Currency risk: a China's advantage

Every now and then we read or listen in the mainstream media that Chinese companies are overpaying for assets. Or that they are undercharging for contracts - like building infrastructure - they are entering into in many parts of the world . Every so often we hear the same arguments from the western companies that lost in competition to their Chinese counterparts. Quite often companies that lost to the Chinese protest and make accusations about Chinese state subsidies, unfair competition, undercutting, etc. All in all, the prevailing media image of the Chinese investors is that their decisions are not commercially sound (because they are overpaying) and politically driven (by overpaying they are trying to build a political influence). Nothing can be further from the truth. Anyone who dealt with the Chinese knows that they are commercially very shrewd indeed. What is the answer? How Chinese can overpay and still be shrewd. The recent negotiations between China and Russia or Turkmenistan regarding natural gas supplies are good examples.

China is sitting on a mountain of foreign reserves, some 3 trillion of the US dollars in value. Around half of that is in the US dollars. It is impossible to spend or invest such massive reserves, or a meaningful portion of it, without undermining their value. In the current economic conditions there is also a very high risk that these reserves will lose value. On top of that Chinese reserves keep on growing, and if Chinese stopped this process, i.e. stopped buying the US securities, the dollar would have collapsed, so their reserves would have lost very significantly. A solution that China pursues is spending a significant portion of their dollar (and generally foreign) reserves on buying assets representing long term tangible value such as natural resources, or making investments that would allow to derive a long term value, e.g. in infrastructure.

In the process of making an investment decision Chinese investors have to take into account that the money they spend carries a significant risk of losing value. Something around 30% - 50%. So if a seller (or a contractor) asks a Chinese company for $1, it represents a risked value of between $0.50 to $0.70 to the Chinese. This is the fiscal arithmetic of Chinese investors that takes into account their currency reserves risk.

On the other side, western companies, especially US' operate in a different fiscal environment, albeit under the same commercial principles. Even if they make investments with their own money, and more often than not it is borrowed money, they have to account for its costs. For example with an effective interest rate of 5%, $1 investment carries costs for an investor of 5 cents a year. So $1 investment represents a risked value of $1 plus interest.

Therefore facing a competition with Chinese investors, western companies, especially US', cannot compete on price. An investment of $1 represent a spending of 50 to 70 cents to Chinese whilst it represents $1 plus interest to a US or western companies. Assuming all other factors are the same (and usually they are quite close) a Chinese company can pay 1.42 to twice the price that a western company can pay acting on the same level of commercial rationality and soundness.

Such issues fly well above the heads of mainstream media pundits, politicians and even western companies' executives. These issues are very important however. They show how western governments' fiscal policy (especially the US') heavily undermined competitiveness of the western companies in the global economy. It all also shows how China is winning commercial game with the west. Crying about and protesting Chinese uncompetitive "commercial irrationality" will not help as it is... commercially irrational.

The chickens are coming home to roost

Mr Robin Griffiths, technical strategist at Cazenove Capital, told CNBC: "If the (dollar index) takes out the low that was made roughly a year ago I really think that will not only encourage more sales, it will cause a little bit of minor panic. A year ago it was deemed too cheap, if it goes any lower than that it's actually become toxic waste."

The blog readers are invited to read (again) an article published on this blog a year and a half ago: "A US way out?" The pundits are slowly getting the message: the chickens are coming home to roost and the US are doing some form of Chapter 11 to the rest of the world. This is the way the US are trying to recover from "The largest heist in history". It does not look too promising to be successful since it appears that the financial pyramid is too large and its mechanisms too powerful. The relationship between the financial industry and the taxpayer was turned into one akin to loan sharks and their victims. Any new spare financial balance or economic capacity will be eaten by the financial industry.

"To the Simple Man"

In the wake of the Wall Street crash in October 1929 as Great Depression erupted Julian Tuwim wrote the following poem. Ten years later the world was engulfed by the World War Two.

To the simple man

When every wall is hid by many
new posters freshly pasted up,
when ‘to the people’, ‘to the Army’,
in black print stare appeals alarming,
and any dolt, and any pup
will take for gospel each old lie
that one should go and shoot off guns
and murder, poison, rob, at once;
start drumming into all our noggins
the ‘Fatherland’; the mob incite,
bamboozle with bright-coloured slogans,
egg on with ‘Our historic right’,
‘every inch’, ‘glory’, ‘sacred borders’,
with ‘our forebears’, ‘pay the price’,
with ‘heroes’, ‘flag’ and ‘sacrifice’;
when bishop, pastor, rabbi come
to say a blessing on each gun,
for God has told them, that His will
is that for Country – you should kill;
when gutter tabloid screams and rages
in letters huge on its front pages,
and herds of females lose their voice
throwing bouquets at ‘our brave boys’,
– O, my untutored simple friend,
mate from this land, or other land!
Know that the bells for these alarums
kings strike, with girls with ample charms,
Know it’s all hogwash, lies perverted,
And when these call out: ‘Shoulder arms!’
That somewhere from the ground oil spurted,
With dollars soiling the bright colours;
That in their banks there’s something rotten,
They smelled some moneybags, it looks,
Or cooked some scheme, the oily crooks,
For higher import tax for cotton.
Drum on the pavement with your gun!
Ours the blood, the oil is theirs!
And through each capital and town
Scream out, to guard your cash blood-won:
‘Tell us another, noble sirs!’.

(translated from Polish by Marcel Weyland)

The real end of the Empire

It has been said on today's BBC "Question time" that for 200 years Britain had greater budget deficit than now. Even after the World War 2 it was able to build an amazing social system with NHS and social housing. "So what's the bother now?" the host, Mr David Dimbleby, asked.

