A China in a Bull's Shop

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.


After its own stock markets closed on January 12th, the PBOC (People's Bank of China) ordered a boost in the yuan reserve requirement ratio for banks by half a percentage point. U.S. stocks immediately sold off on the news, gold dropped $15 in only minutes, and the U.S. dollar also declined. The market viewed this as the beginning of a tightening cycle on the part of the Chinese. While analysts are debating this, it is almost certainly true. Claims that China beginning to tighten monetary policy now will be able to head off future inflation however are grossly overstated and can be put in the category of wishful thinking.

When it comes to bank lending, China has the opposite problem of the United States. Banks in the U.S. have yet to start lending again despite half a dozen support and giveaway programs from the Federal Reserve and Treasury Department that are meant to encourage them to do so. Bank lending in China is surging out of control though. Lending in the first week of 2010 was greater than the entire month of November 2009, which in turn was already strong. Analysts claim that PBOC's move will remove 200 to 300 billion yuan from the banking system. Bank lending in the first week of this year was 600 billion yuan, so the drop in liquidity caused by the new rules represents taking away half a week of lending. That should be about as effective as trying to take down an elephant with a fly swatter.

Only a significant change in monetary policy is going to have any impact on future economic numbers. Central bank interest rates are either zero or close to zero in most major economies. Raising that number half a point, a point, even two points still indicates an easy money policy. Even that is not going to happen in the foreseeable future. China itself uses interest rate hikes to cool down its economy and last did so in 2007. It has yet to start a new tightening cycle. Starting that cycle won't be enough to stop inflation either. Inflation is an insidious phenomenon that takes years to work its way through an economy. There is as much as a four-year lag between a period of easy money and a first peak in the inflation rate. That takes us at least to 2012. In the 1970s U.S., money supply expansion peaked in 1971 and inflation peaked nine years later in 1980. Trying to control inflation after money expansion has occurred doesn't work, unless severe measures are used.

Governments also fail to control inflation because they fail to focus on the cause. In China's cases, they froze their currency at the beginning of the Credit Crisis, so it is extremely undervalued. Keeping a currency at too low an exchange rate is highly inflationary. When inflation shows up in China in the not too distant future, the key to stopping it will be to significantly value the yuan upward. Other measures will prove to be ineffective, but like most government throughout history, China is likely to take the easy way out and avoid taking the necessary steps needed to reduce inflation.

As an interesting aside to China's bank announcement, it should be noted that the yen is selling off against the U.S. dollar. Almost every other currency is rallying against the dollar and some very strongly. It is quite clear that this was part of some central bank maneuver to drive down the yen. The large drop in the price of gold, which took place in minutes on the 12th, also required a large amount of capital backing it. Central banks have that large amount of capital. This ordinarily would have rallied the U.S. dollar strongly, but didn't. Manipulating the gold market is one of the old reliable techniques governments use to support the U.S. currency. Central bank actions rarely impact the markets for too long if there is no fundamental support backing up their moves. When the U.S. stops borrowing and printing money and raises interest rates substantially, real support for the dollar will exist. Until that happens, the long-term downtrend will continually reassert itself.

Disclosure: Long gold.

NEXT: 2009 Retail Sales Deconstructed

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.