Andrew Busch

Last night, an economic advisor to the People’s Bank of China, Fan Gang, suggested that China may resume a “managed float” of the yuan. He said that a return to the pre-crisis structure may happen particularly if the uncertainty over the economic recovery diminishes. Fan warned against a one time revaluation as it would pose an economic danger to both China and the United States. Fan Gang is a professor of economics at Beijing University, director of China’s National Economic Research Institute and a member of the PBOC’s monetary policy committee was writing in an opinion piece published by the official China Daily newspaper.

Also the official China Securities Journal said in an editorial that the Chinese central bank is set to raise banks’ deposit reserve requirement very soon. The story, with an alarming headline declaring that a “Deposit Reserve Hike is Imminent”, said despite recent massive open market operations to drain liquidity from the interbank market, a further deposit reserve hike can’t be ruled out according to MNI. This would be the third reserve requirement hike this year and if done, would take the rate to 17% for large institutions.

Next, China’s bank regulator today asked the country’s banks to toughen their scrutiny of loans to real estate developers, taking another step to prevent soaring property prices from causing runaway inflation. At a conference today in Beijing, Liu Mingkang, chairman of the China Banking Regulatory Commission, said banks are only allowed to make bridging loans for developers that have commercial or residential properties in progress, “never a piece of land.”

Finally, China’s government has ordered nine departments to coordinate efforts to rein in property prices, taking another step to help average income earners afford houses according to Bloomberg. “The departments have been ordered to cap the rise in property prices, crack down on irregularities in the real estate market, stop developers from hoarding land and ban agents from manipulating prices, according to a report in the Securities Daily newspaper. The nine government departments include the central bank, the securities and bank regulators, the finance ministry, the tax bureau and the land ministry, according to the newspaper, citing a government statement dated yesterday.”

Raising reserve requirements, tightening lending standards, and possibly allowing the currency to return to a “managed float” shows that the Chinese are pulling back stimulus across many fronts as concerns over property prices and consumer inflation drive the process. While there has not been a meaningful pick up in inflation in the developed world yet, China is not only worried, but also doing something about it. It’s another chapter in the current fixed income narrative that is pointing towards lower prices and higher yields.

A couple of weeks ago, I attended the NABE conference in DC and had the chance to hear the ECB’s Juergen Stark speak. His topic was, “Is the Global Economy Headed for a Lost Decade. At that time, there was considerable uncertainty over whether there would be any help forthcoming to assist Greece with the debt and austerity program. On that morning, there appeared to be some agreement between France and Germany for assistance and this was seen as a breakthrough for discussions on a backstop lending program. At the luncheon for Stark, he specifically made clear how he felt about it: “No global safety nets for governments or individual corporations.”

How refreshing it is to find that the ECB has decided to pitch in and do their part to assist Greece and all of the PIIGS. Today, ECB President Jean-Claude Trichet said they will leave emergency collateral rules in place into 2011. Previously, the ECB had targeted the end of 2010 to bring back pre-crisis rules. “It is the intention of the ECB’s Governing Council to keep the minimum credit threshold in the collateral framework at investment grade level (BBB-) beyond the end of 2010,” according to Bloomberg. The barring of Greek debt from ECB refinancing operations this had been suggested if Greece had not made serious efforts at austerity and been downgraded further.

The European Union is meeting today and is discussing aid for Greece. However, Germany’s Merkel retained a tough tone towards its southern neighbor by saying that no aid decision would be made today. “A good European is not necessarily one who rushed to assist. A good European is one who abides by the European treaties and national law and thus sees to it that the euro zone’s stability isn’t harmed.” It’s fascinating that Germany has shifted their stance from not allowing the IMF to step in to now allowing them to come in as a last resort. If that should happen, the United States would then be drawn into the process and ultimately be on the hook for supporting Greece.

While Spain has been suggested as the next to follow, Moody’s recently stated that Spain’s use of fiscal space to support activity has not put its AAA rating into question. A major positive for Spain (and something I’ve been writing about) is that they are already actively engaged in an “exit strategy” development. However, there are 27 member countries in the European Union and others may shortly take the lead if growth doesn’t quickly return to the region.

In case you are wondering why this has not led to a Euro rally, the fact is that Portugal was downgraded yesterday and points towards further potential downgrades within the euro zone. Once a country loses its AAA rating, this triggers a dumping of that country’s debt by bondholders who are restricted to only holding AAA paper. In turn, this leads to a dumping of the currency as well as their portfolios adjust.

It’s the threat of additional downgrades and this selling process that is keeping pressure on the Euro. Expect this to continue throughout the year as the market assesses who’s next.

