China's devaluation dilemma: where next with the yuan, dollar and the euro?

The yuan is currently pegged to the US dollar in order to keep Chinese goods comparatively cheap in the key North American markets. As long as the US dollar is weak, the Chinese yuan is weak and therefore competitive in European markets. While complaints abound from the US about this "unfair" trade advantage, is it possible China has been blind-sided by the recent euro woes?

The US$-euro exchange rate is also a pillar to global trade. As the euro falls, countries are also under pressure to weaken their currencies. Specifically, China is under pressure to weaken its currency because Europe is the largest consumer of Chinese goods. In order to remain competitive, Chinese companies must reduce their profit margins or hope to make up reduced profits by increases in volume.

To weaken one's currency, one has to sell it and buy another currency. If you're China, would you rather sell the yuan to buy the euro, yen, or U.S. dollar? In this trio, the US dollar is king because it's the least worst scenario being the global reserve currency.

The Chinese government is now confronted with a policy dilemma because it has painted itself into a corner. Which exchange rate should it "manage" for the long term benefit of its export industries? It can either target the US$-yuan or the euro-yuan. It cannot aim for both as it has no influence over the US$-euro rate. As this chapter unfolds, distant images of how another major economic power blew up in the late 1980s with failed exchange rate targetting, from which it has never recovered, loom ever larger: Japan. This lack of control worries Chinese policymakers. This could be one reason why Chinese entrepreneurs have recently voiced their increasing concerns over their own government's US$-yuan policy. There are now bigger and wider issues at stake because entrepreneurs are not willing to invest in a climate of uncertainty.

Every country desires a weaker currency so it can export more goods. However, the only way to weaken one's currency is to sometimes make bad investments. Such economics make sense to a central banker: more exported goods mean more jobs, social cohesion and a higher GDP. So why would you fundamentally weaken your entire nation for one good year of exports? Imagine breaking all the windows in your city so that you will experience a building boom.

If market forces to allow the exchange rate to find their comfort levels are not the answer for China's zest for "control", then an alternative outlet needs to be created to protect the general Chinese investor community from the future vagaries of their export sectors. A safety valve that can stand the test of time. Precious metals are one such avenue.

The LIBOR-OIS spread is signalling a credit crisis could be brewing again...

One measure of the fear in the credit marketplace is the interest rate that banks charge each other compared to the safe overnight rate.

This is measured by the LIBOR-OIS spread. LIBOR is the London Interbank Offered Rate that banks charge each other for unsecured funds as quoted in London. The OIS is the Overnight Indexed Swap, the interest derived from the central bank’s overnight rate. In the U.S., the OIS is based on the fed funds rate.

The difference between these two rates offers a useful indicator of the risk perceived in the markets and the potential lack of trust banks have with each other. The credit crisis showed that big banks can collapse within a matter of days. No bank wants to be put in a position to recover loans to its peers / counter-parties over protracted periods of time and uncertainty because they have suddenly encountered "difficulties" and may not be able to repay.

The Bloomberg chart above shows how the spread was generally a low 10 basis points (0.1%) until the Credit Crisis. After October 2009, the rate returned to those low levels and has stayed low until this May. Was this recent period the “eye of the storm”?

As you can see, the LIBOR-OIS spread has doubled in just the last two weeks, a clear warning that the new turmoil around the Greek sovereign debt crisis is raising risk levels. Given the inter-connectedness amongst the international financial institutions, those with loans especially in the PIIGS nations may face higher borrowing rates as repayment risks increase. German, French and Spanish bankers with overseas loans in these regions therefore could be subject to more sleepless nights.


US Bonds: a safe haven to diversify away from the PIGS (but for 2010 only) ...

What is currency debasement and why gold will be the next world currency?

If the 2008 financial crisis was characterised by private debt being bailed out by public debt (ie borne by the long suffering taxpayer), then who will come to the rescue of sovereign debt? Which government(s) is going to foot the tab on another's profligacy? It seems another floor has just been built on the house of cards.

With this new set of economic machinations, the chart above points to next year’s sovereign debt estimates for the G7 and other key global economies. The U.S. debt in 2011 would be about equal to GDP (US$15 trillion) while the debt loads carried by Japan, Italy and Greece would exceed GDP.

There is a concern among investors that not all is right with the financial world and they don't fully understand it. They think central bankers might be debasing their currencies and so there is an interest developing in gold. If their personal wealth can be affected by the future inflation spawned by the trillions of dollars and euros created to finance economic rescue plans, then the potential implications for gold are profound.

What is currency debasement and how does one measure it? This may once have been the domain of a few old Germans, Latin Americans and Asians to think about. The recent ferocity in which it has struck Mittel Europa has un-nerved many who are slowly coming round to the view the Euro is heading inexorably towards Argentine peso status. It won't be just clattering pots and pans in the streets...the trade union molly-coddled Greeks can attest to something more vigourous.

