“Thinking about fundamental risk also reduces the “black swan” element of investing. Nassim Taleb defines a black swan as a highly improbable event with three principle characteristics: 1) it is unpredictable; 2) it has a massive impact; and 3) ex post explanations are concocted that make the event appear less random and more predictable than it was.

“It should be noted that some black swans are a matter of perspective. Rather than genuine black swans, most financial implosions are the result of “predictable surprises” . . . Like black swans, predictable surprises have three characteristics: 1) at least some people are aware of the problem; 2) the problem gets worse over time; and 3) eventually the problem explodes into a crisis, much to the shock of most.

“The nature of predictable surprises is that while uncertainty surrounds the details of the impending disaster, there is little uncertainty that a large disaster awaits.”

China’s debt-fueled speculative bubble is likely to be yet another victim in a long list of predictable surprises.  As we discussed in a Cautionary Fable last year, forecasting the timing of such trend changes is always a challenging (and frustrating) exercise.  But just because the timing is questionable doesn’t mean the risks should be ignored.  More often than not, investors are rightly focused on the odds that circumstances turn negative.  But every so often, it is much more important to consider the consequences of these low probability events.  With so many believers in today’s Chinese growth miracle and China’s path to world dominance so obviously clear, risks to the downside are not immaterial, yet insurance to hedge against such a risk is almost free.

Consider that China’s local government debt load has increased by 36 times in nominal terms and five times relative to GDP since 1997.  In just the last three years, total liabilities of local governments have mushroomed from 17% to 27% of GDP based upon the State Council’s Audit Report. With more than 80% of those borrowings going to infrastructure, it’s difficult to imagine that the return on investment for each additional project has not declined.  Aggravating this debt load, about one quarter of it is promised with land sale revenue, making today’s real estate bubble even more detrimental to the command economy.  Defaults are already happening, even with economic growth rates hovering near 10%.  According to Reuters, China’s regulators plan to shift 2-3 TRILLION yuan off local government balance sheets – a massive bailout that is multiples of TARP relative to China’s GDP.  With monetary conditions in China now tighter than the 2007-2008 peak and a global economy much more fragile today, we wonder how fast this number will increase once slowing credit actually stalls economic growth.  Consider that in 1999, after borrowing and binging through the 80s and 90s, the NPL ratio of the Big 4 Banks was a massive 39% or roughly 20% of China’s GDP from 1988 to 1993.  For China, this was a huge sum of money, equivalent to 25% of foreign reserves at the time.  Contrast that with the banks current “reported” NPLs near 1% . . . and consider that Fitch reports bad loans could rise to 15% to 30% of assets.

Consequently, we think a small investment today can serve as an effective hedge on a much larger portfolio, in case the global economy’s locomotive hits a speed bump along the way.  That being said, we are much more comfortable taking larger positions when we can say with confidence, “This is going to happen.”  I’m not sure I can say that with confidence about a yuan devaluation, but I can say that the odds are currently much higher than what Mr. Market is offering today. Aussie housing is one of those “near certainties,” with or without a Chinese hard landing.  And it appears that the risk in the Australian property market has elevated sharply over the past year.  Part of this may be attributable to the slow-down in China.  Part of it may be attributable to the Australian banks’ reliance on European financing. Or it may simply be bursting under its own weight, with a little help from the RBA and higher rates. Whatever the cause, the evidence is right in front of anyone who cares to look.

Gold Coast beachfront values have plunged by as much as 50 percent since the peak of the boom in 2008, states The Australian Newspaper Online. We are beginning to see signs of the “blame game” emerging even as we are very early into the expected decline in property prices – check out the collapse of Ray White Broadbeach. Despite claims of a “housing shortage” which is typical of just about every housing bubble, Real Estate Institute of WA president Alan Bourke said that there were now thousands more properties on the market than needed to meet demand. Meanwhile, real estate agents are cutting their sales commissions to compete for fewer buyers – some below one percent. Major banks have warned that loan arrears have increased, real estate data shows house prices in affluent suburbs have fallen more than the overall market and new loans have dropped sharply. High-income earners are also experiencing mortgage problems but nobody is talking about it – they are financially overstretched and quietly making lifestyle changes, deleveraging and selling investments to reduce loans and other debt, and avoiding unwanted public attention they would have if they had to foreclose on their mortgage.

