Generational Dynamics: Forecasting America's Destiny Generational
 Forecasting America's Destiny ... and the World's


Generational Dynamics Web Log for 18-May-05
Stock market frenzy follows Washington yuan-bashing

Web Log - May, 2005

Stock market frenzy follows Washington yuan-bashing

In an almost meaningless gesture, the Bush administration harshly warned China to revalue its currency within a year, with an implied threat of financial sanctions. (For actual Treasury Dept. statement, click here.)

This move has absolutely no chance whatsoever to improve America's financial picture,

Dow Jones index, minute by minute, on 17-May-2005 <font size=-2>(Source: Yahoo)</font>
Dow Jones index, minute by minute, on 17-May-2005 (Source: Yahoo)

Nonetheless, giddy investors used the gesture as an excuse to spike stocks up. As the adjacent diagram shows, the DJIA was relatively flat all day, until about 2 pm, when Treasury made its announcement about the yuan. After that, the index suddenly took off, rising over 100 points in the two hours remaining of the trading day.

Thus ended another wild, volatile trading today, a kind that we're seeing more and more. As we've written lately, this is an ominous sign because it means that investors are making buy/sell decisions based on their view about where the entire stock market is going, rather than on their evaluations of the individual stocks. This kind of volativity occurs before a stock market crash, though it doesn't mean that a crash must occur at this time.

The Treasury Department Statement was issued because Washington politicians have been increasingly vocal in criticizing China for harming America by supplying products at such low prices that factories and jobs have been leaving America and moving to China. China maintains the low prices by fixing the exchange rate for the yuan to the dollar, and not allowing the exchange rate to float.

The statement does not accuse China of manipulating currency exchange rates, but it's so harsh that it has the smell of desperation:

"The report finds that no major trading partner of the United States met the technical requirements of the statute for designation [as being guilty of manipulating currency exchange rates] during the period covered, which is the second half of 2004. However, it would be a mistake to interpret this conclusion as acquiescence with the foreign exchange policies of many of America's trading partners. In fact Treasury is actively engaged with several economies to promote the adoption of flexible, market-based exchange policies and to help facilitate broader adjustment. Most notable among these is China.

China's rigid currency regime has become highly distortionary. It poses risks to the health of the Chinese economy, such as sowing the seeds for excess liquidity creation, asset price inflation, large speculative capital flows, and over-investment. It also poses risks to its neighbors, since their ability to follow more independent and anti-inflationary monetary policies is constrained by competitiveness considerations relative to China. Sustained, non-inflationary growth in China is important for maintaining strong global growth and a more flexible and market-based renminbi exchange rate would help the Chinese achieve this goal.

A more flexible system will also support economic stability, which we understand is of paramount concern to Chinese leadership. China's ten-year-long pegged currency regime may have contributed to stability in the past, but that is no longer the case today, as China has grown to be a more significant participant in global trade and financial flows. Currently, China relies largely on administrative controls to manage its economy controls that are cumbersome and increasingly ineffective. An independent monetary policy will allow China to more easily and effectively pursue price stability, stabilize growth, and respond to economic shocks. China has a history of significant swings in credit-fueled investment and inflationary pressures and these have often ended in "hard landings." Such swings are disruptive to the Chinese economy and may prove more disruptive in the future not only to China but also to the global economy.

A more flexible system will allow for a more efficient allocation of resources and higher productivity. The current system is fueling over-investment and excessive reliance on export-led growth while under-emphasizing domestic consumption. Moreover, much of the investment and capital flows into these favored sectors and projects may not prove profitable under market-determined prices, which could lead to another investment hard landing, more non-performing loans and a weakened banking sector.

And a more flexible system would also quell speculative capital inflows that are costly to China's government and increasingly likely to prove disruptive. China's ability to sterilize capital inflows is increasingly limited and harmful to its banking sector.

Finally, recent history has taught us that it's better to move from a fixed to a flexible currency system during from a position of strength, and not when economic weakness compels reform."

This statement promises economic stability for China if it allows the exchange rate to be more flexible, but almost no one actually believes that.

In fact, analysts at Goldman Sachs and Morgan Stanley called the statement "political" and "counterproductive."

Nor will yuan flexibility help the American economy at all. China will not adjust the exchange rate by more then 3-4%, and since Chinese textile products are 40% cheaper than similar American products, nothing much will change. And even if China stopped exporting textiles altogether, the slack will be picked up by other third world countries with similarly low prices. Finally, America couldn't pick up the slack itself anyway, since some two-thirds of its textile factories have been bulldozed or converted to other purposes. So the Treasury statement will have no effect whatsoever.

There is a precedent for this kind of thing. After the stock market crash of 1929, the public demanded that American jobs be protected from foreigners, and so Congress passed the Smoot-Hawley Tariff Act in 1930 to prevent imports of foreign products, even though economists were overwhelmingly opposed to it. The act did enormous damage, especially to Japan, whose silk industry was completely shut down, resulting in enormous suffering. Japan considered the Smoot-Hawley law to be an act of war, and it was one of the sequence of events leading to Japan's bombing of Pearl Harbor in 1941.

The Treasury statement is just a statement and not a law, so it probably won't do as much damage as the Smoot-Hawley act did. But it's just as irrational.

In fact, nothing about what happened on Tuesday makes sense. IN a world where standard price/earnings ratios tell us that stocks are overpriced by 100%, investors are no longer making rational decisions; instead they're taking increasing risks in order to make some gains, and they're hoping that irrelevant signals like the Treasury Dept. statement will make a difference.

My original prediction, made in 2002, based on generational analysis and standard growth analysis, was that we would have a major stock market crash (DOW down to 3000-4000 range, S&P 500 index down to 400) by 2006 or 2007. This MUST happen sooner or later because stocks are so far overpriced. The rapidly increasing volatility of the market indicates that that day is coming sooner rather than later. (18-May-05) Permanent Link
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