Today, the House Ways and Means Committee (Chairman Levin, D-Mich.) will hold a hearing on China’s exchange rate policy, focusing on its immediate and long-term impact on U.S. and global economic recoveries and job creation, and steps that could be taken to address the issue according to CQ. Here’s a list witnesses scheduled:

C. Fred Bergsten, director, Peterson Institute for International Economics
Niall Ferguson, professor, Harvard University, Cambridge, Mass.
Philip I. Levy, resident scholar, American Enterprise Institute
Clyde V. Prestowitz, president, Economic Strategy Institute

Also today, US Treasury Secretary Tim Geithner is meeting with Chinese Ambassador Zhang Yesui at Treasury, but the meeting is closed to the press. No exact agenda has been released, but it’s safe to say the currency will be part of the discussions.

While the currency is cited by US lawmakers and some US corporations as a major advantage for the Chinese, the Obama administration and Congress need to take a look at the US and Chinese tax codes to see a bigger advantage. The Chinese have a corporate tax that is far below the United States.

Currently, the Chinese combined corporate tax is 25% versus the United States 40%. With export incentives and other tax policy, the actual Chinese rate is closer to 12.%-15%. This is a massive advantage for the Chinese. This advantage is almost the exact percentage that critics of the currency peg are calling for the Chinese to appreciate the yuan.

Yes, tax changes appear to be boring and you won’t have anyone threatening trade tariffs for media or voter consumption. However, it’s likely to be more effective as it will assist US corporations without needing China to act on their currency and without starting a trade war. It will also create jobs and keep US companies domiciled in the paying taxes.

While there will be a onslaught of currency discussions in the lead up the April 15th Treasury currency manipulator report, Congress should spend more time making the playing field level for US corporations via the tax code rather than the currency markets.

Interesting speech by Federal Reserve chairman Ben Bernanke on Saturday before the Independent Community Bankers of America. “As the crisis has shown, one of the greatest threats to the diversity and efficiency of our financial system is the pernicious problem of financial institutions that are deemed “too big to fail.” Clearly, this and other comments regarding the Fed’s role in regulatory oversight were timed perfectly to coincide with the commencement of debate in the Senate on FRR. In case you think this is going to be easier than the health care bill, there are already roughly 400 amendments that have been filed with 200 by Sen. Shelby and Sen. Corker. At this point, no Republicans are expected to support the bill in it’s current form. However, I do believe there will be bi-partisan support if ideas from both sides are included in the legislation. Neither party can afford to go to the voters in the fall without being able to say they did something to reform the financial system.

According to Reuters, U.S. Senator Charles Schumer said on Friday he plans to move forward soon on legislation aimed at stopping China from “manipulating” its currency. “Now more than ever, there is a consensus to finally confront China’s currency manipulation,” the New York Democrat said in a statement. “It is the single biggest step we can take to promote U.S. job creation, particularly in the manufacturing sector. We plan to move forward with revamped legislation on this issue in the coming days,” he said.

Yesterday on Fox News, U.S. Senator Charles Grassley said that the United States should label China a currency manipulator and prepare a case for the World Trade Organization. “I think we have waited too long,” Grassley said. “I would want the president to order our trade representative to start preparing a case for the WTO. And then I would have to start looking at some legislation, if China does not reply appropriately.” Then, he said this: “I am tired of China crying. We are a 400-year-old society; they are a 5,000-year-old society. They are very mature. I expect China to start acting like adults, instead of crying like children.” It is by far the most inflammatory language I have seen on the Chinese currency situation and represents the mood of Washington at this time.

In 2006, Sen. Schumer and Republican Sen. Lindsey Graham had put forward a bill that had a 27.5% tariff on Chinese goods because of the currency issue. They withdrew after getting assurances from then Treasury Secretary Paulson that the US would engage China on the issue. Now, Graham and Schumer apparently are resurrecting a similar bill and it’s likely to go across all Chinese goods.

This is not an isolated incident. From the IMF to the World Bank, institutions and countries are calling on China to return to their currency program of steady appreciation that was in place prior to the 2008 financial crisis. Chinese Premier Wen Jiabao has responded by saying, “We are opposed to countries pointing fingers at each other or taking strong measures to force other countries to appreciate their currencies.To do this is not beneficial to reform of the renminbi exchange-rate regime.”

What will be the outcome? Yes, Smoot-Hawley comes to mind. However, all nations realize that’s it’s in the best interests of the global economy to resolve this issue and therefore in their best interests. The US-China relationship takes it further as China has $2.4 trillion in US dollar reserves and nearly $900 billion in US Treasury securities. The US is also China’s number one export destination. Therefore, neither nation can afford a protracted trade war.

