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Will the Yuan's Rise Accelerate after Breaking 7.0?
The Chinese CNY (also known as yuan or renminbi) broke below the important threshold of 7.0 to the USD last week, closing at 6.9990 on Thursday, the first time since China devalued the yuan to 8.7 yuan per dollar from 5.8 in 1994. China's central bank (also known as Peoples Bank of China) has been cautious after the break, fixing the daily official CNY rate back to 7.0012 on Friday. This move could be a gesture by the central bank to signal its continued intention of a gradual and measured CNY appreciation.
China unpegged the CNY from the USD on July 2005 with a one step revaluation of 2.1 percent. Since then, the CNY has additional gain of more than 18 percent. The yuan has risen 4.4 percent so far this year, or a 17 percent annualized rate. Reflecting this excitement of faster appreciation, the NDF (Non Deliverable Forward) market has priced in consistently more than 10 percent annual appreciation for the past couple of months.
Why the Fast Pace?
So what has caused the exceptional fast pace in 1Q 2008? The first obvious factor is the overall weakness of the USD. Almost all major currencies had gained against the USD for the first four months this year. The EUR had gained 8.6 percent, while JPY had surged 9.5 percent year-to-date. In comparison, the CNY has not appreciated that much.
Second, curbing inflation has been a macro policy target since last year. The Peoples Bank of China's Q4 monetary policy report cited strong inflation pressures and said that the CNY should be allowed to play a bigger role in balancing international payments and the economy. As a result, Beijing has tolerated a continued stepped-up appreciation of the CNY as a way to restrain inflation. In December, China's CPI was 6.5 percent. In January, it rose to 7.1 percent and the February figure is expected to be around 8.5 percent.
Another important factor is that capital inflows from the trade surplus and foreign direct investment have increased the demand for CNY and accelerate its rise. This is evidenced by China's record increase of reserves during Q1 by $154 billion as the central bank buys the bulk of USD flowing into China. March FX reserves rose to new monthly high of $1.68 trillion, dwarfing last year's average monthly rise of $38.5 billion.
The increased inflow had a lot to do with the annual $50,000 foreign exchange conversion quota. Many Chinese households rushed to make use of their quota in Q1 with the expectation that the conversion rate will get worse later as the CNY continues to appreciate. Anecdotal evidence also suggests that another source of inflow is coming from Hong Kong, whose citizens may transfer 20,000 CNY a day into an account in mainland China. For companies operating in China, borrowing in USD and repaying in CNY is becoming a very profitable exercise. As companies convert these loan proceeds into CNY, it adds to the USD inflows.
For the first quarter of the year, exports grew 21.4 percent to USD 306 billion. With no sign of adverse near-term impact on export by a stronger CNY, the authorities had an increasing level of confidence in allowing a slightly faster CNY appreciation.
Will the Fast Pace Continue?
The question: now that we are below 7, will the CNY continue its fast appreciation pace for the remaining of 2008? The present momentum might keep the CNY strengthening at a brisk pace until the end of June. But its annualized rate of appreciation in Q2 will likely moderate down to around 7 percent.
The first moderating factor is the possible USD recovery towards the end of 2008. As the broad weakening of USD had helped the CNY, a USD recovery, particularly against the major currencies, will ease off the pressure for faster CNY appreciation. Recent trading patterns have indicated a possible topping of EUR-USD at current high levels. And any initial signs of economic weaknesses in Europe and Japan and increasing concerns of concerted intervention by central banks will ease the downward pressure on the USD.
The second factor is that China's trade surplus has been flat or falling for 18 months. Surplus for Q1 shrank to $14.4 billion from $46.5 billion in Q1 2007. If this trend continues into 2008 – 09 as the world economy slows, China will be under less political pressure from other countries to allow faster CNY appreciation.
Third, China's army of small and medium sized enterprises (SME), which together account for 60 percent of exports, are facing multiple shocks causing many to go belly-up this year. Apart from rising raw material prices and higher wages, uppermost of these shocks is the surge of the CNY. Coupled with slowing demand in major markets such as U.S. and Europe, many may go belly-up this year. Chinese authorities may thus choose to rescue these SMEs to promote economic and social stability by slowing the pace of CNY appreciation.
