China Aims to Diversify Reserves in Agricultural Space

Talking Points China Should Invest FX Reserves In Agriculture Abroad -Govt Researcher
China should use its huge foreign exchange reserves to expand investment in the agricultural sector overseas, in an effort to increase domestic market supply, a researcher with a government-owned economic institute said.

China's foreign exchange reserves, the world's largest, rose to $3.04 trillion as of the end of March, with a substantial portion invested in U.S. Treasurys.

China should build grain production bases abroad, especially in South America, Africa and some neighbouring countries with great potential to increase grain production, Chen Jie, a researcher with the Research Center For Rural Economy, a consultancy under the Ministry of Agriculture, said in an essay published in the state-owned Farmer's Daily dated May 21.

We must not rely on imports to meet domestic demand for grains," she said in the article.

"Otherwise, the issue of grain supply could become a national security problem anytime," he said, adding that cereal exporters could easily embargo trade in grains when supplies are tight.

Chinese agricultural companies are eager to tap overseas resources as domestic demand is rising quickly and domestic grain and edible oil production is approaching full capacity due to rapid urbanization.

Both the Chinese government and marketers also want to insulate prices from volatility in major markets such as the Chicago Board of Trade, and controlling upstream resources including land and crop selection would be the best way.

Local media have reported that the state-owned Chongqing Grain Group Co. to spend more than CNY2.5 billion to purchase land in Brazil for soybean cultivation, as part of a $3.4 billion plan to build oilseed and rice production bases overseas including bases for rapeseed in Canada and Australia, palm oil in Malaysia and rice in Cambodia.

The Tianjin-based Julong Group, a privately-owned palm oil trader and importer, has spent $200 million to buy 20,000 hectares of land in Indonesia to plant oil palm. The company plans to expand its oil palm planting area overseas to 200,000 hectares, with a total investment of $2 billion.

Meanwhile, China's state-owned Cofco Group is seeking to acquire Australia-based sugar producer Tully Sugar Ltd., competing with the New York-based Bunge Ltd.

China, the world's largest importer of soybeans and palm oil, is attempting to maintain a grain self-sufficiency rate above 95%.

Source: CME News for Tomorrow

Why Germany Should Learn to Love the Euro

Have you ever wondered why German politicians are so supportive of the Euro? Besides attaching a great deal of their political currency (and hence careers) on the Euro, there is another more fundamental reason behind supporting the single currency.

Export subsidies. The Euro acts as an export subsidy for German manufacturers and exporters. But one may glance at the forex charts and say the Euro is so expensive! Not really - the Euro is very cheap compared to what the Deutschmark would be trading at now. Remember that Euro trading prices in factors such as deterioration of the peripheral PIIGS countries.

The Euro is also a blessing in another guise. In continental Europe, economic activity has always gravitated towards the center - in particular to Germany. The EU is a 2 engine economy led by Germany and (and to a much lesser extent) France. Wage growth is being kept relatively low by migrant workers from Eastern Europe and the periphery imposed legally per the EU treaties.

The last blessing in disguise is the German consumer and investor's rise in purchasing power. Sure, the EU is in horrid economic shape but the Euro is still trading at a premium relative to the dollar. As a result, things are cheaper for travelers and asset managers who wish to engage in speculative carry trading.

The Bottom Line: German taxpayers may grumble about the Euro but the elites have, ironically, their best interests at heart.

Emerging Markets' Biggest Threat is Deflation - Not Inflation

Brazil and other emerging markets are also leveraged in another way - to the dollar. The commodities trade in particular for exporters is prone to violent swings. Oil and many agricultural products are tied to benchmark rates set on the CME and CBOT in the USA b/c futures contracts continue to be priced in dollars. Recent margin hikes on oil and precious metals are warning signs to me to contain volatility. For Brazil, agricultural commodities are capped w/lock limit prices on the Chicago exchanges so volatility won't come from that corner. Instead it will come from base metals traded on the LME like copper (see prior article about China and copper for a more reasoned explanation).

The long term fundamentals of supply and demand for agriculture are expected to remain strong for the next several years -supportive of continued inflation of land, inputs and machinery.

But what comes up must come down. Demand destruction is real - the world cannot survive for long on oil >$100/barrel and oil is considered a leading industrial indicator. The velocity and supply of money has turned from a stream into a river in many developing countries. Some of this can be attributed to Western investors but a lot more is sourced from the native governments.

The biggest culprit I see now is China - M2 has jumped despite efforts by the PBOC to play games (http://ftalphaville.ft.com/blog/2011/03/21/520846/chinas-missing-m2/). M2 is STILL up b/c the Politburo has focused its efforts on blaming Western foreigners (US and British investors) instead of looking in the mirror - the explosion in money supply is due to FORCED domestic lending by banks from the 2009 stimulus effort. Simply put, loans are being made to people who should not be receiving them - all in the effort to keep employment high.

