Last week, when President Obama signed off on the new tariffs on imported tires from China, an immediate response from China followed.  In short, the action take was protectionist, without merit, and they had the data to support it.  It was a reaction that indicated to me that, they had their ducks in a row.  And spreadsheets in tow.

In recent comments, Thomas Donohue, head of the US Chamber of Commerce added some color to the picture that is now hanging on the wall of the Oval Office.

“This is an agreement we made when the Chinese went into the WTO,” Donohue said. “At the time we were making low-end tires. We don’t make low-end tires in this country any more; it’s not a competitive business for us.”

Although Obama isn’t applying all the penalties he could, Donahue said, “Most people didn’t want to pull that trigger for the simple reason of getting into a trade war, because we don’t make the tires any more. What’s going to happen is the price of tires is going to go up and people may lose their jobs because of this.”

.. and why is he saying this?  why is he worried?

Chinese retaliation could hurt U.S. auto companies, which last year agreed to export more than $2 billion in vehicles and auto parts to China, including thousands of Michigan-made vehicles and transmissions.

.. which aren’t the only only trade relationship(s) that may be at risk

Donohue urged the Obama administration to complete pending trade deals with Columbia, Korea and Panama, as well as finishing the stalled Doha Round agreement with the WTO.

He noted that a Chamber study found more than 380,000 U.S. jobs and $40 billion in potential export sales are at risk if the trade agreements aren’t completed

[...]

The U.S. chamber study also forecast another 120,000 potential lost jobs from ongoing problems over cross-border trucking with Mexico and possible foreign retaliation against “Buy American”

Now, without getting into the politics of this particular issue, my concern here is that we are still facing what is a systematic gap in reasonable knowledge, understanding, and decision making when it comes to the global economy.  It is an issue I wrote on when questions how trade statistics were being measured and used in policy in today’s environment, and how arbitrary the application of different policies could become.

In short, the system isn’t a system, or at the very least the system is not functioning as one, and as a result the credibility of the system is diminished.

It is an issue (tires) that in the short term leads to a situation where two leaders question each other in the open, support the case for the opposition, and show a clear need for changes to be made in how issues will be addressed going forward.

Over the past few months, a new trade related story has begun to pick up steam, the settlement of crossborder trade in various currencies other than the US Dollar.  At first glance it is a story that does not catch the eye, because it is often laden with economic analysis that is less than exciting, however its impact (over the long term) could be significant.

As my good friend Denis McMahon highlights in his article today, Banks Sign Agreements on Yuan Trade, and in his previous piece, China Sets New Yuan-Clearing Process, China has started a process within Asia that would (potentially) remove the USD from trade contracts.  A move that, over time, could significantly reduce it USD surpluses, its need to sterilize vast amounts of USD, and its need to purchase USD denominate Treasuries.

Working on a solution to diversify its currency holdings through trade, this is not be a process that will lead to immediate short term relief for Beijing, particularly those who are worried about the value of the US Dollar.  If successful, it will alleviate future pressure over the short-to-near term from additional USD stock piling, but more importantly, it would build the business case to further expand the program on a wider basis (below the equator economies first) and to reduce the pressure of central bankers to have to offload the USD they currently maintain.

A story to keep a close eye on going forward.

With my post earlier this week graphically showing China’s recent export trajectory, the news that April 2009 saw a 33% Y-o-Y dropmay suggest we have yet to truly turn the corner.

Not only is it 5% more than expected by analysts, it is the first month in the last 3 where the number has eroded from the previous month. Perhaps indicating the dead cat bounce may be over, and we are at the top of the next downhill slide (A topic Andy Xie’s recent piece speaks to).

With only the first reports in, it is hard to give much of an analysis at this point – or more appropriately the context behind the number, however a few lines from the Forbes article Amid Green Shoots, China’s Exports Still Barren offers a few interesting quotes:

The spring China Import and Export Fair, which ended last week, saw orders fall 17% from the fall fair, according to J.P. Morgan.

and

Exports in textiles, toys and plastics have shown signs of improving. But there are concerns that the stabilization is on the back of a restocking of depleted inventories, rather than a demand rebound. Li & Fung, a major supplier of consumer goods to Wal-Mart, said last week that some U.S. customers have been reordering to restock inventory levels, which are down from seven to four weeks, according to J.P. Morgan.