Here’s one way to look at currency destruction. 10 years ago this week, US$1,000 bought nearly four ounces of gold and today US$1,000 won’t even get you a single ounce (today's spot price is US$1,215). Gold is money, so when you look at the gold-US dollar exchange rate, the dollar’s value has fallen by a startling 70%+ just in the past decade...and that's the global reserve currency!

To hold gold is not about getting rich, but a means to diversify assets and protect wealth.

Acropolis now...the web of PIIGS debt exposed in technicolour

The following pentagram is from the New York Times. Crafted from the BIS (Bank of International Settlements) data, it shows the total debt load of the PIIGS (Portugal, Ireland, Italy, Greece and Spain) nations as at 31st December, 2009 spotlighting how much is owed:
1. between the PIIGS nations themselves and
2. from the PIIGS to the major trading European partners, France, Germany and the UK
Arrow widths are proportional to debt amounts.

The joint EU/IMF rescue package this week of euro 111 billion or US$145 billion (bn) to bail-out Greece has triggered a burning fuse which will have global ramifications. It will leave the much maligned 1990s Asia currency contagion in the dust. There is simply too much interlinked debt in the European financial system at alarming proportions of national GDPs, one wonders how they will ever be rolled-over, never mind paid off.



After Greece, like dominoes, the other PIIGs are about to topple.

It's a sobering thought. EU leadership has been virtually non-existent. The world got a glimpse of this when the Eyjafjallajökull volcano erupted in April and paralysed European airspace for days costing the airlines billions. The Greece situation has merely amplified this.

The value of fiat paper money is waning. We are still some distance from the devastation wrought by hyperinflation in 1920s Germany, 1990s Argentina and 2000s Zimbabwe. It will take magical healing powers for the European financial system to untangle itself and escape the dark forces of dislocation building up within this pentagram.

The watershed moment has finally arrived to fully recognise gold and silver are real alternatives to holding paper money as a store of value.

Today the UK is at a crossroads. A general election with a vital decision to make and action urgently required...

In the tightest United Kingdom general election since 1974, the three main political parties are slugging it out to carve out a mandate to govern this island nation of circa 62 million, the 6th biggest economy in the world.

Speaking on Wednesday at Bradford University, the last day of campaigning, the Prime Minister, Gordon Brown said: "I know there are people who say, or hope, the election is already over. But I tell you that tomorrow is the time for the thousands of people to speak for themselves.

"Tomorrow doesn't belong to the press, to the commentators, to the insiders, to the vested interests or even to the political parties. Tomorrow your voice shall be heard and your vote will determine the direction of this country."

The right to vote in an open and transparent manner is commonly taken for granted in the western hemisphere. In Asia today, with perhaps India, Indonesia and the Philippines excepted, this is still very much a work-in-progress. We should genuflect on the millions of people who aspired and struggled to achieve this vision and did not live to realise their dreams.

During this momentary interlude in the daily heartbeat of a nation, the attention on the economy will rightfully and respectfully take a back seat while the heeled populace makes a beeline to the ballet box and cast a life influencing decision. Today nobody, including the Prime Minister, need be “primus inter pares” (first amongst equals). Amen to that…

Australia's new 40% mining super profits tax...the "Greater China tariff "

On Tuesday, the Australian government levied a 40% Resource Super Profits Tax on its mining industry to take effect from July 2012. The company tax rate would be cut from 30 percent to 29 percent in July 2013 and to 28 percent a year later.

In one stroke, the cost of doing business shot up overnight. The Australian mining sector accounted for $94 billion in exports during 2009, 38% of the total.

Multinationals like Rio Tinto and BHP Billiton were left scrambling in their wake as Australia is a vital cog in their global mining operations. Resource mining is a capital intensive industry and long term planning is essential, sometimes with payback taking many years.

Perversely, is this otherwise a Great China Tariff, a tax to soak the Chinese? The resource sector comprises 9% of Australia's economy. Australia exports 80% of its resources. Who is the biggest buyer of those resources? China. The Chinese bought US$42.4 billion of resources from Australia in 2009.

China is scouring the world for oil, natural gas, copper, coal, and iron ore supplies. It has a desperate need for the raw materials ... and lots of money to toss around in order to get it. Plus…China doesn't just buy products from Australia, it buys mining companies too (US$$20 billion worth in the last 18 months or so).

The proposed Australian super-profit tax reinforces the lesson China learned in 2005 and 2006: the resources aren't yours unless they are in your house. Instead of sending more money on taxes to foreign governments, China will spend that money in its domestic mining and energy infrastructure. Right now, China has no choice but to "pay up" for Australian resources. It has to have them to continue building. But stories like this are huge drivers for China's domestic exploration programs...

China can't replace Australian supplies of iron ore, tin, and oil with domestic deposits tomorrow... but the country does have some excellent prospects.