China's leaders are following this policy b/c they value social stability above all. But the policy is ruinous and leading to a credit bubble. Already we are seeing signs of a coming deflation in wage growth. I was reading in the Financial Times where the reporter stated China and India are leading the world in wage inflation by repeatedly raising minimum wages . In the short term that is a good policy to have - but the 2 countries are already losing their competitive advantages to smaller, cheaper players like Vietnam, Philippines, and Indonesia.

Conclusion: Emerging markets' biggest threat now is deflation - NOT inflation. The current runup in inflation is due to a massive increase in credit since the Lehman bubble popped in 2008. But this rise in inflation is only short term - it will pop as over-capacity in capital stock comes downstream. Politicians are stuck between choosing growth or choosing inflation. Instead the choice will be made for them by the markets. I predict a hard landing for many markets w/in the next 9-15 months, 2013 by the latest.

European Wheat Weakness

Any strength in bullish prices can be tempered by the seasonal weakness in associated equity markets. In a POMO liquidity driven world, computer trading has followed into commodities to push prices higher.

European Wheat Prices To Revisit 3-Year Highs On Drought-Analysts
Forecasters and traders said wheat prices could hit the three-year highs touched in February if drought in Europe and the U.S. continues to stress next year's wheat crop.

New-crop wheat prices have gained sharply this week, hitting three-month peaks of EUR251.50 a metric ton on the November Paris milling wheat contract on Thursday, driven by concerns next season's harvest could be irreparably damaged.

But now analysts say the current bull run may continue, taking futures above the near-record highs of EUR281/ton touched in February as the worst drought in decades tightens its grip on Europe's fecund farmland.

"I think there are still significant risks that wheat prices could push back to the highs we saw in February if weather doesn't improve in the coming weeks," said Erin Fitzpatrick, an analyst at Rabobank.

Production expectations for next season are falling by the day as drought across key growing regions of France, Germany, the U.K. and Poland--which account for 65% of EU-27 output--wilts the young crops in the fields.

Parts of Europe received less than 40% of their average rainfall between February and April and analysts now say up to 12% of France and Germany's crop will be lost even if rain does arrive.

"If we do not get the right mix of rain and sun in the coming 8-10 weeks, then later this year we will see record price levels," said Charles Robertson of Renaissance Capital.

Concerns about crops in the U.S., Australia, Canada and Russia are also keeping the market nervous. Last year's rally was sparked when an historic drought in Russia prompted the Kremlin to ban exports and take tens of millions of tons of the world's cheapest wheat out of the international market.

Although initially delayed by poor weather, at the end of last week Russian farmers had planted spring crops on 18.921 million hectares, only 4.5% less than on the same date last year, the Agriculture Ministry reported.

In forecast generally regarded as over-optimistic by the trade, the U.S. Department of Agriculture last week forecast that wheat exports from the Black Sea region, including Russia, Ukraine and Kazakhstan could double to more than 26 million tons in 2011-12.

But Eugen Weinberg, analyst at Commerzbank, said with weather so unpredictable at this stage, any production estimates are very much uncertain until the grain is in the storage bins.

"We're still in the development stage," he said. "The troubles last year only came in June to July.

"EUR280/ton is definitely on the cards at the moment."

Source: CME News for Tomorrow

China, The IMF, and Dominique Strauss Kahn

What do China, the IMF, and Dominique Strauss Kahn ("DSK" hereafter) share in common? Most media have become transfixed by front page coverage of how the now disgraced banker's political career was destroyed by a low paid, immigrant maid. Rather than go into the increasingly lurid details, of which many other sources are covering, I will attempt to explain the potential ramifications on the IMF and China.

There is now a power vacuum in place at the IMF. While an interim head has been selected, no permanent selection mechanism has been activated. Instead, we are witnessing an intense, behind the scenes political jockeying for power and influence that stretches around the globe. I speak of course about China and her ambitious rise to prominence.

For years, the IMF has been dominated by a succession of figures chosen from the ranks of Western European and American financial and government elites. The selection process is a delicate balance that in theory has a foundation in its quota system. Quotas are broad reflections of member states' econonomy. Dues or quota subscriptions are 25% paid in a major international currency (e.g. typically $, Euros, or yen w/the dollar being preferred) and the remainder 75% in their own currency.

The quota system for emerging economies was raised in April 2008. The system is reviewed every 5 years - w/the next review having been completed earlier this year (2years ahead of schedule) in January.

So, how does the above apply to China? January is not so far away from May that a re-assessment may be called for by some members on the governing council. China's has strong incentives to get a native representative (or at least someone loyal to Beijing's cause). In 2010, China surpassed Japan to become the world's second largest economy. In 2011, she remains the world's most populous state. Chinese loans are supporting the economic backbone of the West - a teetering EU and a profligately consuming USA. It is w/regards to American spending that this tense dynamic that is currently underscoring international trade and public policy.

