Wednesday, November 26, 2008

China Spends Cash While The U.S. Just Prints It

There are some indications that all is not well in China:

China’s biggest interest-rate cut in 11 years highlights government concerns that the country risks spiraling unemployment, social unrest and the deepest economic slowdown in almost two decades.

However, the rate stands now at 5.58%, much higher than interest rates in the Anglo-West economies. There's plenty of room for China to cut more if needed, whereas the U.S. is rapidly approaching ZIRP (a zero-interest rate policy, i.e. the approach that kept Japan's economy anemic for a decade). Interest-rate parity will soon be at work here, sports fans, which means that deploying capital in low-yielding U.S. bonds will look less attractive to Chinese investors.

China can afford other things besides further interest rate cuts:

China’s foreign-exchange reserves topped $2 trillion for the first time, strengthening the nation’s finances as the government boosts spending and cuts interest rates to counter the financial crisis.

Is the rise in reserves due partly to the sudden rise in value of the U.S. dollar? If so, China would be wise to liquidate the dollars in its reserve disproportionately to other currencies as it executes its massive fiscal stimulus plan. The levitating dollar will have to come down as an unintended consequence of the Fed's latest $800B boondoggle:

The Federal Reserve’s new $800 billion effort to combat the financial crisis is designed to make credit more accessible to shaken consumers who aren’t sure they want more debt.

Households and lenders may not respond much because of the wealth destruction from plunging property and stock values, and the deepening economic slump, economists say. That means banks may end up returning the Fed’s new liquidity through deposits at the central bank.

While officials yesterday contested claims that the Fed is undertaking quantitative easing, they acknowledged that the central bank’s new actions will result in another injection of funds into the system. Officials said their objective is to affect credit markets rather than to target money supply.

The point of adding this last excerpt is that China has productive uses for its available savings, while the U.S. must print new money just to stand still. Monetary policy has about a six-month time lag before its effects are felt in the real economy. The inflationary effects of the Fed's quantitative easing should be very apparent by the end of 2Q09.

I believe my overall stance of bullish on China, bearish on the U.S. is valid at least through 2009. China may very well see much slower GDP growth in the near future (as the first article warns), which is why I feel comfortable writing call options on my FXI holdings.

Nota bene: Anthony J. Alfidi is long FXI (with covered calls) at the time this commentary was published.