China

A month ago, Sarkozy was pissed that Merkel had dared to take the initiative over him and to ban naked CDS trading. Being a stubborn reactionary, this action only prolonged his inevitable decision to do the same (because politicians, being the wise Ph.D's they are, realize fully all the nuances of screwing around with the financial ecosystem). However, looking at this week's DTCC data, we have a feeling he may accelerate his decision to join the CDS-ban team. With a total of 456 million in net notional derisking, France was the top entity in which protection was sought in the past week. In a very quiet week, where the 5th most active name did not even make it past the $100 mm threshold, France was more than double the number two sovereign - Mexico (we are unclear if this is some sort of contrarian move to the Yuan reval, which Goldman was pitching as MXN positive, which means traders likely hedged by loading up on Mexican CDS). But what is probably most notable, is the sudden and dramatic appearance of China in the top 3rd position. Welcome China! And after tonight's surprise PMI miss and the resulting market drubbing, we are confident within a week or two, China will promptly become a mainstay of the top 3, and will quickly rise to the top position, where it rightfully belongs. We are also confident those perennial Eastern European underdogs, Romania and Bulgaria will shyly make an entrance in the top 10 next week.

The debate of China's double dip may have just been sealed after the "Conference Board corrected its
April gauge for the outlook of China’s economy, saying its
leading index for the country rose the least since November,
rather than registering the biggest gain in 14 months. The gauge compiled by the New York-based research group
rose 0.3 percent, less than the 1.7 percent gain reported on
June 15." Ignoring for a second the fact that such massive swings in amplitude imply either a malicious data misrepresentation intent or weapons grade stupidity, the second derivative in Chinese growth has now peaked, just at the time when the country for whatever optically political reason decided to unpeg its currency. We are now looking forward to the official rescinding of that decision, and a resumption of the peg. Of course, the fine gentlemen at the Conference Board, have come up with some trivial excuse, namely that the previous release contained a “calculation
error” for total floor space on which construction began, but it is now too late - the discrediting is beyond terminal. And anyone who believes this same agency for its monthly "consumer confidence" reading should ask themselves repeatedly if the CB did not, by mistake or just by following guidelines from above, drop the minus sign.

As every kitchen sink appears to have a definitive opinion on the impact on the CNY rebalance, we would like to step back for a second and present a historical chart of the country's trade balances not only in total, but by individual country. As the chart shows, and as David Rosenberg also highlights, providing a blanket summary as to the impact of a CNY revaluation is a rather foolhardy thing: while China may enjoy a positive trade surplus with the US and EU, it certainly has a trade deficit with some other key producer countries, namely Korea ($61 billion LTM), Japan ($47 billion), Taiwan ($79 billion), and Australia ($27 billion). So while it could be argued that the US and EU's manufacturing sectors benefit from a stronger Yuan, what happens to the exports of the traditional Chinese partners? Absent the PBoC going full tilt and scaling up its imports across the board, there will be some very unhappy traditional Chinese trade counterparts. Although in this age, when even presumably smart economists beckon to "Spend now, save tomorrow", why bother with something as simple as the Capital to Current account equality. China should buy up everything, and use reverse money or something to then reinvest the reverse proceeds from all the exports into sovereign bonds... or something.

We pointed out previously that the one certain mid- to long-term impact of China's revaluation decision, aside from stimulating the US manufacturing export economy (don't laugh), will be to trim Chinese interest for bonds. This is due to a direct effect of fewer Chinese dollars being recycled into USTs now that less USD reserves will be accumulated, but also due to an indirect effect of stimulating demand for risky assets, pushing USTs off the plate of investors. For a much more in depth perspective, we provide the views of MS Rates strategists Jim Caron and Igor Cashyn.

In a statement posted on the PBOC's website late last night, the Chinese central bank has announced it will seek a flexible yuan, ending a two-year peg to the dollar. The news comes a week before the G-20 meeting at which the CNY exchange rate was set to be a key issue of debate. On the other hand, as the PBoC noted, With the BOP account moving closer to equilibrium, the basis for large-scale appreciation of the RMB exchange rate does not exist." As such, a large initial move is unlikely to occur, and the bulk of the volatility will likely strike at traded CNY forwards. Either way, this is sure to play major havoc with already extremely volatile EUR, CHF, GBP and JPY pairs.

With everyone focused on the dead and buried Spanish interbank market (no, no STD is the healthiest bank in the world, for realz) is the real liquidity threat elsewhere... about half a world away to be precise? As the chart below shows, since June, the Chinese 1 Month Repo Rate has exploded and is not looking back.After trading in the 1.5% area for years, in the past 3 weeks, this has nearly tripled, and today traded at a 52-week (and close to all time) high of 3.8%. While for many Chinese banks, flush to the gills with money due to a tapering in consumer lending, this is not an issue, we are fairly confident there are various banks that will be impaired by this spike. And it certainly did not occur in a vacuum - there a distinct, and extremely levered, correlation between the CNY fixing and the 30 Day Repo. Should China go ahead and reval the renminbi, must we expect a complete lock up of the Chinese lending market? Perhaps with the Shanghai Composite hitting a fresh 52 week low today, at least someone is paying attention.