In multiple speeches during the past two years, Chinese officials have repeatedly voiced their concerns about the viability of the dollar's role as a reserve currency.

Open calls to American politicians to preserve the value of their investments have been ignored. Actions always speak louder than words and while US officials publicly support a strong dollar policy their actions speak to the direct opposite. China is not entirely w/o fault however as Congressional calls for China to revalue the renminbi have an air of truth about them.

One interesting angle of critique has been the proposal for a new SDR currency that would place the renminbi among the basket of currencies allowed to be held in the 25%quota.

Besides the symbolic value, a Chinese Managing Director (CMD) of the IMF would secure substantial political leverage against the American's weak dollar policy and ensure a margin of security against Congressional voices against a strengthening renminbi. From the IMF's podium, the CMD would be able to issue damning critiques against the Federal Reserve and US Treasury w/the full force of international law (for what that's worth).

A more focal point is the IMF's control over the purse strings of emergency bailout loans to sovereigns. The IMF has historically made loans to developing nations (formally referred to as the 3rd world). If a global cooling in commodity prices does occur, these emerging market nations that have been the recipients of so much hot money would face capital flight and enormous political/economic devastation. China itself has been pumping large amounts of capital into sub-Saharan Africa, Latin America, and South Asia. A CMD would be able to direct the organization to help offset any losses the Chinese state would suffer on these investments. More ominously, the day may come in the not so distant future that the IMF's funds may be directed in the explicit bailout of a Western European or (and previously unthinkable) America itself.

But it is not so cut and dry. The United States has a major say in determining who will head the IMF, in part because it holds the largest number of votes at the 187-nation international lending agency, in the quota system. Both sides have likely begun marshaling allies to support bids for respective candidates.



The bottom line: DSK's fall from grace is not the main story. China has been lobbying for years to obtain a stronger international voice. Placing a Managing Director favorable to Beijing would ensure it greater leverage against the USA.

A Penny Saved Is Not a Penny Earned: Copper Pricing and China

"A penny saved is a penny earned" is a famous quote from American Founding Father, Benjamin Franklin. However, this maxim is hardly true today - the modern penny having been diluted by a 97.5% base of zinc and a thin copper covering of 2.5% after prices had become too expensive.

Copper is an industrial metals bellwether and more importantly, a risk on trade bellwether (dollar down/risk on assets up). Unlike oil, which has a substantial political volatility premium built into its pricing, copper's output is constrained by mining difficulties. Both commodities take years for efficient resource extraction, but base metals had been comparatively neglected in the past 2 decades compared to energy.

Consequently, any fall in copper prices are likely to be due to falling demand as opposed to speculative swings in prices. Technicians can see this trend outlook in the MACD in the above charts.

Compare copper to the volatile price swings in other risk on assets such as gold and silver. While precious metals retain intrinsic value in preserving wealth they had also taken on bubble like characteristics in recent months - just look at silver's dramatic rise to near $50/ounce before its violent 1 week correction earlier this month. Of course, no discussion about copper would not be complete without mentioning China.

China has been the biggest source of demand for copper with anecdotal reports of manufacturers stockpiling the shiny metal in warehouses. But authorities have been on a decidedly hawkish stance since last year with persistent interest rate increases and bank reserve requirements. The renminbi has also been allowed to appreciate the most in its history - by differing accounts from between 3.5% - 4.5%. This rate rise may sound small compared to swings in other currencies but remember that China's exchange rate remains tightly controlled for political and economic reasons.

An appreciation on the order of AT LEAST 5% is needed to be effective in constraining runaway inflation. Official inflation rates for April 2011 were 5.3%. Real inflation rates are estimated to be much, much higher - on an order in the double digits. Volatile food and energy costs are estimated to comprise much of this increase. To be truly effective in constraining price pressures, Chinese authorities would have to allow the renminbi to appreciate to double digit percentage levels. Of course, this will never happen. Allowing the currency to appreciate to such levels would devastate the export manufacturing sector and lead to a massive loss of jobs.

The Chinese government is left w/alternative policy controls such as raising bank reserve requirements, hiking margin on stock exchanges, loosening currency flow restrictions (e.g. allowing renminbi denominated accounts to be opened elsewhere outside Hong Kong), and allowing wage increases among broad swathes of the employment sector (more on this topic in the next post). These methods have had varying levels of success in cooling the economy. One thing is certain though: as inflationary pressures continue to rise, Chinese authorities will ultimately be forced to allow the renmimbi to appreciate to higher levels.

The bottom line:
Bulls on risk on assets are now engaged in a fight w/the Chinese central banking authorities.