Coming back to China, the 1880s – 1890s boom provides an interesting parallel.    In 1890, more than half of Australia’s exports went to Britain, with wool making up the majority.  This concentration of exports was a critical vulnerability then, as it is now.  Today, Australia’s exports are again dominated by commodities (iron ore) and its future is almost entirely tied to its largest customer, China.  That said, the magnitude of the housing boom in the 1880s is dwarfed by what we’ve seen in the past two decades – where prices have more than doubled in real terms versus a gain of a third the first time around.

Then, the withdrawal of foreign capital served as a catalyst for recession, credit crunch and price declines.  Today, Australian banks find themselves in an eerily similar position – almost entirely reliant on foreign funding (chart below from RBA), which Moody’s recently cited as they downgraded the major banks.  “With the domestic economy increasingly biased to the commodity sector, terms of trade that are exceptionally favorable by historical standards, and high asset prices, there is a potential for confidence shocks to impact the bank’s access to funding.”  We believe slowing Chinese demand will be a catalyst for an abrupt reversal in Australia’s terms of trade, likely followed by a collapsing currency, vanishing foreign capital and significant stress on the banking system.  Aussie bank CDS look very cheap relative to global peers.  The sovereign looks even cheaper when one considers the potential cost of a bank bail-out.

Disclosure: At the time of publication, the author was short the Chinese Yuan, Australian Dollar, various Australian financials and long Australian interest rates via traditional and derivative investment vehicles, although positions may change at any time.

Our friends at Research Edge referred to this weekend’s announcement as The Keynesian Elixir.  Wikipedia defines an elixir as “a sweet flavored liquid used in compounding medicines to be taken orally in order to mask an unpleasant taste and intended to cure one’s ills. Elixir in the noun form means a drink which makes people last forever.”  In this case, the Euro Elixir is masking the unpleasant aftertaste of unintended consequences.  The cure will buy some time, but will emphatically, not last forever.  Per John Hussman this AM:

Looking at the current state of the world economy, the underlying reality remains little changed: there is more debt outstanding than is capable of being properly serviced. It’s certainly possible to issue government debt in order to bail out one borrower or another (and prevent their bondholders from taking a loss). However, this means that for every dollar of bad debt that should have been wiped off the books, the world economy is left with two – the initial dollar of debt that has been bailed out and must continue to be serviced, and an additional dollar of government debt that was issued to execute the bailout.

Notice also that the capital that is used to provide the bailout goes from the hands of savers into the hands of bondholders who made bad investments. We are not only allocating global savings to governments. We are further allocating global savings precisely to those who were the worst stewards of the world’s capital. From a productivity standpoint, this is a nightmare. New investment capital, properly allocated, is almost invariably more productive than existing investment, and is undoubtedly more productive than past bad investment. By effectively re-capitalizing bad stewards of capital, at the expense of good investments that could otherwise occur, the policy of bailouts does violence to long-term prospects for growth. Looking out to a future population that will increasingly rely on the productivity of a smaller set of younger workers (and foreign labor) in order to provide for an aging demographic, this is not a luxury that our nation or the world can afford.

“Failure” and “restructuring” mean only that bondholders don’t get 100 cents on the dollar. We can continue to bail out the poor stewards of capital who voluntarily made bad, unproductive investments, and waste our future productivity in order to make those lenders whole, or we can turn the debate toward deciding the best strategies for restructuring existing debt.

And the skeptical David Rosenberg raises the following concerns in his morning commentary:

Beyond today’s knee-jerk reaction, there are issues left on the table. The emergency measures just announced buys some time but should help take some of the fear and illiquidity out of the market over the near-term. However, what were not addressed are the intense structural fiscal problems plaguing much of the Eurozone.