It appears the there is a significant difference. For 200 hundred years at the time Britain was an empire, a real superpower that controlled its destiny. The financial markets and other lenders to the government at that time had really had to rely on what British government had been prepared to pay. And they had to lend if they wanted to exist. In a way it was a synergy but with Britain, as a state, had an upper hand over the financial industry. Now it is the other way round: Britain is at the mercy of the financial markets. It does not act like a sovereign state but like a minion being bullied by a loan shark. This is a reason why we see savage budget cuts now, and despite that, times are very uncertain indeed.

Globalisation is not a new phenomenon. The British Empire was truly global: "the Empire on which the sun never sets". What changed is who is in charge.

On a slippery slope

This week announced spending cuts on defence in the UK indicate the scale of the current financial crisis. Even, as a result of the previous Labour regime brought about economic disaster, at the end of 1970's the UK did not have to cut its forces that deep. In 1982 it was still able to mount a successful Falklands campaign. In the height of Conservative induced recession of the early 1990's it was able to provide a significant contribution to the First Gulf War. After the defence budget cuts just announced the British conventional military capability will be reduced to symbolic. Only nuclear deterrent will keep British position on the UN Security Council not reduced to a rather indefensible remains of a period when Britain was still a power.

Cuts of public spending in general on a similar scale will happen in other areas. They are also happening other countries like France where a very generous pension age is to be extended from the age of 60 to 65. So be it one might say. Maybe it all makes sense. Maybe it is not in British national interest to remain a significant military power. Maybe rising pension age is good for society. After all people who work longer (in good conditions, of course) are healthier and live longer. Besides industries and businesses propelled by the public sector are usually not the best examples of efficiency and productivity. The point is however not whether such saving and cuts make sense but why they are a financial necessity. Why such public spending cuts are not diverted through tax cuts or other spending to education, research, better pensions, health service, etc.

All the public spending is necessary because of the depth and spread of the financial crisis. This financial crisis is reshaping our social lives. It is done under propaganda of necessity and impunity for all those responsible. There is not much public debate. Having organised a pyramid scheme that pumped the cash out of the economy (and a lot of it is sitting in shadow banking and offshore financial centres), as described in "The largest heist in history", governments have kept taking money out of taxpayers pockets by making cuts and raising taxes, to sustain a pyramid of liabilities created by the financial industry (that incidentally has been funding a pretty good lifestyles of its administrators, i.e. the bankers).

In the UK the Prime Minister, Mr David Cameron, naively believes that this is "taking the Britain out of the danger zone". Nothing can be further from the truth. In fact the bankers achieved what the author of this blog warned about well over a year ago: they control, through mechanisms of the financial markets, the taxpayers in the same way as loan sharks control their victims with bullies with baseball bats. It is not more sophisticated in practice. It is not a socialist view but a laissez-faire perspective. The bankers are running a creeping October Revolution of our times: killing free market-based capitalism and replacing it with a communism for the filthy rich. As the recent Irish experience indicates, they are preparing to come for more. The present improvements of the UK standing on the financial markets after making cuts promises is an encouragement to make further cuts. Once the "markets" judge them deep enough, i.e. maximising a room in the budget to transfer more money to the banks, the "markets" will go the other way. The most obvious mechanism will be through downgrading British rating giving completely free cash to the financial industry. Due to the scale of the financial pyramid the end to this is not in sight. We are on a slippery slope and any talk about a better future is fooling people. Unless it is a better future for the bankers. On the face of it, leaving political wranglings aside, whilst the last Labour administration allowed (or even colluded) the financial pyramid to grow, the current Conservative one appears to sustain it. There is a solution however. But it requires guts, competence and wisdom.

Liquidity v money supply/demand

On 7 October 2010 The Economist published an article "The costs of repair". Its author wrote:

"So far the current recovery is following this post-crisis script. Output is sluggish and credit is growing weakly or shrinking across much of the rich world. But is this because over-leveraged households and firms have become less willing to borrow or because banks have become less willing to lend? In other words, is the credit problem one of demand or supply?"

Then the author concluded: "Both supply and demand probably play a role."

The question is wrong and the answer is wrong too. The problem is neither of supply nor demand but of liquidity: i.e. too high money multiplier makes it too risky to lend and to borrow. Banks do not have money to lend without fear of losing liquidity and money is too hard to come by to repay loans which is putting off prospective borrowers. In terms of statistical analysis (correlation) such situation will show up on both: supply and demand as causes, as both are causally subsequent to an underlying (and overriding) cause which is too high money multiplier (i.e. liquidity shortage). Here you can read more on liquidity shortage caused by high money multiplier.

Hopefully such money multiplier based analysis of the current financial crisis finds its way into the mainstream.

Incidentally it appears that the mainstream economists put too much weight, without understanding, on statistics and real analysis (in mathematics) and too little (practically nothing) on other branches of maths such as topology (that allow to determine relationships between phenomena which are the subject of an analysis). And The Economist and the mainstream media and the politicians are just confused. Little wonder, over 2 years after the Lehman Bros collapse the financial world remains in a mess and the taxpayers keep paying for it: after stimuli, spending cuts. What's next since the end is not in sight?

PS. Interestingly, it was The Economist that wrote the post script to this article. On 22 October 2010 they wrote in Benoit Mandelbrot obituary: "That markets are not Gaussian has now been accepted. Dr Mandelbrot’s interpretation, however, has not. Even if it had been, the bankers might not have noticed. They preferred algorithms to geometry." It is a good step forward. However if The Economist understood what they were writing about they would refer to topology rather than geometry.