Most concerning for me, given the long term nature of this:

Morgan Stanley analysts have warned that China investors face a profit letdown, as the state-owned industrial sector prioritizes protecting jobs and produces in excess despite depressed prices. That excess output will still need to be absorbed by the West, as Chinese domestic demand cannot rise fast enough. With a boom in bank lending, China is making a “leveraged bet” on Western demand recovery by next year, rather than decoupling, they concluded.

A statement that, if true, would lead me to believe that any further fallout could have a knock on effect that would be greater than planned for. That essentially, China has built in a lot of risk into their plans, and should the plans not materialize for whatever reason, we could see effects whose ripples are large/ wide

UPDATE: From the FT China’s factory output slows in April, it appears that exports are not the only thing to slow down.

With all the doom and gloom that has become the current economic cycle, and the fact that the current cycle largely comes as a result of poor debt management, I have always worried a bit about the long term attractiveness of US Debt as an investment vehicle.

Yes, I will agree that US treasuries have historically been seen as risk free, or as offering the least amount of risk, but it has been clear to me for a long time that China was not all that comfortable taking up as much as they have been.

That they would have preferred other instruments to bring a bit of balance to their portfolio

In fact, it wasn’t more than a few weeks ago that Luo Ping was quoted as saying that they hated their position.

“We hate you guys. Once you start issuing $1 trillion-$2 trillion…we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do.

today, that was taken to a higher level when premier Wen Jia Bao offered a bit of color to what otherwise was a standard NPCC:

“Of course we are concerned about the security of our assets and, to speak truthfully, I do have some worries,” Wen said.

“I would like, through you, to once again request America to maintain their trustworthiness, keep their promise and guarantee the safety of Chinese assets.”

A big statement. HUGE in fact

Seeing this coming early on, I once quipped that the US should just offer Alaska as collateral to keep the Chinese investing.  It has oil, it has clean water in the form of icebergs, it has fish, and it can “almost be seen” from China’s northern border anyway. (I WAS KIDDING… DON’T SEND ME HATE MAIL)

It is clear that the US needs the money (Obama’s plan requires funding), and that the only alternatives were either printing money (Carter era inflation) or keep their Chinese buyer’s happy… or at least reduce the risk of default (Mexican Style).

So, the question now. the real question. Is what does the US need to do at a policy and fiscal level to maintain their credit trust worthiness, and what will be the cost of capital going forward? What should happen were China to finally act in a much larger measure to diversify their risk?

Obviously China cannot do anything drastic as that would cause the dollar to the wrong way, but like any boxer in the corner taking body blows, China is going to look for a way to get out and may need to throw a punch or two to do so.

It only takes a day like today to put force analysts to retrace their footsteps, see where they went wrong when calling for a recovery, and then set off on the path to recovery again.

Today’s numbers that China’s February trade figures have PLUMMETED 25.7 % from February 2008 were stunning.  Especially as orders to the US (China’s largest trade partner) fell off more than 45%…

45 percent

What were the analysts expecting?

5 percent

Imports fell at nearly the same pace, but in anther sign that people have yet to understand the fundamentals of the economy, CNN is saying that this 24.1% represents China’s consumers failing to keep up their end of the bargain.

Interesting considering anyone who is operating or monitoring the manufacturing economy would know that the majority of imports from the world are for goods that are reprocessed for export/ manufacturing.  not for consumption.

LCD screens from Korea, recycled Pulp/ paper from the US, Hard wood logs from Indonesia, and so on.  It is all destined for the manufacturing economy

Why I think this needs to be clarified is that while the 25.7% drop in export number is a measure of past performance, the 24.1% drop in imports is a measure of future performance.  That, and let’s assume exports were going to rebound, imports of materials would need to happen (on a broad base) at least 2-3 months in advance or export.

Thus, I predict two things:
(1) Exports will continue to be at least 20% off for the next two months against their 2008 figures
(2) when the manufacturing economy starts turning around, it will be shown thorugh the imports first and then through the exports (2-3 months later).

