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Bridgewater Associates: A Wise Move By The Chinese - July 2005


Bridgewater Associates: Collection of Writings (1999-2012)

Bridgewater Associates: Collection of Writings (1999-2012)

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  • 1. Bridgewater ® Daily Observations is protected by copyright. No part of the Bridgewater ® Daily Observations can be duplicated or redistributed without prior consent from Bridgewater Associates. Copying or redistribution of The Bridgewater ® Daily Observations is in violation of the U.S. Federal copyright law (T 17,U.S. code). 1 Bridgewater ® Daily Observations 4/26/2006 Bridgewater® Daily Observations July 21, 2005 © 2005 Bridgewater Associates, Inc. (203) 226-3030 Ray Dalio Jason Rotenberg A Wise Move by the Chinese Revised 3/10/2006 The Chinese wisely created an exchange rate system that gave them the freedom to do whatever they want and the ability to convey to others (e.g. those in the U.S. Congress) that this change is whatever they wish it to be. Henceforth, the Chinese will not have to break any promises – i.e., they can stick to this new currency regime forever, if they choose to. This new forex policy will also allow them to test the waters to see what impacts the currency will have on other things (e.g. domestic growth) so that they can respond accordingly. Surprisingly, if we could have designed the currency system that would be best for them, this would have been it. While we won’t dwell on the particulars that you can read on the news services, in brief the Chinese can change the currency at up to 0.3%/day against a basket of currencies, so a) the revaluation can be as slow or fast as they like and b) there will be less buying of dollars and U.S. bonds relative to yen and euros and their credit instruments. Wisely, they didn’t revalue by something like 5% which wouldn’t have changed anything, would have required them to break another promise soon and would have given the U.S. Congress more reason to say that they are “manipulating the currency” (rather than “transitioning to a free float in a managed way”, which they can now claim). Of course, since the basic path is inevitable, even if the Chinese did something different at this stage, the forces would have driven them in the same basic direction. So, this development is just an inevitable step, not a landmark event that fundamentally changes things. Our view of that inevitable path is based on our belief that China will do what is in its best interest – and that is to a) develop an independent monetary policy that allows it to better balance inflation and growth, b) have the amount and mix of forex determined based on what is best for its balance of payments picture and c) slow the American (and European) move toward protectionism. What the Chinese and the Americans are both having a tough time understanding is that, if faced with the choice between a) having the Chinese hold their currency down, lend the U.S. lots of money to buy Chinese goods, and have the Chinese increasingly stimulate their economy, and b) letting the RMB appreciate, have the Chinese lend the U.S. less money and allow the Chinese to tighten monetary policy, it is clearly in America’s interest to choose a) and in China’s interest to choose b). Some people think that the opposite is true – i.e., they think that it is in America’s interest to have the RMB revalue, (i.e., to make American goods more competitive and to have the Chinese buy fewer U.S. bonds) because they put the emphasis on the “make the U.S. more competitive” part and less emphasis on the “buy fewer U.S. bonds” part. Spending on borrowed money is enjoyable – whenever any country (or person) can spend more than they earn (i.e., run a current account deficit) it holds living standards higher than they would otherwise be. So, having them lend us the money to buy their goods now is clearly better for us than having them not lend us the money to buy their goods. Look at the history of this dynamic in all countries, especially in emerging countries – when the lending is curtailed, the trade balances improve and the living standards fall. So, it’s a bit funny that the Chinese are hesitant to revalue because they figure that, if the Americans want them to do it, that must mean that it is in their interest to do the opposite. Remember the Chinese curse – “may you get what you ask for”. It could be a curse for Americans. The Chinese should give the Americans exactly what the Americans want – less intervention in the U.S. currency and the U.S.