The Shadow Banking System in Emerging Markets

Shadow banking. These two words have come to encompass everything that was wrong about the 2008-2009 financial crisis. Shadow banking was first used by Paul McCulley of PIMCO in 2007 to describe the giant "soup" of non-depository institutions but later popularized by supremely bearish economists such as Nouriel Roubini in 2008 (then among a small list of contrarian opionists) to include all forms of financial institutions like hedge funds, insurance companies, and investment banks. But this term is not just confined to the West.

The superficial forms may be different but the underlying structures and intent - off balance sheet money creation - remain just as potent in a broad swathe of regions ranging from Latin America to the Middle East, Far East, South Asia, and Eastern Europe (including the CIS countries).

Most economists ignore these capital flows b/c it is hard to capture systematic data on such a diverse group but their influence is equally hard to dismiss - surging inflation, and frenzied speculation on (insert favored asset class of the month - real estate and stocks remain favorites but other speculative targets include precious metals, art, jewelry, and even wine). Sources include remittances from foreign workers and family, off the book transfers to SOEs (state owned enterprises), grey market additions or subtractions on trade letters of credit, unofficial lending systems like "hawala" prevalent in many Muslim communities, and even funds from organized crime syndicates.

I would argue that in some cases (depending on the country's level of official financial innovation), these flow of funds can surpass the volume of funds issued by the central bank and can add huge pressure. While the individual actors in the system may be small their collective impact is overwhelming. Certain regions receive their funding sources from a small but dominant group. For example, Latin America tends to receive a huge number of remittances, so much so that in countries like Mexico, remittances are the number 1 or 2 (depending on whose counting and what political agenda they may have) source of GDP growth. In other states with Communist backgrounds (the CIS, China, Vietnam), off balance sheet transfers to SOEs are prevalent.

An additional note about China. Due to its enormous size, China has a proportionate impact on global levels of supply and demand, and - despite protestations of party officials - inflows and outflows of money. For years, the fixed (now tightly managed band) exchange rate contributed to all sorts of games played by exporters and importers on letters of credit, the trade documents that serve to lubricate wholesale trade. Parties to a transaction would routinely mark up or down their costs at the behest of their partners (usually for tax reasons) but also to import additional funds beyond the official limits. China also has its SOE legacy. It is hard to imagine now, but China used to be a Maoist state in every sense of the word. Money losing ventures in (sometimes) obscure parts of the country would produce goods for the sake of producing goods. These operations have more or less ceased to exist but their "losses" remain on the country's financial balance sheets (no one is really talking at Beijing much about this problem - did you really expect transparency from an authoritarian state?). But by some independent accounts, the scale of losses on these operations rivals the deflationary collapse in 1980s Japanese real estate.

Halwa, or the unofficial Muslim money transfer network, deserves special mention. The system incorporates scores - if not hundreds - of semi-independent brokers interwoven in a complicated network of trust. Deals are sometimes made on nothing more than handshake and accounts kept in paper ledgers. On this framework alone, funds can be sent from the rudest mountain village to the shiny cosmopolitan cities of Europe and North America. The system was developed in an effort to frustrate medieval tax authorities but was also molded in the cauldrons of internecine conflicts (called "brush wars" by Western analysts) when funds needed to be quickly sent and official lines of communication had broken down.

Organized crime has a special place in the role of money creation and transfer. It is prevalent in every society but really flourishes in regions where the rule of law is weak or more sinisterly, incorporated, into elements of the government. Profits from illegal activities such as the narcotics trade, piracy, human smuggling, prostitution, arms trafficking, counterfeiting, and credit card fraud (to name but a few sources of revenue) contribute unofficial amounts to GDP growth. The funds are sent through multiple channels - some of it is laundered to foreign operations and some of it is spent at home. The ruthless intelligences directing these funds make organized crime figures some of the shrewdest and most efficient capitalists of all. In their own ways, crime lords provide a source of jobs and growth to regions unmatched by official government stimulus efforts.

The sum effect of all this additional money sloshing around the globe is the same as that created by official government sources. The effects are currently inflationary, buoyed in large part by the interplay between central bankers - the doves of the West and the hawks of, well, everywhere else. But the pendulum can easily swing the other way - prolonged periods of economic malaise can send foreign workers packing back home and a key source of remittances would dry up. The same applies to cases of trade finance where importers and exporters depend on certain assumptions underlying their relationship - cheap, unofficial subsidies and exchange rates to artificially boost buying power. Even successful law enforcement efforts to clean up crime can have a short term deflationary effect on local economies.

The Bottom Line: The Shadow Banking system operates all over the world and should not just be applied to cases of large sophisticated fund managers. The collective force of many small actors can be enough to rival or even surpass official authorities. The global sloshing of funds is currently tilted firmly towards the inflationary camp but may swing the other way due to macro-economic developments in the West.