Washington, DC -- (ReleaseWire) -- 08/24/2015 --BENNET: Chris Whalen is a Senior Managing Director and Head of Research of Kroll Bond Rating Agency. Over the past two decades, he has worked for financial firms such as Bear, Stearns, Prudential Securities and Tangent Capital Partners. He is also an author of two books. The first one, Inflated: How Money and Debt Built the American Dream, came out in 2010. In 2014, he released his second book, Financial Stability: Fraud, Confidence & the Wealth of Nations. On August 14, 2015, Chris published an article titled "China's Devaluation, Simply a Part of a Global Currency War?" in the National Interest Magazine. Chris, welcome to Financial Myth Busting.
WHALEN: Good morning. Thank you for having me.
BENNETT: Let me ask the question from your article's title: was China's devaluation this past week part of a global currency war?
WHALEN: I think it was. It's a reaction to what the U.S. has been doing since 2008. If you ask the question, the Fed fired the first shot. When we dropped interest rates and the dollar weakened considerably, that was really the first shot of a currency war, as my friend Jim Rickards has put it in his own book. And I think it's a reaction now by the Chinese; the Chinese had actually been pegging their currency to the dollar for the past year or more, and it had appreciated quite a lot, so this was more an adjustment on their part to try and get back in the line with Japan and the European Union, which are big customers for Chinese exports.
BENNETT: With weaker than expected export data, as well as the steepest decline in factory-gate prices in the last six years underscoring the extent to which the engine of the global growth in trade has stalled, my thought is that Beijing had no choice but to join this global currency war. The yuan's peg to the dollar is just too painful to maintain.
WHALEN: I think it is. I mean, they were pegging to the dollar because they're trying to get admitted into the big club, which is the International Monetary Fund. They want the Chinese currency to become part of the basket of funds inside the IMF, special drawing rights. So I think they were trying, on the one hand, to become fully part of the club of big nations. But on the other hand, stability and political concerns are ultimately what drive all economic decisions in China. The reason that they've incurred so much debt and they've been spending to build railroads and cities and everything else in China is to try and maintain a certain level of activity and employment, because ultimately they are afraid of social instability. This hasn't changed in years, and it's especially driven their behavior in the past couple of decades. All of the expenditures by the state in China are really aimed at maintaining the control of the communist party.
BENNETT: Do you think that this also means that Chinese quantitative easing is now inevitable?
WHALEN: Well, I suppose. You know, China's economy is not really like western economies. When you lower interest rates in China, you do affect behavior the same way you do in the west, but the notion of banks and credit in China is very different, because everything is ultimately controlled by the state. They can allocate endless amounts of funds internally, and they don't worry about getting paid back. When banks make loans in China, often times if the borrower is politically connected, which is frequently the case, they don't pay it back. There are no banks in China, and the way I like to tell people how to think about this is in the west, we have church and state; in China, we only have the state. There is no counterbalance to their power and their authority. So you've got to always remember that this isn't really a market driven society; it's a very authoritarian command economy, despite the fact that they do allow speculation in stocks, they do allow speculation in real estate, because they're trying to keep that money inside. The leakage in China and the huge flow of financial resources to the west—here in the U.S., for example, in real estate—is an enormous factor, because Communist Party cadres don't want to keep their money in China. They're afraid of the future, so they put it in the U.S., they put it in Europe.
BENNETT: Why do you think the Chinese government is choosing its current time now to improve the parity of the RMB against the U.S. dollar?
WHALEN: Well, I think that what's happened is that over the past year and more, really since the crises, you've had a collapse in the western demand for Chinese goods. Exports are down significantly. They tried for the past few years to focus on internal demand. You had this silly idea of rebalancing, where somehow or another we were going to suddenly see the Chinese consumer replace western consumerism, in terms of demand for Chinese goods. But the reality is that a lot of the demand in the west was driven by debt; the real estate bubble in the U.S., you had similar phenomenon in Europe. And now that we're not willing to continue to accumulate debt to fund the trade imbalance with China, it's hard for them to sell us goods. This entire period, over the last 20 years, going back to the dot-com bubble and before, was in large part driven by the west's willingness to incur debt. The Chinese, on the other hand, had this huge trade surplus with us, and then they recycled that money back into our real estate market during the 2000s. A lot of what drove the bubble in the U.S. was the fact that you had this huge flow of capital from China going into securities, not only issued by the government, like Ginnie Maes, Fannie Maes, Freddie Macs, that sort of thing, but also directly into real estate. And they continue to do this. Same thing with commodities; oil, copper, most of the major industrial commodities, the high prices we saw four, five years ago were driven by demand from China. But now that they're no longer able to finance that, you've seen commodity prices collapse. In fact, I think oil prices are probably going to stay at current level for years.