  • 2. 2 Bridgewater ® Daily Observations 4/26/2006 credit markets – and do this as quickly as they can while keeping the markets orderly. The Chinese are gradually and wisely coming around to this point of view. As you know, we think that it is inevitable that the RMB will be about 25% to 30% higher in three years and about 60% higher in 10 years, because we believe that it is in China’s interest to have this happen. The big picture is that it is inevitable that per capita income in China will rise relative to per capita income in the U.S., so China will have a bad inflation problem (and lots of foreign bonds) if they keep the exchange rate fixed. For example, over the last several years per capita GDP in China rose at an annualized rate of about 8% while in the U.S. it rose at 2%; this took the average Chinese worker’s income from about 1.5% of the average American’s to about 2.7%. Since we think that an average Chinese worker is worth more than about 1/35th of an average American worker (and apparently many multi-national businesses agree with us), we expect this income gap to narrow. Let’s say that this continues at the past rate (i.e. Chinese income rises 6%/year faster than American income) and that Chinese inflation mirrors income growth (which isn’t exactly true, but is enough true to convey the point); then China will certainly have lots of inflation. Because this inflation is going into investments (like real estate) – due to the high propensity to save in China – it produces a bubble as well as classic inflation. A free Chinese central bank that seeks to balance inflation and growth will tighten monetary policy and have the currency appreciate so that Chinese nominal GDP growth is desirable. While real incomes in China will rise relative to those elsewhere, this needn’t show up in undesirably higher inflation if the exchange rate rises commensurately. Since we think that it is inevitable that real incomes in China will continue to rise relative to those in the U.S. at a fast pace and that it’s in China’s interest to run monetary policy to balance growth and inflation, we believe that it is in China’s interest to have its real exchange rate appreciate at a fast pace and to have an independent monetary policy. In our opinion, we are shifting from an era during which the foreign exchange rate policy drove the monetary policy to one in which the monetary policy will drive the exchange rate. Said differently, domestic conditions will be more important than exchange rate stability in setting policies and driving markets (as it is just about everywhere else in the world). As you know, we believe that the relevant analog is Japan in 1968-78 when the circumstances were similar – i.e., a) real per capita incomes in Japan were very low relative to the U.S. (60%), b) the trade balance/current account, growth rate and investment/saving rates gaps were huge and c) the Japanese were trying to hold the exchange rate the same via huge bond purchases. The three charts below show Japan’s forex reserves, its current account balance, and its real exchange rate from 1970 to 1975. As shown, the acceleration of reserves and widening of the current account surplus continued until there was a total revaluation of 34%, consisting of two discreet revaluations (18% and 14%). Note that in Japan’s case, reserves increased by about 3-4% of GDP to fill the gap. In China’s case, the increase was more than 20% of GDP.
  • 3. Japan Reserves %GDP 1% 2% 3% 4% 5% 6% Jan-70 Jan-71 Jan-72 Jan-73 Jan-74 1st revaluation 2nd revaluation As shown below, the first revaluation had virtually no effect on the current account. The current account didn’t decline until after the second devaluation and the first oil shock. Japan Current Account %GDP -2% -1% 0% 1% 2% 3% 4% 5% Jan-70 Jan-71 Jan-72 Jan-73 Jan-74 1st revaluation 2nd revaluation Japan Real FX vs. USD -40% -35% -30% -25% -20% -15% -10% -5% 0% 5% 10% Jan-70 Jan-71 Jan-72 Jan-73 Jan-74 1st revaluation 2nd revaluation 3 Bridgewater ® Daily Observations 4/26/2006
