this were to occur, it will hurt China’s economy while benefiting US’s domestic economy by reducing its trade imbalance and trade deficit.

From a global perspective, in the recent G20 meeting, the G20 leaders have announced plans under Point 19 of the communiqué to replace the role of U.S. dollar as the world reserve currency, which stated to support a general SDR allocation into the world economy and increase liquidity, which is not under the control of any sovereign body. The G20 leaders have activated the IMF’s power to create money and begin global ‘quantitative easing.’ The global leaders also agreed to increase IMF’s financial capacity to $1 trillion commitment.

Moreover, it is possible for China to first create a common currency among the East Asian countries that mirrors the euro, which was established in 1999 by the European Union. The euro’s position has becoming increasingly important since then. As of today, the euro is even more expensive than a dollar. However, critics argue that this process would require a tight trade agreement among the East Asian countries, which will potentially take a long time to become stabilized.

While it is still early to draw conclusions about whether the switch to a new reserve currency is technically feasible, it would take a long time for this global currency reform to take effect. We can also see that this new global currency proposal is a two-edge sword to China. However, this currency debate will surely mark the beginning of a new era when emerging markets, especially China, are developing the capabilities to lead major reforms in the international monetary system.

Thursday, April 16, 2009

RE: J. Frieboes's post: "Pirates, Pirates, Pirates..."

In response to J. Frieboes’s recent blog post “Pirates, Pirates, Pirates…,” Somalia’s pirates are definitely causing lots of sea-trade problems around the Gulf of Aden.

Even after the pirates were defeated in the Maersk-Alabama hijack, the pirates not only refused to scale back their hijack activities around the Gulf of Aden, but according to a recent report from the US Report, the pirates were also seeking revenge on the U.S. Navy after three of their pirates were shot and killed by the U.S. Navy’s snipers in the Maersk-Alabama rescue mission over the weekend.

The comment from the pirate also reminds me of what happened in Somalia in 1993, which was depicted in the Hollywood movie: Black Hawk Down, about a conflict between the U.S. Army and the Somalia militias. That event resulted in the death of more than a thousand Somalia militias and 19 American Soldiers. Eventually, the former U.S. President, Bill Clinton, decided to pull out the U.S. Army from Somalia.

Instead of a clash between the Somalia militia and U.S. Army similar to the one in 1993, would this conflict lead to another tragic event between the Somalia pirates and the U.S. Navy again?

Tuesday, April 14, 2009

Bull-fight in Spain

Last week, I finally uploaded several bull-fight video clips that I took during my spring-break trip in Spain. This bull-fight took place in Las Ventas, the bull-fight arena in Madrid. I was amazed by the scenes as it was different from what I expected from reading magazines and watching bull-fights on television.

The first clip shows that the picadore, who was riding the armored horse, was rammed by the bull, and the picadore used the lance to stab the bull’s neck to weaken the bull’s muscle and draw the bull’s first blood.

The second clip shows three banderilleros stab the bull with three banderillas, which are sharp barbed sticks, onto the wound on the bull’s neck to further weaken the bull and cause more blood loss.

The third clip shows the bullfighter killed the bull with a final sword thrust, which penetrated the bull’s shoulder and heart. Even though the bull was still moving afterward, it didn’t take much longer for the bull to hit the ground in the end.

The last clip shows that after the bull was dead, it was dragged by the horses around the arena for a lap before exiting the arena.

The bull-fight was one of my favorite parts during the trip. In addition to the show, the bullfighters’ colorful costumes were beautiful and the bull-fight arena was also gorgeously constructed. All these characteristics reflected one of the important traditional cultures in Spain.

Friday, April 10, 2009

Are we setting for another commodity bubble?

Since the commodity bubble burst in the summer of 2008, many agricultural futures prices plunged for almost 50%. Even though consumers might find some agricultural products such as corn and wheat became cheaper, many consumers might not sense the worse will come in the year ahead.

According to the USDA’s planting survey released on March 31, 2009, it showed that many U.S. farmers plan to cut back on planting. Corn production is reduced from 86 million acres in 2008 to 84.7 million acres in 2009. However, only the soybeans production has increased slightly from 75.7 million acres in 2009 to 79.1 million acres in 2009. However, the actual planting may change due to weather during the planting season and agricultural products’ futures prices movement. Therefore, we should pay attention to the upcoming Acreage report released by USDA at the end of June, which shows how many acreage did the farmers actually planted.

