Some good points here, but does Andy just think China will go ahead and empty all the commodity shelves, and not do anything about it. My favorite canary in the mine shaft, copper is now down (despite a slowdown, and brief feeble destocking) to 105,518 MT in LME and Comex today. It's not hedge fund who are pricing either copper or energy right now, their favored game is stocks, bonds, and anti-USD bets.
Asia-Pacific: The Casino
Andy Xie (from the Bahamas)
Long commodities and short dollar remain the dominant trades among most money managers that I have met this week in the US. The large US current-account deficit and a major revaluation by China are the underpinnings for this trade. Because most money managers are on the same side, the only scenario for most to make money would be a major revaluation by China that would fundamentally re-price assets that allow the current positions to be taken off profitably. Otherwise, the long-commodities and short-dollar trades would be zero-sum games.
I believe that China would not revalue its currency for the foreseeable future. Any move toward flexibility would have to wait for the Chinese economy to land and for the speculative enthusiasm surrounding China to cool. And any move toward currency flexibility would not be a significant appreciation and would be balanced in upward or downward bias.
Instead of a major revaluation, I expect the Chinese economy will cool sharply in the coming year due to (1) supply overwhelming demand in property and other major sectors and (2) a sharp slowdown in exports on rising Fed funds rate. The cooler Chinese economy would reduce commodity demand and bring down commodity prices sharply.
The flawed logic for Chinese revaluation
The dream that, when one wakes up some day, Chinese currency will be up by 25% is driving financial speculation in the world today. The theory is that China could raise the currency value to deal with inflation and make commodities more affordable to continue high growth, which would support even higher commodity prices. Chinese revaluation would allow China to take over from the US to drive global growth, which would justify a lower dollar.
The above view is one-sided and ignores the adverse impact on China from revaluing its currency. First, speculation makes the outcome unpredictable. If the revaluation is big enough, overseas Chinese who have parked a massive amount of money in Chinese banking system to speculate in the Chinese currency would withdraw the money to take profit. That would depress domestic money supply and pop the property bubble. If the currency appreciates a little, it would incite more speculation and attract more inflow, which would inflate the property bubble and cause a bigger crash afterwards.
Second, China is experiencing a massive investment bubble, especially in its property sector. Currency appreciation after experiencing a bubble would cause the economy to remain depressed for many years, as Japan saw in the 1990s. It is not logical to appreciate a currency substantially after a bubble.
Third, Chinese revaluation would cause the expectation for commodity prices to rise further, which would make growth even more expensive for China. Hence, the outcome for Chinese commodity users would be the opposite to the current expectation. Financial speculators have run up commodity prices to tax China for growth. Chinese revaluation would only increase their appetite to tax China.
...causes another round of carry trades
What is occurring, in my view, is that there is too much money chasing returns in a world of low interest rates. Even though the Fed has raised interest rate four times, the level is still low and below inflation. The liquidity sloshing around in the hedge-fund community is still massive. What is occurring in financial markets is another round of carry trades (see 'Last Frenzy', October 4, 2004).
The current round of carry trades began in mid-September, when China did not raise interest rate as some feared (see 'Last Frenzy', October 4, 2004). It began with a big rebound in the H-share in mid-September, which prompted most money managers to believe that China would appreciate the currency to deal with inflation and keep interest rates low to sustain demand growth.
Commodity prices followed the H-share index. Copper and oil rallied sharply. The copper fell apart first when China raised margin requirements for copper futures in Shanghai. China's rate hike on October 28 has cooled the oil market.
Short dollar appears to be the last phase of this round of carry trades. Many of the money managers I have met in the past two weeks were convinced that China was selling dollars in preparation of an imminent change in the exchange-rate regime, even though such rumors came before and were proven to be unfounded.
...driven by Greenspan's liquidity
The global economy has experienced a massive liquidity bubble, as the tech burst, '9-11' and the Iraqi War caused central banks around the world to keep interest rates at historical lows and for unprecedented long periods. The liquidity bubble has turned into demand mainly through speculation in asset markets, mainly property. The resulting high asset prices have turned into a consumption boom in OECD economies through the wealth effect from higher property prices and an investment boom in China funded by rapid exports to the OECD economies and capital inflow.
The strong demand growth has led to the high commodity prices and the expectation of Chinese revaluation. The current round of carry trades is a derivative of the strong global demand from the property bubble. As the property bubble begins to deflate, though slowly, the case for the carry trades would weaken overtime.
...on random China rumors
Every other week, it seems, markets move on the prospect credibility for the rumor is usually from someone who claims to have heard from some senior government official. Even though such rumors came and went so many times before, it still works. The reason for the recurring potency of China rumors is because the markets have nothing else to trade on.
China is big and opaque. Everyone can have a strong view on China and it cannot be proven either wrong or right. The best line to explain away the inconsistencies of a view is that Chinese data are not reliable and the real data would support the view.
The most popular misconception about China is that its top leaders are in control of everything. Hence, if you can understand what Chinese leaders want, you can predict what Chinese economy will be. The role of market is lost in this sort of thinking. If market forces are so useless in China, why is China trying to become a market economy?
China has so many government officials. Everyone has an impressive title and has an opinion on everything. When an issue becomes hot, all sorts of people in the government come out to express their views, even on something as serious as the exchange rate. The market interprets what one government official says as reflecting the government position. This is a misunderstanding of how China works. Very few people in the government have real power over important decisions.
China's opaqueness and the abundant supply of official views have created ample ammunition for speculation. As long as liquidity is still ample among hedge funds, there will always be speculation around China. Indeed, China and hedge funds are perfectly made for each other.
...and creating a sharks-eat-sharks world
The level of speculation in financial markets is so high, that I believe it is frightening away other investors. When a market makes a major move, it is hard to tell if the fundamentals have changed or if it is just hedge funds. The uncertainty about the market prices has made most long-term investors unwilling to trade. Hence, hedge funds become more and more dominant in financial markets, increasing the odds that market moves are zero-sum games.
Most of the market moves in 2004 have been zero-sum games. This has led to a new game in the financial markets: hedge funds try to front-run other hedge funds. For example, one could guess what sort of rumor would come out of China and take a position before it comes out. Alternatively, one could take a position and then start a China rumor.
The world is truly a giant casino today. |