  • 4. Here is the China picture regarding reserves, the current account balance, and the real exchange rate. Clearly, the Chinese have let the pressures build way beyond the level that the Japanese let them get to before moving. The fundamental imbalance is much larger in China’s case. China Reserves %GDP 14% 19% 24% 29% 34% 39% Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Note that the current account surplus is at over 5% of GDP and rising, despite strong growth in China. That’s impressive. China Current Account %GDP 0% 1% 2% 3% 4% 5% 6% Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Here is the real exchange rate. We expect it to follow the same path as Japan’s (shown in the earlier chart). China Real FX vs USD -10% -5% 0% 5% 10% 15% 20% 25% Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Revaluation 4 Bridgewater ® Daily Observations 4/26/2006
  • 5. Taking the longer-term view, we expect the path of the RMB over the next ten years to roughly track that of the yen during the 1970s. That is shown below in total return terms (in the first chart) and in real and spot terms (in the second chart). Note that in the 1970’s the yen returned 85% in U.S. dollars. We expect a similar move for the RMB. Yen B&H Index vs. USD 90 100 110 120 130 140 150 160 170 180 190 70 71 72 73 74 75 76 77 78 Spot and Real Exchange Rate 50 100 150 200 250 300 350 400 70 71 72 73 74 75 76 77 78 Yen vs. USD (real FX) Yen vs USD (spot FX) We don’t expect the forwards, which reflect the interest rate diffs, to come close to discounting this. On the contrary, we expect to see the Chinese tighten relative to the Americans – in fact, we wouldn’t be surprised to see Chinese interest rates go to a premium to U.S. rates. Wow! What a deal! Of course, this will drive the spot rate up very fast. That’s exactly what happened in Japan. The chart below shows Japanese bond yields minus U.S. bond yields in the 1970s. Japan Minus US Bond Yield Differential -4% -3% -2% -1% 0% 1% 2% 3% 70 71 72 73 74 75 76 77 78 5 Bridgewater ® Daily Observations 4/26/2006
  • 6. The Moves Will be Big, Even Though the Market is Discounting Them to be Small Interestingly, the market was surprised by the revaluation and continues to discount relatively small changes. It doesn’t have perspective on this. Exchange rate moves, in order to have any effect, need to be in the double digits. For example, the chart below shows past RMB moves against the dollar – they have ranged from 10% to 33%. Yuan vs USD 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05 -33% -20% -10% 10% -15% 19% 13% Further, there is virtually no case of even one improperly pegged exchange rate being repegged at another improper level (i.e. that which doesn’t rectify the BoP imbalance) and sticking for long. The table on the next page shows all the pegged exchange rate breaks since 1970 for the currencies that we follow (which is all but the really obscure ones), as well as the devaluation of the dollar against gold in 1933. Because one country’s revaluation is another’s devaluation, we show the absolute values of the changes. As shown in this table, a) the average devaluation/revaluation was about 25% after the first three months and 35% after 18 months, b) in 49 out of 56 of these cases, the initial moves continued for 18 months, c) 89% of the initial devaluations/revaluations were more than 5% and 98% of devaluations/revaluations were more than 5% after 12 months, and d) in those cases in which the moves were small and repegged (i.e. not enough to rectify the imbalance), the subsequent 12 to 18 month moves in the same direction were much larger than in those cases in which the currency was floated to that level that allowed the BoP to balance. In other words, if one simplistically considers these stats to be representative of the odds of a 5% revaluation of the RMB ending up being just 5% after 12 months, then one would conclude that the odds are 1 in 50 (i.e. 2%). However, if one considers the fundamentals (i.e. the magnitude of the BoP imbalance that has to be rectified in order for China to regain full control of its monetary policy), the probability of a 5% revaluation sticking is less than 2% (because the imbalance is so great, and it will increase). 6 Bridgewater ® Daily Observations 4/26/2006