In Brad Setser’s recent piece Secrets of SAFE: A sharp slowdown in reserve growth and large “hot” outflows in q4…. I found the graph below

Speaks volumes.

Anyone care to predict the next three splice for M12 2009, M12 2010,  M12 2011?

Prior to the new year, and in preparation for an interview, I asked readers to send in their thoughts on the prospects for the new year.  I received some interesting responses, none of which were willing to do so using their name on All Roads, but I convinced one person to allow me to post them on their behalf as I found the answers very interesting.

What I can tell you is the person who wrote the comments they have a strong basis in economic analysis, investment banking, and China… and has been based in Shanghai for 5 years.

1) What role does China have in correcting the current imbalances?
General status:  China is a major exporter to the world.  US (and West generally) is a major importer of Chinese (and Asian) goods.  This trade surplus naturally leads to an appreciating RMB.  To stop the appreciation, China intervenes and buys USD, which leads directly to its huge FX reserves.  Now China is the largest owner of US treasury debt.

Given that the US (and West) are likely to be facing a heavy economic downturn, this pattern of trade is unlikely to continue.  US consumer can no longer support US and Chinese growth.  Negative impact on Chinese exporters, implies excess supply in China.

China:
* government should push stimulus package
* should strongly encourage domestic consumption
* do not push increasing export-driven growth
* do not push further investment into capital goods (excess supply)
* Should lower trade barriers
* Allow appreciation of RMB
* Allow slow reduction of accumulated FX reserves or actually use FX reserves as fiscal stimulus
* Consider reduction in tax (consumption taxes – VAT tax)
* Government Investment into education, social services
* continue with all the other usual good stuff (transparency, anti-corruption, etc.)

2) What will be the growth rate for 2009 and where will the growth come from?
I couldn’t break out the components of that growth now, so I can’t give you an intelligent answer.

I suspect you’ll see a significant increase in government led investment and consumption.  Construction from what I hear is declining.  A suppose a lot will depend on consumption.

3) If China took an approach to protect its economy first, what steps would be taken?
This would be exceptionally foolish to take a beggar-thy-neighbor policy.  Global macro problems are (almost always) a coordination problem.

Enlightened protecting economy first is as stated above:
- what’s good for world is generally also good for China
- especially in the long term

Not Enlightened “good for China” policies
- protective trade barriers
- promoting national champions
- promoting exports
- RMB depreciation

4) Will China be able to spur domestic consumption, and if so, would that save the global economy?
I would say it would start with aggressive consumption tax cuts, aimed at lower class.  Cut all those taxes on the agricultural economy.  Keep trying to fight corruption, because that deters small businesses from trying.

Would that “save” the global economy?  No.  Not alone.  Serious Chinese consumers are too small a subset of overall economy.  The super-rich here aren’t exactly spreading their wealth around.  The economic dividends system is not progressive enough – rich get stupidly richer — even more so than in America.  World can’t count on consumption by Shanghai and Beijing elite to save global economy.

5) Where are China’s most exposed joints, and where are the tipping points?  what is hiding in the shadows?

Exposure:
- Inflated Asset Markets
- Real Estate ?
- Equities ?

- Financial panic / crisis
- Banks in China may not have had CDOs and credit default swaps, but they’re sitting on plenty of bad debt.
- Many corporates in China are going to get hurt in this process (business damage)
- That is going to have a knock-on effect in terms of credit

- General over investment
- China has a talent for overbuilding
- This can work in a rising environment
- Now they are going to see what over investment looks like in a falling demand environment

- unemployment
- social instability
- lack of safety net
- people’s expectations about future could reverse
- corruption hurts when things are good (it’s not fair, but we’re all getting better), but it’s lethal when things are bad (it’s not fair, and I’m suffering)

Tipping points
- If you start to see high profile bankruptcies
- If there is noticeable rising unemployment effects — like > x% unemployment and enough people are milling around.

6) What sectors offer the most opportunity for foreign firms to participate in the new China?

- If you have interesting technology to bring to China, which you can adapt to China, I think that is still interesting.
- China has problems on a scale like no other country.  So your small idea to make things better, might actually get scale in China
- Of course, most foreign firms probably do not know how to handle China, nor do they know which of these ideas could actually take root in China.