When commodity prices fell in the second half of 2009, U.S. farmers responded by cutting back their planting and production. In March 2009, the agricultural Department said that farmers will idle millions of acres of land as they cut production of corn, wheat, and soybean. However, as the consumption of corn and soybeans are still high in developing countries such as China, this planting reduction will increase the volatility in crops prices in the coming year in from packaged food and biofuels to feeding livestocks.

Furthermore, farmers moved away from high-cost crops such as corn in exchange of soybeans which don’t require expensive nitrogen fertilizer, but cheaper phosphate and potash. They are reducing production because of increasing costs of fertilizer and seed, and the slowing demand of crops in some countries during this economic downturn. Even though farmers are cutting back crops’ acreage in 2009, the potential shortage in crops will eventually bring the crops’ acreage back to a higher level in 2010. Therefore, fertilizer companies will face a higher demand from farmers in 2010.

In my opinion, the recent sharp planting reduction will potentially lead to another commodity bubble in the coming year. If consumers are aware of this problem now, they can effective protect their food expenses by hedging on the cheap agricultural products’ futures contracts now.

Tuesday, April 7, 2009

Healthcare Sector Review

In the end of the first quarter of 2009, I have a few thoughts on the healthcare industry. The healthcare industry is perceived to be relatively secure during recessionary periods because consumers consider most of its products to be necessities. In the past year, this sector has outperformed the S&P 500 by approximately 15%. This index is currently composed of four subcategories—biotechnology, healthcare facilities, major drugs, and medical equipment and supplies.

In Q1 of 2009, the U.S. M&A deal volume was almost double the total volume in Q4 of 2008. However, these gains were mainly derived from two major deals in the healthcare sector—Pfizer acquiring Wyeth for $68 billion and Merck acquiring Schering-Plough for $41 billion. These two acquisitions alone accounted for more than half of total U.S. deal volume. The justifications behind these aggressive inorganic growth strategies were:

• Pharmaceutical firms have been concerned with the pending patent expirations of its blockbuster drugs, which have driven a majority of their revenues. In addition, generic drug competition will continue to drive drug prices down, and negatively impact the profitability of these firms.

• Even during the market downturn, these companies have continually maintained large cash positions on their balance sheets. This financial flexibility enables firms to expand their businesses when investment opportunities arise.

• An additional bonus is the current low stock prices of target firms, which makes them attractive to larger pharmaceutical acquirers.

As a result of these acquisitions, the combined synergies will bolster product pipelines and lower expenses, thus increasing operating margins and partially-solving the patent problems.

President Obama’s $634 billion healthcare reform plan calls for health coverage affordability. The savings will come from quality incentives, efficiency and accountability, and shared responsibility. In particular, the U.S. government has increased Medicaid rebates from 15% to 22%; however, Medicaid sales as a percentage of overall U.S. pharmaceutical sales remain relatively small (less than 10%). In addition, federal law requires these healthcare companies to pay specified rebates for medicines reimbursed by Medicaid in order to provide discounts for certain healthcare facilities.

In the coming months, the federal administration also plans to crackdown on U.S. companies’ ability to avoid taxation on international earnings. Consequently, Obama has aimed his efforts to shut down offshore tax abuses, which currently amounts to $100 billion each year. This will negatively affect the large pharmaceutical companies that generate a significant portion of sales abroad.

Some people may believe the opposite view, but I can see the healthcare industry will face a certain amount of pressure from the government in the coming year.

Wednesday, April 1, 2009

The Global Strategy of the Dragon (Part 2)

Continuing with my discussion of China’s most recent economic and investments strategies last month, we can see that this month, China has been stepping up its efforts to achieve its goal of becoming a global economic leader as well as actively participating in more global economic affairs.

In early March, amid the slowdown in foreign investments, the Chinese government announced a decision to lower its conventional heavy bureaucratic hurdles for foreign companies and allow local governments to approve certain foreign investments, shifting control away from Beijing in a move to ease foreign investment at a time when it has been declining sharply. Under the new rules, foreign businesses setting up an investment company with registered capital of less than $100 million will need to seek approval only from local commerce bureaus. The rules will create greater transparency of approval processes on a local government level and attracts more foreign investments.

Foreign investments have been vital for providing jobs and introducing new technology and management practices. However, amid the global financial crisis, China cannot solely rely on economic growth stemming from foreign investments, but rather in conjunction with domestic demand. During the annual meeting of the National People’s Congress (NPC) in China in mid-March, which delivered the 2008 government work report and 2009 economic and budget plan, China’s Premier Wen Jiabao stated that China must significantly increase investments and government expenditures to stimulate economic growth, improve people’s lives and deepen reform. Even though there are no major changes from the existing objectives and expansionary policy framework set last year, I think the Chinese government can achieve its objectives by expanding its expansionary monetary policy which aims for credit growth. With China’s new loans extended in February came in at $1.03 trillion yuan which grew strongly to 24.2% from 21.3% in January, I believe this loan growth will remain positive while slowly decreasing in the following months for two reasons.

