Please, click here to read this article in pdf format:january-21-20111

We had our hesitations about writing today, for nothing new has occurred in the past sessions, right? Or has it…Well, yes, we know, you must be thinking that the recent sell-off in commodities, stocks and rates should be enough proof that perhaps the three key assumptions for 2011 that we presented in our last letter are weak at best…Well….think again.

Has anything happened this week that may challenge the assumption of further consolidation in Europe? No. In fact, we have heard and read many times about Spain’s resolution to inject more capital to its savings banks (i.e. “cajas”) and Ireland may end up paying a lower interest rate on the bailout fund. In the US, the weekly jobless claims data showed that at least, they did not increase. Anecdotally also, the S&P National AMT-Free Municipal Bond Index has withstood the sell-off in risk. Existing home sales data also surprised with a stronger than expected rise. The Philly Fed manufacturing survey remained strong, and leading economic also provided positive news. However too, a weak TIPS auction shadowed the UST market.

Ah, but of course, it seems that the main concern comes from China. Apparently, given the last release of activity data, China is growing even in the face of incipient inflation (officially gauged at around 5%) and investors fear that an interest rate increase is on the works…Who spread this rumor? Why was it spread coincidentally with China’s Jintao visit to the US? We have no idea. Has China not been increasing interest rates unsuccessfully? Yes, they have. Has China not just manipulated the cost of capital (i.e. rates) but also its quantity via increases in the reserve ratio requirements (RRR)? Yes, they have.

Any basic textbook of macroeconomics will teach us that when a country decides to fix the value of its currency, it loses control over interest rates. At least the “real” interest rates…The same applies to credit controls. History shows they have always, always failed. Why would China ignore these facts? Because they have nothing to lose with trying. Because they seek to delay the inevitable. However, today we want to show that these manipulations can actually have the opposite effect, if they are abused. For instance, let’s take their policy of increasing RRR to the extreme. Below, we show the balance sheets of the People’s Bank of China (PBOC) and the Yuan banking system, in a very stylized way. On the asset side of the PBOC’s balance sheet, we find mostly US Treasuries backing the Yuan. On the liabilities’ side, banks’ reserves. On the asset side of the banks’ balance sheet, we find reserves and interest-bearing assets (loans). On the liabilities’ side, deposits and their net worth.

We have divided the process of taking the reserves requirement ratio to 100%, in three stages. In the second one we can see that as loans mature, their net issuance decreases, to boost reserves. We assume here that the process is neutral: Higher funding costs have no effect on defaults and the banks’ aggregate net worth does not need to change. The overall impact is simply a change in the composition of the banks’ asset side of their balance sheet.

As aggregate leverage decreases to the extreme, as we can see in stage 3, the PBOC is simply left with US sovereign debt fully backing reserves. Effectively, all deposits have been invested in these securities. The financial savings of the Chinese people have been coercively “loaned” to the US sovereign. With this extreme example, you start to realize the folly of this monetary policy.

Implicitly, once leverage is taken out of the picture, the PBOC is irrelevant. Legally, it continues to serve as a lender of last resort, but China is left entirely at the mercy of the US Treasury. As the US approaches default, the value of its debt will collapse…and so will the value of the deposits of Chinese citizens! The irony here is that a run against China’s financial system would not be triggered by an internal development. Nevertheless, if the PBOC had to bail out a financial institution in this context (by extending loans and/or decreasing reserve requirements), the increase in money supply would be felt much more than if there was leverage. For on the margin, the new quantity of Yuan being printed by the PBOC would truly stand out.

Therefore, the Yuan would depreciate and it would do so at the worst time, exactly when the world would need a strong reserve currency. The contagion from the US to the rest of the world would be widespread and more violently than necessary.

How would the rest of the world sort this out? Gold would have to fill the void, which is why the recent weakness represents an opportunity to us.

Martin Sibileau