  • 7. Currency Adjustments, Subsequent Currency Changes Country Date 3mo 6mo 12mo 18mo Gold vs US$ Sep-33 13.4% 12.6% 16.0% 16.1% Philippines Feb-70 8.8% 10.3% 9.2% 27.5% Indonesia Apr-70 23.6% 28.2% 24.9% 25.0% Turkey Aug-70 3.0% 7.2% 1.3% 1.6% Korea Jun-71 22.7% 32.2% 32.8% 36.2% United Kingdom Aug-71 8.4% 15.2% 18.7% 18.6% Japan Aug-71 44.3% 69.3% 69.3% 69.3% Germany Aug-71 8.8% 13.2% 14.5% 15.0% France Dec-71 50.0% 85.5% 93.3% 96.4% China Jan-72 29.6% 31.9% 32.7% 33.1% China Mar-73 4.5% 9.6% 15.6% 22.8% Korea Dec-74 22.7% 28.7% 46.8% 50.5% Argentina Mar-75 38.9% 42.0% 47.5% 54.1% Malaysia Jun-75 4.2% 11.0% 22.7% 23.7% South Africa Sep-75 39.5% 43.9% 54.1% 63.8% China Sep-76 38.5% 38.5% 54.1% 57.6% Turkey Mar-78 24.5% 30.9% 41.9% 50.0% Indonesia Nov-78 7.0% 6.9% 7.5% 18.1% Hungary Jan-80 11.4% 10.3% 10.4% 2.4% Korea Jan-80 25.6% 55.7% 83.6% 69.4% Turkey Jan-80 30.6% 30.1% 30.5% 31.5% Mexico Feb-82 30.0% 30.3% 31.0% 35.8% Chile Jun-82 33.8% 33.7% 34.2% 34.6% Mexico Dec-82 13.8% 13.8% 13.8% 21.4% Ecuador Mar-83 46.0% 34.0% 34.2% 25.5% Indonesia Apr-83 17.4% 19.7% 26.7% 29.4% Philippines Oct-83 17.5% 17.6% 17.5% 17.8% China Jan-84 12.0% 12.0% 17.6% 18.2% Venezuela Feb-84 10.0% 12.6% 11.8% 10.8% South Africa Jun-84 42.0% 44.2% 54.3% 53.7% Chile Sep-84 53.8% 53.7% 55.9% 62.4% Ecuador Dec-85 43.9% 46.3% 82.5% 82.6% Philippines Feb-86 17.5% 29.9% 47.9% 55.5% China Jul-86 9.5% 15.9% 17.0% 14.0% Indonesia Sep-86 8.4% 7.6% 10.4% 9.5% Venezuela Dec-86 20.8% 22.4% 39.8% 33.8% Hungary Mar-87 36.9% 37.0% 38.8% 38.8% Ecuador Aug-88 15.6% 19.0% 20.1% 20.8% Venezuela Mar-89 18.5% 31.1% 35.7% 52.6% Chile Jul-89 17.9% 18.0% 17.6% 17.7% China Dec-89 4.0% 5.9% 6.5% 7.8% Philippines Jul-90 28.6% 46.2% 38.8% 28.7% Peru Apr-92 50.0% 55.1% 60.8% 68.1% United Kingdom Sep-92 23.0% 23.0% 23.0% 45.0% Italy Sep-92 39.4% 39.4% 39.4% 36.1% France Oct-92 55.9% 63.4% 64.0% 64.7% China Jan-94 62.5% 62.1% 66.8% 71.1% Mexico Dec-94 48.3% 48.3% 48.3% 48.3% Taiwan May-95 42.7% 42.7% 42.7% 42.7% Venezuela Nov-95 8.6% 8.6% 9.9% 28.5% South Africa Feb-96 7.4% 10.8% 5.5% 7.9% Czech Republic Sep-96 2.6% 3.1% 5.6% 14.6% Indonesia Jul-97 3.6% 10.2% 28.8% 29.7% Thailand Jul-97 14.5% 13.2% 15.3% 12.6% Korea Oct-97 20.1% 21.5% 21.3% 28.3% Brazil Jan-99 33.4% 33.0% 33.0% 30.1% Average 24.5% 28.5% 32.9% 35.4% Median 21.7% 28.5% 30.8% 29.9% Stdev 16.1% 18.5% 21.6% 21.6% 7 Bridgewater ® Daily Observations 4/26/2006
  • 8. 8 Bridgewater ® Daily Observations 4/26/2006 So, we expect the RMB to revalue at a relatively quick pace and believe that the Chinese will learn to like this set of circumstances rather than fear them. For the next several years their competitiveness will continue to improve rather than worsen (so their fears of harming the economy will prove misplaced) and they will enjoy seeing import prices (especially of commodities) and foreign investment assets (like companies) become cheaper. Bridgewater Daily Observations is prepared by and is the property of Bridgewater Associates, Inc. and is circulated for informational and educational purposes only. There is no consideration given to the specific investment needs, objectives or tolerances of any of the recipients. Recipients should consult their own advisors, including tax advisors, before making any investment decision. This report is not an offer to sell or the solicitation of an offer to buy the securities or other instruments mentioned. Bridgewater research is based primarily upon proprietary analysis of current public information from sources that Bridgewater considers reliable, but it do not assume responsibility for the accuracy of the data. The views expressed herein are solely those of Bridgewater as of the date of this report and are subject to change without notice. The views represent Bridgewater's outright views in these specific markets, but not all markets that Bridgewater trades. Bridgewater may have a significant financial interest in one or more of the positions and/or securities or derivatives discussed. Those responsible for preparing this report receive compensation based upon various factors, including, among other things, the quality of their work and firm revenues.