The fate of the dollar is in the ECB's hands

Outlook:

We are waiting for data. We get housing starts, existing home sales, the FHFA Home Price Index, the Philadelphia Fed nonmanufacturing index and Markit PMI. Will any of it make a difference to the driving forces (i.e., the Fed)? Probably not, but assuming data is good, the mood could improve.

Something else improving the mood is a re-consideration of conditions in China. As noted above, China is about to resume its role as the world’s darling. On Thursday it will issue the first-ever one-year bill at probably 3.3%, according to the FT, raising ¥5 billion or about £509 million. This is cheap compared to 3.65% for Hong Kong HIBOR. President Xi’s visit to London will also wrap up £30 billion in bilateral investment deals, whatever that is. China becoming a player in the global bond market is a Very Big Deal. Okay, the one-year issue is small and short, but who does not think investors will rush to demand this new paper? Everyone who is dumping Brazil, Turkey, and the other big emerging markets will be forming a line around the block. Argentina is so old hat now.

It is probably wrong in a dozen ways to extrapolate the robustness of an economy from its stock market, especially one with low penetration like the Shanghai (fewer than 10% of all citizens engage in equity investing). All the same, take a look at the Shanghai chart (ends at Monday’s close). After the August drop and ensuing government blunders, the Shanghai looks like it’s in recovery mode. Is this the stock market of a country about to fall off a cliff?

The NY Times asserts that “Discordant Financial Messages from China Spur Global Unease”—too many cooks are spoiling the pot. “The situation is complicated by the competition and the lack of coordination among the many agencies charged with managing China’s economy. The central bank, securities regulator, Finance Ministry and economic planning agency, among others, have different agendas and goals. The collective result is that it is difficult to discern exactly what is happening in China. From the outside, officials appear to be reversing course on long-held reform plans that are broadly considered critical for the health of the economy.”

The main grievance is the pace of financial reform and tightening control of state-owned firms instead of loosening or privatizing. And yet in the past few months, China has embraced the foreign exchange market with open arms, if not letting go of the controlled yet just yet. It is setting the stage and selecting the cast, with opening night some unspecified day in the future. We worry that analysts are seeing the glass half empty when there is a pitcher right above ready to make it more than half-full. Of course Chinese leaders must be concerned about slowing growth. But that doesn’t mean they are flinging spaghetti at the wall to see what will stick. To say they are in “distress” is to overstate the case.

Yesterday the US Treasury released the Semi-Annual Report To Congress on International Economic and Exchange Rate Policies ( http://www.treasury.gov/resource-center/international/exchange-rate-policies/Pages/index.aspx.). China gets a lot of the ink, more than any other country. The Treasury estimates that China had a capital outflow of over $500 million in the year to end-August, $200 million in August alone. Compare with 2014, when in the first six months, the outflow was only $26 billion. And in July, August and September, the PBOC intervened to the tune of nearly $230 billion to support the yuan. All the same, the Treasury now judges that the currency is no longer “significantly undervalued” but rather “below its appropriate medium-term valuation.” Consider the size of these flows—outflows are in millions and intervention is in billions.

Bottom line—given rocky conditions, the Treasury thinks the yuan will get weaker before it gets stronger. Former IMF China hand Prasad told the FT the US is in an awkward position. A falling yuan means bigger US trade deficits with China at the same time the US wants to encourage the new free-market reforms. Everybody seems to forget that China is allowing the capital outflow. For many decades, no flow was permitted in either direction. If things get out of hand, China can shut off the spigot again. Recall that in the 1997-98 crisis, all the troubled countries (Thailand, et. al.) went along with the IMF on devaluation, austerity, etc. All but one—Malaysia imposed total capital controls for a year and by gum, it worked. Malaysia did not do it gracefully, but sometimes capital controls are a good thing, which the IMF belatedly acknowledged a few years later. We have no doubt whatever that what is scaring Western economists—capital outflow!—would be addressed smartly if it were actually scaring the guys in charge in China.

Besides, right on schedule, analysts are starting to say things are not as bad as the 6.9% GDP growth rate yesterday may suggest. After all, 6.9% is “about” 7%. And services were up 8.4%, with components like movie ticket sales up over 50%. The WSJ writes “…internet traffic through mobile devices has nearly doubled and railway passenger traffic and civil aviation are increasing steadily, government data show.” Services are more than 50% of GDP for the first time and growing by leaps and bounds. One analyst notes “Twenty percent more Chinese companies reported higher earnings for the most recent quarter than reported declines, in line with the historical median.” We can add that foreign companies struggling (like McDonalds and Yum) might actually be struggling because their products are crummy.

This is not to downplay the capital outflow or the scary stock market slide and mismanaged government response to it, but it is to say sky-is-falling pessimism is not warranted. The IMF says about one-third of global growth can be attributed to China. Not to doubt the IMF, but if services are becom-ing a higher proportion of GDP and already exceeds 50%, surely “dependence” on China going forward must be reduced. Maybe China has overcapacity in primary industries like steel and in manufacturing, but suppliers to those Chinese buyers must have overcapacity, too. Perhaps the drop in commodity pric-es is a normal, long-term cyclical development and not a “crisis” at all.

Let’s say the world changes its mind about China driving the world into the snake-pit and instead shifting the ground under our feet in ways we have not yet foreseen that are not necessarily bad. From Brazil’s point of view as a supplier to China, it may be bad news that China is re-directing its economy from goods to services and also issuing notes and bonds to compete with its own.

But to the developed world and to yield-hungry investors, China’s outreach is a welcome new development, even if we don’t understand it all just yet. Maybe those failing banks and enterprises carrying too much debt can be restructured out of sight behind a golden curtain. It will be interesting to see if nonperformings go down.

China’s Chapter Two, if that’s what it is, doesn’t offer much guidance to FX. At some point we will see the market decide whether the renminbi is overvalued and that will have the appropriate effect on the dollar.

For the immediate future, the fate of the dollar is in the ECB’s hands. We continue to think the ECB is probably pretty happy with QE so far, as shown by today’s survey results showing lending conditions are easing. It ain’t broke, let’s not fix it. The ECB is probably less happy about the euro rising, but we doubt it would enlarge or extend QE for that reason alone. What we may get is a change in the negative deposit rate, currently -0.20%. That would be a pro-growth initiative and goose lending further. But not upsetting apple carts is a standard central bank stance, so probably not. We guess the dollar continues to slump against the euro even as it rises, probably, against the Other Dollars and peso.