The risk of a sharp turn for the worse in global demand might cause the authorities to put off the effort of using a stronger CNY to reduce the rising import cost and curb inflation. A declining global growth would ease price pressures and reduce the urgency to fight inflation. In any case, recent CNY strength showed no near-term impact on the CPI with CPI now above 8 percent.
In view of the above, for the rest of 2008, CNY might not appreciate as fast as the past four months.
— Fernand Kong, Manager of FX, Silicon Valley Bank's Global Financial Services
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Flying Solo
Called lifestyle businesses or peopleless enterprises, one-person companies are becoming increasingly common as the Internet allows entrepreneurs to leverage their limited resources for everything from marketing to customer service. Owners depend on high-speed connectivity and mobile applications to work from anywhere and create virtual teams and partnerships. They also rely on their customer bases/user communities to help with essential operations. "There's an entire generation of workers coming into the business world who have no intention of working 20 years for other people. They have grown up assuming that their work lives will contain a great deal of autonomy," notes Terry Loier of WorkingSolo.com. (InformationWeek)
Mobile Diversity
A recent Gartner study found that the user profile to which most mobile products are targeted is a Western adult male between the ages of 30 and 64 — a mere 32 percent of the market. However, mobile products should address gender and ethnic diversity to develop a full range of differentiated consumer solutions. The research firm predicted that by 2015, people will customize 90 percent of the information and tools they use at work and that the progression of the worker population towards younger individuals and women will force organizations to rethink their working structures and processes. (BusinessWire)
Stem Cell Roadmap
Last week FDA advisors began to draw a blueprint for how embryonic stem cell tests will be conducted. This is an important regulatory step that could lead to human testing as early as this year. At the hearing, the FDA said that any therapies must have very compelling data in order to move into human trials. The FDA's caution is due to stem cells' possible side effect of producing tumors. Because of the "potential risks" of human embryonic stem cell products, data showing a drug's effectiveness "may need to be particularly strong." (CNNMoney.com)
Pharma R&D Shrinking
The latest new annual report issued by PhRMA, the pharma industry's trade organization, reports that research and development investment is shrinking. The total U.S. employment by the group's members in R&D fell by 3.9 percent in 2006, (the last year for which data was available) to 79,856. Meanwhile, industry spending on R&D hit an estimated $44.5 billion, a "modest" 2.5 percent increase. The U.S. figure was $35.4 billion, a 2.7 percent rise, compared to 2006 when U.S. spending rose 11.3 percent over the previous year. (Pharmalot)
Big Biotech as Investor Haven
Stock investors have had a rough go of it lately, but biotechnology has held its own, with the Dow Jones Wilshire U.S. Biotechnology Index up 1 percent year to date, compared with a 9 percent decline in the broader health care index and a 5.6 percent loss in the Dow Jones Industrial Average. The industry has traditionally been viewed as a risky business prone to mood swings among investors. However, the perception of biotech might be changing, particularly that of big firms with deep pipelines that depend more on breakthroughs in drug technology and long-term contracts with health care providers than on the ups and downs of the economy. (Wall Street Journal)
Accelerating Innovation
Many of the interactivity features in the Apple iPhone and Nintendo Wii are due to the use of accelerometers, which can be used to create innovative features like the iPhone's ability to shift between vertical and horizontal views. ABI Research analyst Douglas McEuen remarks, "Major game console manufacturers are . . . seeking accelerometer applications for their next-generation products. But games are only one use for these specialized devices. The growth rate of this market will be determined by the imaginations of designers as they think up innovative and unexpected ways to incorporate accelerometers into new devices." (TechWeb)
Private Equity Fundraising Strong in Q1
Private equity fundraising remained strong in first quarter, with venture capital increasing by more than $1 billion compared to last year. According to Private Equity Analyst, 81 U.S.-focused PE funds raised $58.5 billion, up 32 percent from the $44.3 billion raised across 68 funds in the same period a year ago. The venture capital market in particular is being viewed more positively than other areas. Venture firms raised $4.9 billion this quarter across 32 funds, up from $3.8 billion raised by 22 funds at this point last year. Industry analysts expect VC firms to garner more money this year, as well as other niches less dependent on debt financing. (VentureWire)
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April 14, 2008
Teaching Johnny to Read
On February 28, Justice H. Walter Croskey and two other judges on California's Second District Court of Appeal ruled that, "Parents do not have a constitutional right to home school their children."* The implication that parents without a teaching credential could now face criminal prosecution for teaching their kids at home sent shockwaves across the political spectrum. Except for the education establishment who saw it as a reaffirmation of their monopoly and a strengthening of the guild-like control asserted by the teachers' unions. "We're happy," said Lloyd Porter, who is on the California Teachers Association board of directors. "We always think students should be taught by credentialed teachers, no matter what the setting." In the Middle Ages, numerous guilds were established to ensure the quality of a particular craft. A secondary agenda was to restrict access to competition and protect high prices.