Green technologies
Agriculture
Poverty / low-resource focused

Finance:  highly regulated, entirely dependent on government I think
Internet Technology:  Local competition is already awesome

7) What sectors / geographies offer the most interesting plays for China firms looking to buy global revenue and distribution streams?

Anything in the US
- I imagine US assets are going for a song right now
- This is a good time to make strategic moves, provided you actually have the talent, capability, to handle it
- That being said, you have to do it sensitively considering the environment.  China isn’t going to look good if it is pushing beggar-thy-neighbor policies while trying to take advantage of other countries’ open economic system.

The recent jobs report literally rocked the house on Friday as a reported 533,000 jobs were lost in November.

Particularly noteworthy on Larry King Live, and concerning to me, was that for the first time ever retail jobs were lost in November.  A time that retailers are typically bulking up for the Christmas season.  Which was matched by a report from the International Council of Shopping Centers’ that:

same-store sales index fell 2.7 percent in November from the same month last year. That was the largest drop since the council started tracking the data in 1969.

With China’s economy driving a large amount of income from providing large retailers, and producing many of the consumer items that Americans buy outside of the Christmas season, it begs the questions…

1) What China specific conclusions should be drawn from this report?
2) Are the economic ripples set to get larger?
3) What are the likely actions Beijing will take to cushion its economic exposure?
4) How long can China sustain its current model absent a freak US rebound?
5) Does anyone really believe that Chinese consumers will take up the slack, or is this a US administration pipe dream?

following my earlier post on reports that traffic at the Canton fair was off significantly, here is a CCTV report which provides more details.  There are other articles at FT,China Stakes, IHT, Washington Post, and others.

A few years back a friend of mine was the speaker at a small gathering and he made a comment that at the time was a bit different than the mainstream

He said (and I am paraphrasing), that America created the current global environment without being ready for it.

It was a statement he was making in response to recent calls on China to stop manipulating its currency, that China was stealing jobs, and that China was just not playing fair in the market in a  whole host of other way(tariff barriers, non-tariff barriers, etc).

However, during the summer of 2007, this statement would carry a different meaning as Mattel’s Lead Paint Barbie, FTS’s tires, and IAMS dog food highlighted the fact that there was little infrastructure in place to effectively manage the inspection and testing of goods being imported.

Inspection rates in the single digits were being carried out by Homeland Security, the FDA was a fraction of that, and while the cases were fortunately few… it was only a matter of time before the system was tested again and a failure presented itself.

The Safety Gap, an article from Gardiner Harris at the New York Times, highlights how serious the gaps in the system are when it comes to food and pharmaceutical items.

As a person who avoids pills at all costs, what was disconcerting was that even after the issues of last year, it does not appear that much has changed.

The staff levels are still low, the staff they have are either unqualified to manage the current portfolio of items from China or they are apathetic to the situation, computer programs are not in sync, and even the basic forms have yet to be developed that would introduce the very basics hardware ofa system.

For me, the line that showed just how disorganized the agency was, was:

Customs seizes any steroids and narcotics they find, but they give other drugs to F.D.A. inspectors, who laboriously fill out handwritten forms and send letters to intended recipients. If the recipient swears that the drugs are for his or her own personal use, the F.D.A. often releases the detained package. It takes an hour or two to process each package, “an obstacle that makes their job functionally impossible,”according to a 2003 Congressional investigation

Who handwrites letters these days?  Why not have an intern do this?  Better yet, have the intern write a bit of Access code to create a template that would minimize the need for agents who should be focused on finding dodgy toothpaste to hand write the address on the envelope.

In sum, this is one of the most interesting articles I have seen on the agency side of inspections, and I would suggest everyone read this.

After reading this article, I have a few questions

1) Is outsourcing pharmaceutical ingredients, or complete products in whole, to a country clearly having a history of serious quality issues in the a good idea?

2) Are the numbers of deaths and illnesses an acceptable price, and how do these numbers compare to times before China?

3) If consumers knew where their pharmaceuticals were being made, would that make a difference?

4) When will the US government, and US industry leaders, accept the fact that they have a much larger role to play in the quality control of items imported from other countries?