One of the parallel news lines that was buried in last week's oil spill, was the pick up in Chinese currency manipulation rhetoric (with the Treasury now two months behind its April 15 deadline on determining if China is an FX manipulator, indicating just how terrified of an adverse response Geithner truly is), particularly that by Chuck Shumer, whose most recent proposal is not to vote China off the face of the manipulative planet (yet all China does is peg its currency to the dollar, which is kept at its level by US Fed monetary policy - does that mean that the Fed is a currency manipulator too?), but to effectively change the entire concept of "currency manipulation" and rebrand it to "currency misalignment" thus reducing the risk of political fallout. Couple this with several complaints received by the Dept of Commerce from domestic manufacturers alleging Chinese subsidies, and the Chinese FX relations, now that global liquidity is assumed to be once again "under control", may once again deteriorate rapidly. Attached is a succinct summary from Goldman's Alec Phillips which present the key issues in the upcoming weeks over the China currency manipulation situation. While most of the observations are not unexpected, the following bears pointing out: " Last week the Senate approved an amendment that would require the Treasury to report quarterly on foreign holdings of US debt and to determine whether any country’s holdings posed a national security risk.  This proposal appears aimed mainly at curbing federal spending rather than influencing international purchases of US Treasury debt, and it seems unlikely to have major ramifications.  Still, there is irony in the prospect of Congress requiring an additional politically sensitive periodic report from the Treasury, as it awaits the first one on foreign exchange.

Today's early market exuberance (which did nothing but provide various FX arb opportunities during the day), was largely attributed to the news that China's export economy is surging. Alas, even a brief read between the lines indicates that this should have been fully priced in. The reason is very simple, as our friend Thermidor explains.

The China Investment Corporation, also known as China's sovereign wealth fund, and the entity that allocates China's nearly $3 trillion in foreign assets, which in February filed it first ever 13-F statement disclosing just under $10 billion in holdings, has announced a 10% Mark-To-Market loss in the month of May according to RanSquawk. We are trying to get confirmation whether this is equivalent to a $1 billion loss on equity investments - we will get you more as we get it. In the meantime, here is the snapshot of CIC we conducted in February. With the recent 10% plunge, the fund has now wiped out all of its 2009 gains, which were announced at 11%!

Another horrendous day shaping up for Europe. Spanish Bund spreads have surged to all time highs just south of 200 bps, Hungary confirms that it was not exaggerating comments about chances of (not) avoiding Greek situation, pushing its CDS even wider, the EURCHF has dropped to under 1.40 and the SNB has not intervened yet, while the EURUSD is down to 4 year lows below 1.21. The nail in the euro coffin is a report by Reuters that a growing number of Chinese exporters turn down euro payment, flatly refuting anything SAFE may be saying officially.

"If I stick with my principles, of using what you develop to keep you objective, it seems pretty clear to me that the cycle of Chinese momentum has peaked….there you go, I feel relief…from now on, I suspect we are going to see more and more evidence of this. It will scare many, please the China bubble blowers, but to those of you that think in sensible terms, this is actually good news. China over eased, they have “ over rebounded” and need to get back within a 8-12pct range as measured by our proprietary GDP indicator, the GSCA." Jim O'Neill

There has been much talk about the FT's story that China could be evaluating its eurobond holdings. So much in fact that the Chinese State Administration of Foreign Exchange has issued an official statement denying the validity of the story: an unprecedented step by the Chinese to respond to market rumors. We are surprised that SAFE actually found time to write this up with all the EUR buying that everyone in China seems to be doing these days. "China's foreign exchange reserves as a responsible long-term investors, and always adhere to the principle of decentralized investment, the European market in the past, present and future foreign exchange reserves are one of the most important investment market." For a minute there we wonder what they were expected to say: "Yes, we are only buying gold and oil going forward. So please don't buy it ahead of us."

Is China about to start dumping its $630 billion in eurozone debt holdings? Maybe not yet, although the FT reports that China's State Administration of Foreign Exchange, the central bank's foreign reserves manager, has "expressed concern about its exposure" to the PIIGS. Obviously, with China moving away from dollar denominated assets for the past six months would represent a "big strategic shift" as "last year, the Chinese were trying to reduce their exposure to dollar assets by buying eurozone assets. This would be a complete reversal." Additionally a Chinese diplomat noted that, "The euro’s fluctuation will have an impact on China’s thinking, but it’s only one element” in any decision to allow the Chinese currency to rise, He Yafei, a vice foreign minister, said, according to Bloomberg." The question then arises of just what assets China would be comfortable holding? Alas, the only readily available answer we can come up with rhymes it old and has 79 protons.

First a glance at the macro scene in China and then a look at how our China short thesis has played out thus far. Feel free to compare my work to Goldman and the other big banks, the challenge is welcome.

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2.    White House calls ship sinking a peace-challenging 'act of aggression' by N. Korea
3.    White House says North Korean action is challenge to international peace and violation of armistice pact