Today there are 166,000 students home schooled in California or about 2.5 percent of the total K to12 population. If you run through the roster of the kids in your children's extracurricular activities, you're likely to encounter a number of home schooled children. Interestingly, their parents do not meet the media stereotypes of the religious creationist zealot or the off-the-grid dead-ender. Rather, these folks are well educated professionals who determined that their expectations for a quality education for their kids would not be met in the public system. Unable to afford the expense of a private school, they made the extraordinary commitment to undertake that education themselves. In effect, they're making a dual choice for better quality and lower cost.
According to the April 2008 report by the U.S. Census Bureau titled "Public Education Finance in 2006," the state of California spends $10,254 per student on education. In Massachusetts that number is $14,762. Of these amounts about 82 percent is spent in the current year on delivering services, but those amounts are further reduced by significant overhead costs. California only spends about $5,127 per student on actual instruction. The rest of the money (about 39 percent) is used up in central office administrative activities. In the San Francisco district, which shrinks by about 400 students per year, that administrative fixed cost is a rapidly increasing percentage of the total. If, in the economics of public education industry, the students represent clients (and thus are a source of revenue), then forcing the 166,000 back into the system would produce an additional $1.7 billion in revenue. Providing this service would require an additional 7,500 teachers. The stakes in snuffing out home schooling are high. From a taxpayer perspective, it appears that we are saving over $5,000 on every home schooled kid. Even better, we still collect the property taxes from their parents — a nice trade by any measure.
Then there is the other guild argument about ensuring quality. Ten years of statistics show that home schooled children generally score slightly better (ACT scores of 22.4 vs. 21.1) on college entrance exams than those coming from the public system. A bigger question may be which system is better at delivering that opportunity to go to college in the first place. In that regard, the members of the current system have a tough case to prove. According to
High School Dropouts, Enrollment, and Graduation Rates in California by Patricia L. de Cos (2005), high school graduation rates in public schools now average less than 70 percent and have been declining for 40 years. Big cities succeed less than 50 percent of the time. In Oakland, a mere 30 percent leave with a diploma. To be sure, the education industry disputes this data. How are they to know if a student is a real dropout or simply moves out of the district? They have a case. We suppose it is possible that 70 percent of the kids in Oakland public schools move to Australia between ninth grade and their senior year. Most businesses would not even consider articulating an excuse for service failure rate of 50+ percent. One perverse effect of the poor quality in the public system is that it supports high tuition for private schools. As in any other economic system when the competition is weak, the prices go up.
Source: U.S. Census Bureau,
2006 American Community Survey
As the chart nearby documents, the vast majority of Americans never make it to that bachelor's degree. The economic disparity that they will suffer as a result is well understood. With more than one million high school dropouts annually, this is unlikely to change soon. So how will the economy continue to grow with such a poorly educated population? Simple: we'll just import educated people from abroad. But wait . . . Congress limits those H1B visas to 65,000 per year. Although the link between economic progress and education is axiomatic in academia, it seems they still need some convincing on Capitol Hill.
Generally Electrified
The market was jolted by GE's non-earnings announcement. Profit dropped 6 percent, but, more importantly, they missed earnings expectations by a whopping 13 percent. To think that the poster child of solid financial management did not know until the last two weeks of the quarter that this was the outcome is disconcerting. Some $41 billion in market cap was vaporized. One observer noted, "Now we know we're in recession."
The depression at GE was reflected in consumer confidence numbers, which dropped to 63.2, obliging us to extend our Bloomberg graph all the way back to 1981 to find a similarly low data point. It's clear that the folks are no longer smirking about the poor judgment of their neighbors with too much mortgage and too little cash flow. As house prices continue to fall in some areas, the thinking is, "There but for the grace of God go I." Not a bullish sentiment to be sure. Further, we suspect that some fair portion of those depressed consumers are boomers on the brink of retirement realizing that retirement is years, possibly decades away. With the S&P essentially flat for the last 10 years, fixed income credit risk worsening, and massive tax increases on the horizon, they have no place to turn for those safe relaxing days in their sunset years. Better to keep at the grindstone.