BENNETT: The People's Bank of China said there was absolutely no economic basis for the yuan's devaluation last week. They also said they aren't going to continuously devalue. Do you believe that this is the last devaluation, or is this likely not a one-time event, but rather the beginning of this ongoing, persistent depreciation of the yuan versus the dollar?
WHALEN: It's an interesting statement they made. I think they're right. I mean, the basis was political, their concern that the slack in the Chinese economy is going to manifest itself in increased social unrest. But I think also the really significant thing about this move is that it brings into question the ability of the Chinese Communist Party to manage the economy. Once they shake that faith on the part of the Chinese citizenry, I think that in and of itself may drive them to continue slowly adjusting the price of currency down to where it was, say, a year, two years ago. And again, think of it in terms of the relationship between the Chinese currency versus the yen, which is a very important relationship for them in terms of trade, and also Europe and the nations of Asia. The Chinese currency has appreciated against all of them, so it's really disrupted their economic relationship with all of these countries, and I think that that's the driver. I think about a 10% adjustment would be about right to get them back where they were, say, 18 months ago.
BENNETT: Will the embedded U.S. dollar short position within the carry trades begin to result in losses and margin calls, as the USD appreciates versus the Chinese yuan? Isn't that going to force investors to liquidate some of their positions?
WHALEN: Well, it may. I think it's interesting; the foreign investors had the same degree of confidence in the stability of the exchange rate that many Chinese citizens had. The surprise was the adjustment and the scope of the adjustment. Usually the Chinese central bank manages the exchange rate very, very carefully and keeps volatility down. What we saw in the past couple of weeks was an extraordinary degree of volatility, and that may, in fact, do exactly what you suggested, which is it may force investors who were doing that long short carry trade with a currency component to have to square up their positions, because they don't know what's going to happen. You may indeed see more adjustment in the next few weeks and months, and I think the surprise factor alone and the fact that investors, both inside China and outside China, now have to factor in a larger degree of volatility and uncertainty, I think is going to change investment decisions.
BENNETT: We're seeing a global currency war, and China, of course, was a major volley. Which country is going to be next to try and compete by weakening its currency?
WHALEN: Well, the context here is important. For the past couple of decades, most of the industrial nations have been using deficits and debt, both privately and publicly, to keep demand at levels that are politically acceptable. So all of the nations now are seeing China adjust, they've seen the euro drop considerably after a long period of kind of extraordinary strength, even despite their economic problems. So now you may look at countries like Australia and New Zealand. You may look at other nations around the world, perhaps Brazil, all of whom have to maintain a certain degree of competitiveness in the international market if they want to continue to export. And this goes back to what we saw in the 1930s. You had a "beggar thy neighbor" sort of problem, because in those days you had high tariffs and you also had currency devaluation aggressively used by many nations, because they faced such dramatic unemployment and other social problems at home. I think we're kind of seeing a replay of that period. And the way I put it in my first book is that you have to understand that the growth rate, the increase in wealth in any society, is usually pretty closely correlated to population growth. And in all of these societies population growth is pretty low. Here in the U.S., it's half of 1% now. After World War II, it was 1.5%. It almost hit 2% at one point, the baby boom and all of that. So it was easy to drive growth when I was a kid; we had inflation, demand-pull inflation, as they call it in economics. But now you have the opposite. You have slack, in terms of labor markets globally, and you even now have slack in commodities that a couple of years ago we thought were scarce, right? We thought we were going to run out of certain of these key commodities, and now prices are falling. So I think deflation is still the general theme. And think about the Fed. I mean, how can they raise interest rates when the dollar is soaring, and you have deflation across most global commodity markets? It's really quite an interesting problem. I think they're painted into a corner. I really don't think the Fed has any latitude at all to raise interest rates.
BENNETT: Are we heading down a dangerous path, where countries are going to engage in a race to the bottom, collapsing, which of course would collapse the global economy? It's been said that the worst part about our currency war is everybody loses. What's your take on that?
WHALEN: Well, that's true. When you race to the bottom, everyone does lose. You know, it's sad, because the periods of maximum growth in the past 150, 200 years have come after wars. If you look at the period after the U.S. Civil War, after World War II, these were all periods of rebuilding, credit expansion, when you saw a lot of growth and also a lot of population growth. Now we're in the opposite situation, where population growth levels, even in China, because of the one-child policy they adopted, are very low. And I think that the real challenge for all of us is how do we navigate this period of slack demand, low commodity prices, and essentially very low growth overall, without ending up in another war? Because, to me, that's the danger, is that you may have politicians in some of these countries who say, 'Well, I'm facing an insoluble position politically at home; why don't we go start a fight with somebody and distract everyone?'