In the final analysis, if the EU lends money to Greece or to any other problem country in the zone, debt ratios (including contingent liabilities) in the region will only rise further. It will be interesting to see how the rating agencies end up handling this. It cannot be lost on them, or the global investment community, that while loans, guarantees and central bank provisioning can deal effectively with liquidity issues, they are ineffective in addressing what’s really at stake here, which are structural fiscal issues. So the deal over the weekend is only going to be successful insofar as they are backed up by meaningful reforms (it must be emphasized that the rescue package critically hinges on the Club Med countries accepting deep budgetary retrenchment notwithstanding their weak economic structures. Indeed, it will be interesting to see how Spain can manage to meet EMU deficit requirements at a time when the unemployment rate is currently at 20%, just as one example.)

Since the ECB has come out and said that it will buy both government and corporate bonds, then what is clear is that any rally in the Euro should be faded because the lines between fiscal and monetary policy has just become blurred. The cost of the ECB helping drive long-term yields in the periphery lower is jeopardizing the sanctity of the central bank balance sheet. And, just as the Fed has ceased in expanding its balance sheet, the ECB is set to expand its balance sheet, and this is a Euro-negative. Of all the knee-jerk bounces today, the Euro is the one most vulnerable to reversal.

Although the measures will help mitigate the growing dangers of contagion in the Euro area, the IMF/EU loans come with a “strong conditionality” with respect to intense budgetary restraint and structural fiscal reforms. The massive package of loans and guarantees buys time, but the issue of whether the austerity package for Greece will be accepted by the public (almost half do not approve) is still up in the air. Portugal and Spain are in need of credible packages to cut their deficits. This will exert an enormous fiscal squeeze across wide swaths of the Eurozone and require a weaker Euro as an antidote.

Against this backdrop, the threat of default and concerns over the future of the Euro will not dissipate entirely. The region, especially the Club Med partners, will be in for a long period of extremely weak economic growth.

Obviously, we agree.  The Euro dropped from about 1.33 to 1.25 since we suggested that investors Remain Calm – “the Euro still has a ways to go before reaching fair value on a purchasing-power-parity basis.  Given the prospects for an extended deflationary period ahead, we think the odds of a downside overshoot are “strong to very strong.”  We are not there yet.  Sell the bounce.

Disclosure: At the time of publication, the author was short the Euro, although positions may change at any time.

1. Tron Lincoln – American

2. Boba Fett Dollar – American

3. Sparta $ – American

4. Iraq Dollar – American

5. Tron – Canadian

6. Donnie Darko  Rabbit -Canadian

7. iPod Dollar – American

8. Smoking Bill – American

9. Spend More Live Less – Canadian

10. Moth Dollar

11. Dr ZoidBerg – American

12. Ronald McDonald – Canadian

13. Baby Dollar Bill

14. Cartoon Dollar – American

15. Wicked Queen 20 Pound Note – British

16. Mario – American

17. Sofa Dollar – American

18. Museum Dollar – American

19. Pizza Dollar – American

20. El Barto – American

21. Tulip Dollar – American

22. Emo President, 20 Pesos- Mexico

23. Ninja Dollar

24. Alice In Wonderland

25. Clown Five Pound Note – British

 26. 2 Girls, 1 Cup Dollar – American

27. Half Life Dollar – American

28. Teenage Mutant Hero Dollar – American

29. KISS 20 Dollar – American

30. Assassination Five Dollar

We came across an interesting piece from Ned Davis Research recently that increases our conviction for a Chinese currency revaluation.  Recall we first discussed the prospects for a major revaluation of the renminbi here.  NDR compiled the table below to illustrate current economic indicators relative to levels seen in July 2005 and July 2008 – other instances when China changed their currency peg.

Source: Ned Davis Research, Inc.

For individual investors unable to trade currency forward contracts, the Wisdom Tree Dreyfus Chinese Yuan Fund (CYB) remains the best vehicle to position for this event.  CYB is comprised primarily of U.S. government, corporate and treasury bonds; repurchase agreements; and short-term currency forwards.  The fund seeks to achieve total returns reflective of both money market rates in China and changes in value of the Chinese yuan relative to the USD.  While CYB does make income distributions, investors should not expect large movements in value until an actual revaluation takes place, so patience is a virtue.  That being said, when viewed relative to earning approximately nothing in a US savings account – and the near certainty of decaying purchasing power due to reckless monetary and fiscal policy – we are happy to sit and wait.  As we stated in our initial post:

We don’t believe that today’s expectations accurately reflect the yuan’s true trajectory.  To effectively dampen China’s underlying inflationary pressures, exchange rates would have to rise substantially more than levels implied by the market today.  A 50-100% revaluation is even plausible if trends in commodity prices persist, and as history suggests, China overshoots in policy accommodations.