First of all, we can expect China’s budget surplus will decrease as the government plans to use cuts and rebates to ease tax burdens for businesses and individuals. This would be the most efficient way to release consumers’ purchasing power and boost consumption, especially for the urban middle class. If the Chinese government wants to maintain an 8% revenue growth while reducing tax for businesses and individuals, the only achievable way is to provide that businesses and individuals will increase their borrowing needs.

Secondly, with the $4 trillion yuan the Chinese government’s stimulus package starting to show some positive effects, China’s manufacturing indicator – the Purchasing Manager Index – showed an ease in dropping in February and reflected some signs of stabilization and recovery. Moreover, China’s fixed-asset investment exceeded the market expectation with a growth of 26.5% from a year earlier. In my opinion, with more investment projects to start in the coming months, businesses should increase their borrowings. Therefore, with both increasing businesses and individuals expenditures, the loan growth can be maintained at a firm level while slowly decreasing throughout the year.

In order to cope with oversupply and under-demand in the Chinese economy, another significant economic reform highlighted by the premier during the NPC is the industry revitalization plans announced over the past couple of months. In addition to conventional monetary and fiscal policies that focus on boosting demand, these revitalization plans from the Chinese macroeconomic management are largely focused on reducing overcapacity through two measures to facilitate supply control: mergers and acquisitions, and increasing national strategic reserves of various commodities.

First of all, in an economic reform generated by mergers and acquisitions, big state-owned companies with close relationships with the central government will be most likely to survive in the consolidation waves while small companies, especially those that are not state-owned will be restructured and acquired by the big state-owned companies. This process enables enterprises to preserve the overall industrial profit margins. As part of the supply control, the Chinese government raised gasoline price to encourage competition among fuel suppliers and better reflect supply and demand. It also helped to protect the domestic refiners’ margins and prevent them from incurring losses, which in turn the government will have to provide more subsidies to the refiners.

Secondly, in terms of increasing national strategic reserves of commodities which I correctly predicted in my China’s strategy discussion last month, China has started to build up its sugar reserve inventory in March to 2.8 million metric tons to secure an adequate food supply. This measure not only comes at a time when commodity prices are low but also helps the government to prepare for any unforeseen disasters that would severely drop the global sugar production. The success in both measures would be able to bring supply and demand back to equilibrium.

In late March, China raised the heated debate of substituting the U.S. dollar’s dominant currency status with a new reserve currency. China’s central bank governor, Zhou Xiaochuan, called for moving toward a super-sovereign reserve currency, or one that doesn’t belong to any particular country, and expand the International Monetary Fund’s Special Drawing Rights (SDR) – a kind of synthetic currency whose value is determined by a basket of major currencies – by including the Chinese yuan. According to Zhou, moving to a reserve currency that belongs to no individual nation would make it easier for all nations to manage their economies better because it would give the reserve-currency nations more freedom to shift monetary policy and exchange rates. Even though this is a possibility, it would take a long time for this global currency reform to take effect. Moreover, though a move towards global currency reform may detract from the dominance of the U.S. dollar in the foreign exchange market, it may not necessarily be a bad thing. By losing the dominant status in the foreign exchange market, U.S. dollar would depreciate, making its exports relatively cheaper and more price-competitive than those in China. If this were to occur, it would beneficially impact the U.S.’s current trade imbalance and reduce its trade deficit. While it is still early to draw a conclusion of its technical feasibility, this currency debate will surely mark the beginning of a new era when emerging markets, especially China, are developing capabilities to lead major reforms in the international monetary system.

Paving the way for China to assume more active participation in the global economic platform, most recently, China expressed its willingness to add funding to the IMF to help developing countries hurt by the financial crisis and also to buy bonds issued by the IMF. However, with sufficient liquidity on China’s hand thus more leverage in negotiating, China wants to have more voting power in IMF in exchange for the new funding. If these objectives are achieved, it will provide more influence to China in the IMF and global finance in the coming decades.

Although China’s aggressive policy stimulus remains absolutely crucial in terms of China’s economic outlook, its strength of recovery still hinges on that in the developed economies. If the developed economies fail to rebound in the second half of this year, it will hinder China’s economic recovery and will require more policy stimulus on top of the existing package in order to sustain a rebound. But with China's stronger influence in the overall structure of the new global financial system, surely China’s international economic and finance position will gain more credibility and exert more impact over this economic downturn and in the future.