BENNETT: Let's talk about Washington politicians. They're accusing China of manipulating its currency in a bid to strengthen its export market, vis-à-vis the U.S. My belief is that, with their currency pegged to the dollar, if they're manipulating their currency, it's only because they're importing our monetary policy. What's your take on that?
WHALEN: Well, I think that's right. You know, as we said at the start, the Fed fired the first shot in this war by dropping interest rates and weakening the dollar. That's a very significant act, because the dollar is still the dominant means of exchange in the world. It immediately made oil more expensive and other commodities more expensive, so other nations had to react. And I think that for politicians to be criticizing China over the past couple of years for currency manipulation was silly, because they were effectively pegging their currency to the dollar; it was getting stronger. Now if they start that course, I think that that would be a little bit shortsighted, because the Chinese currency is still quite srong, versus where it was four and five years ago.
BENNETT: The U.S. has been embarked on its own monetary stimulus campaign for about seven years now. With indefinite zero interest rates and quantitative easing, aren't we also engaging in a policy of dollar debasement?
WHALEN: Well, we are. I mean, the thinking inside the Fed is driven by a kind of Keynesian socialist construct that really, I think, is at odds with market based economics. You have to remember that the driver of Ben Bernanke's actions early on after the crisis was to try and get the bond market functioning again. If you go back and read his essay in 1983—which is up on the web and it's easy to find—what he talked about was the difference in spreads between government bonds, corporate bonds, and junk. When that relationship gets too wide, essentially the market stops functioning. Now, what happened, though, is they're trying to use low interest rates to get employment—or at least they say get employment—and other basic economic factors to improve, but all we've really done is create a bubble in the bond market, particularly in sectors like oil, where you've had an awful lot of cash raids. We have record issuance in the corporate bond market. The auto sector has also been very hot. So I think that now the Fed needs to raise rates to restore income to savers, to the elderly, to other sectors who have been punished by what's rightly called financial repression, and see if we can rebalance policy a little bit. Because the thing that worries me is we take so much money out of the hands of grandma and other savers, corporate savers, banks, that we're actually driving deflation. We keep taking income out of the system because rates are so low. This impacts banks. I work with banks every day, and I can tell you that over the next couple of years we're really going to hurt bank earnings, because it'll take a long time to restore that income to the system as rates go up, if they go up. My own view is I think the Fed could raise short term rates tomorrow, but then we'd see a rally in the bond market, and you'd probably see the 10-year yields drop again, simply because there's so much cash out there looking for returns.
BENNETT: You spoke about this in your National Interest article, where forecasted that if the Fed raises rates, the dollar's actually going to appreciate against a host of depreciating currencies, and this is an event you likened to a black hole, pulling in loose capital from all over the world. Is that right?
WHALEN: That's correct. I think that, for a lot of reasons, the US is seen as a safe haven. Even though interest rates are very low in the U.S., you've seen an enormous flow of capital into real estate. Here in New York City, for example, the cost to acquire and build a new condominium is $3500 per square foot. Think about that; that's crazy. You could never buy that apartment and rent it profitably. Real estate prices, generally, in the Northeast, on the West Coast are still quite high compared to the income that a property would generate if you rented it. In fact, you'd be under water, because you couldn't make enough money on rent to cover your costs. So I think these are all indicators that say that these asset prices really are excessive, and that as and when the party stops and the flow of capital into real estate, for example, slows, we're going to probably see a correction.
BENNETT: China's move to allow its currency to be weakened can also be viewed as its first step from detaching from the U.S. dollar. Do you think this increase of independence is part of a bigger strategy, and perhaps side-stepping of the U.S. and creating its own currency?
WHALEN: People talk about that, but the reality is that investors and everyday citizens pick the currency where they want to keep their assets based on a lot of factors that have nothing to do with economics; it has to do with the rule of law and basic security. And even with all the problems we have here in the U.S., the reality is we still have a society where property rights and the rule of law are much stronger than they are in most other societies. Vladimir Putin has enough gold, for example, to back his currency 100%. Would people put their money into the ruble? No way, because they don't trust him. And likewise in China, the day you see Communist Party cadres end capital flight and their purchases of real estate in Vancouver and San Francisco and keep their money at home, then that becomes a concern. But when you see today the huge outflow of money from China, because people don't trust the system, I think it kind of weakens that argument. I don't see the Chinese currency supplanting the dollar any time soon.
BENNETT: Thank you, Chris. Chris Whalen's National Interest article can be found on the web free of charge, and copies of both his books are available on Amazon.
All data sourced through Bloomberg
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About Dawn Bennett
Dawn Bennett is CEO and Founder of Bennett Group Financial Services. She hosts a national radio program called Financial Myth Busting http://www.financialmythbusting.com
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