Disclosure:  At the time of publication, the author was long WisdomTree China Yuan Fund, although positions may change at any time.

In just the past few weeks President Hu Jintao has politely ignored requests from President Barack Obama, the president of the ECB and the managing director of the IMF to adjust its currency.  While most of the developed world harps on China for alleged currency manipulation, we believe it is entirely possible (if not likely) that the Chinese have already begun a multi-year process that will accelerate toward the free float of the yuan in the intermediate term.  (We also believe this would occur much quicker if foreign policy makers quit their nagging.)  Perhaps it is because the existing peg has served China so well (through turbo-charged exports) that those of us in the developed world find it so difficult to envision China abandoning it? 

However, the next phase of the Chinese Growth Miracle cannot be achieved using the same old tricks.  For China, the peg (and accompanying dollar depreciation) translates into rising prices for energy, food and a number of other essentials.  As we’ve discussed previously, China cannot readily combat this inflation through traditional measures of monetary policy since the existing peg effectively cedes control of monetary policy to Ben Bernanke & Co.  To make matters worse, as Helicopter Ben pursues an ongoing easy-money, debauch-the-dollar policy in the wake of recurring financial catastrophes, China faces even greater inflationary risks.  Monetary and fiscal stimulus pumped into the government-controlled Chinese economy on a scale that dwarfs even our own unprecedented stimulus efforts, assures the return of uncomfortable inflation as we turn the calendar.  (A number of economic variables we monitor already point to double digit increases in Chinese CPI next year.)

A stronger yuan would help rebalance China’s economy, making it less dependent on exports and putting future growth on a more sustainable path.  But Chinese policymakers understand that there is no free lunch in capital markets.  While concerns of an export sector collapse are overblown, the dollar price of Chinese goods would certainly increase.  And the largest losses would undoubtedly come in China’s vast dollar-denominated bond portfolio.  But importantly, reductions in the yuan price of oil and other imports would more than offset these losses.  Hence, an accelerated depegging would alleviate many of China’s inflation problems, as oil and other commodities would decline in yuan terms, relieving pressure on Chinese consumers and improving the cost structure of Chinese manufactures.

There is no way to know precisely how undervalued the yuan is, but most indications point to a free float at levels much stronger than today’s consensus expectations.  Twelve month yuan non-deliverable forwards currently suggest that traders expect the yuan to strengthen 3% in a year, while the Economist’s Big Mac Index (burgers are much better forecasters than traders) points to a near 50% undervaluation.

Source: The Economist

We don’t believe that today’s expectations accurately reflect the yuan’s true trajectory.  To effectively dampen China’s underlying inflationary pressures, exchange rates would have to rise substantially more than levels implied by the market today.  A 50-100% revaluation is even plausible if trends in commodity prices persist, and as history suggests, China overshoots in policy accommodations.  If such a move seems extreme in light of forecasts made by mainstream blue chip economists, consider that in 1976-1978 and again in 1985-1987, Japan (then the fast-growing, pre-eminent Asian exporter) allowed the yen to double to endure a diving dollar and rising import prices.

China allowed its currency to appreciate 21% in the three years after they replaced a pure dollar peg with a basket of currencies in July 2005, but has kept its currency pegged at about 6.83 per dollar since July 2008 to help sustain exports.  As PIMCO has suggested, “A market-based currency would shift the focus of China’s growth to domestic demand from exports, more efficiently allocate resources and reduce the risk of asset bubbles.”

The introduction and tremendous growth of Exchange Traded Funds (ETFs) provides a cost-efficient opportunity for individual investors to gain exposure to the Chinese yuan through an ETF.  The Wisdom Tree Dreyfus Chinese Yuan Fund (CYB) seeks to achieve total returns reflective of money market rates in China as well as changes in the value of the Chinese yuan relative to the U.S. dollar.

WisdomTree: Case for the Chinese Yuan

Disclosure: At the time of publication, the author was long WisdomTree China Yuan Fund, although positions may change at any time.