Now that the Fed is accepting a variety of securities for cash at the discount window, some very modest part of the credit markets are liquefying. The Fed Funds futures are still looking for 50 bps more juice before rates bottom out this summer.
Let Them Eat Cake
Speaking from the G-7 summit, Treasury Secretary Paulson advised Third World governments to avoid price controls on food as those artificial limits are harmful to the economy in the long-term. Evidently, the Secretary has never experienced a good, old fashioned food riot. The reason these governments implement price controls is to feed the populace and to save themselves. As Louis XVI discovered long ago, any government ignoring a 30 percent rise in the staple foodstuff will not last long.
— Jim Anderson, Editor
To review the published opinion, visit http://www.courtinfo.ca.gov/opinions/documents/B192878.PDF
Investment Strategy Outlook is published each week to highlight issues we hope you find relevant and topical. The views expressed in this newsletter are solely those of its authors and do not reflect the views of SVB Asset Management, Silicon Valley Bank, or any of its affiliates.
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U.K. Producer Prices Rises Fastest Since ‘91
British producer prices rose in March at the highest annual rate since 1991 because of record increases in raw material costs, adding to the danger that faster inflation will become entrenched in their economy. Prices at factory gates climbed 6.2 percent from a year earlier, compared with 5.9 percent in February. Raw materials rose 20.6 percent on the year, the most since records began in 1986. (Bloomberg)
High Gas Prices Fuel Higher Retail Sales
Americans spent less on furniture, clothing and appliances in March as more of their money went to pay for gasoline and food. Retail sales rose 0.2 percent, above economists' expectations. The figures also showed purchases excluding were unchanged. Consumer spending, which accounts for more than two-thirds of the economy, is waning as households struggle with an 11 percent jump in gas prices this year to $3.37 a gallon, a rising jobless rate and a slump in home values. (Bloomberg)
Housing Woes Go Global
The collapse of the U.S. housing bubble is mutating into a global phenomenon, with real estate prices swooning from the Irish countryside and the Spanish coast to Baltic seaports and even parts of northern India. This synchronized global slowdown, which has become increasingly stark in recent months, is hobbling economic growth worldwide, affecting not just homes but jobs as well. In Ireland, Spain, Britain, and elsewhere, housing markets that soared over the last decade are falling back to earth. Property analysts predict that some countries will face an even more wrenching adjustment than that of the United States. (New York Times)
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Corporate Bond Risk Rises
The cost to protect corporate bonds from default increased over the weekend after Wachovia Corp., the fourth-largest U.S. bank, posted its first quarterly loss in six years and Royal Philips Electronics NV said profit fell 75 percent. Wachovia lost $393 million in the first quarter, cut its dividend and plans to raise about $7 billion in a share sale to replenish capital. The report fueled investor concern that the housing slump will trigger further losses as Citigroup, the biggest U.S. bank, Merrill Lynch, the world's largest brokerage, and Bank of America post earnings this week. (Bloomberg)
Mortgage Collateral Makes Treasuries Nothing Special
The dollar isn't the only casualty of the Federal Reserve's rescue of seized-up credit markets. Bond traders are finding there is nothing special about Treasuries anymore, now that the Fed accepts substitutes for government securities as collateral. As recently as March 21, Treasuries were in such demand that traders were willing to lend cash at rates 2 percentage points less than the Fed's target rate for overnight loans. Now, the gap is back in line with the 0.06 percentage point average in the 10 years prior to August. (Bloomberg)
Bernanke Says Regulators to Review Capital Guidelines
Fed Chairman Ben Bernanke said regulators must strengthen oversight of financial markets, ensuring that banks have enough capital and that accounting rules aren't "destabilizing." "Mark-to-market accounting has sometimes been destabilizing," resulting in write-downs and the "fire sale" of assets, Bernanke said. The rules generally require firms to value assets at current prices, which may not be appropriate when markets aren't functioning properly, he said. U.S. regulators have begun an analysis of how markets and regulatory enforcement failed, producing what former Fed chairman Alan Greenspan calls the "most wrenching" credit crisis since World War II. (Bloomberg)
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