Unfortunately, the Congress is unhappy over the lack of progress with China on the currency. The fact that the Chinese economy is growing rapidly and the US is struggling to create jobs is also making for a very heated environment. Now more than ever, the rhetoric is turning ugly and the antipathy between the nations growing. This is not healthy and will lead to additional uncertainty over the global economic recovery. While this is not a major weight on the markets at this time, it may develop into a significant negative for the summer.

In a point I’ve been making in speeches recently, Congress has very limited time to get things done this year. Yesterday upon the release of the financial regulatory reform bill, Sen. Dodd said they only have about 60 days to get this done. The summer break and the mid-term elections are going to limit the schedule.

Here’s one more big one: expect a Supreme Court retirement this summer. In a bombshell New Yorker interview, Justice John Paul Stevens announced he is likely to retire before Obama leaves office and potentially this summer.

In the interview, he told the reporter he would make up his mind by mid-April.

” Since 1994, Stevens has been the senior Associate Justice and so has been responsible for assigning opinions when the Chief Justice is not in the majority. He has used that power to build coalitions and has become the undisputed leader of the resistance against the conservatives on the Court. “For those fifteen years, John Stevens has essentially served as the Chief Justice of the Liberal Supreme Court,” Walter Dellinger, who was the acting Solicitor General in the Clinton Administration and is a frequent advocate before the Court, says.” The remaining liberal voters on the court are Ginsburg, Breyer, and Sotomayor.

Given the potential for big Democratic losses in the House and Senate, Stevens could be contemplating leaving this summer to ensure the President has a strong position to nominate and add a liberal justice to replace him. In case you forgot, the announcement of a Supreme Court or SCOTUS retirement means Congress shuts down almost completely during the process. Given the 5-4 nature of many recent SCOTUS decisions, you can understand why this would occur.

If there is a protracted battle on any nominee or if any nominee is withdrawn after they are proposed, the process has the potential to wipe out most of the summer and part of the fall. This would leave little time to pass any meaningful legislation before Congress adjourns before the mid-term elections.

The process also has the potential to further divide the parties and not generate meaningful work on the remaining issues for the fall: budgets and deficits. It is no small wonder that Moody’s indicated that they were concerned over the trajectory of the US deficits and the looming US increase of debt service as a percentage of revenue.

By trajectory, I believe they mean the dedication towards reducing the problem. Given the schedule of Congress and a potential SCOTUS retirement, I believe Moody’s is prescient in their analysis and the markets will be disappointed that no meaningful action will be taken on the deficit until 2011.

By now, most of you have read the comments by Chinese Premier Wen Jiabao at his annual press conference. However, there are some aspects worth expanding on for their importance. With arm sales to Taiwan, Dalai Lama meeting, and the Copenhagen climate talks all important areas for questions, the very first question he was asked and addressed dealt with the currency. This doesn’t happen randomly. Clearly, this issue is of critical importance to the Chinese. “First of all, I do not think the renminbi is undervalued…We are opposed to countries pointing fingers at each other or taking strong measures to force other countries to appreciate their currencies.To do this is not beneficial to reform of the renminbi exchange-rate regime.”

“I can understand that some countries want to increase their share of exports…..What I don’t understand is the practice of depreciating one’s own currency and attempting to press other countries to appreciate their own currencies solely for the purpose of increasing one’s own exports. This kind of practice I think is a kind of trade protectionism…..Since the U.S. is the issuer of the main international currency, any instability in its currency causes us great concern. Last year I said I am worried, and this year I also say I am worried,” stated Wen.

Last week, I wrote about the Obama administration has a goal of increasing exports over the next five years and how the President critiqued China for their currency peg. I also stated that the IMF and Roubini both thought that China would move on the currency and I agreed with them. The comments by Wen underscore the salient point that China will not be backed into a corner on the currency and will act when it’s in their best interests. Clearly, they are not there yet.

But there’s a gathering storm on China and their trade. Here’s a NYT article today discussing the Chinese using global trade to their advantage. Also, U.S. Senator Chuck Schumer announced Friday that he would be moving forward on legislation aimed at stopping China from manipulating their currency. “Now more than ever, there is a consensus to finally confront China’s currency manipulation. It is the single biggest step we can take to promote U.S. job creation, particularly in the manufacturing sector. We plan to move forward with revamped legislation on this issue in the coming days,” he said. Finally, the US Treasury will have to rule in mid-April on whether China manipulates their currency.

The Chinese currency question will continue to follow a circuitous path but the direction is towards more confrontation than less. Real or not, this should add volatility into the picture as the language for a trade war will be kicked around and minor trade sanctions will continue to be brought up.

Thursday, President Obama addressed the key subject of US trade policy. Last year, the Obama administration set a goal of adding two million jobs to the economy by doubling exports in the next five years. The added benefit is that export related jobs are generally higher paying than domestically focused work with the likely exception of government jobs. Last October, I met with senior US Treasury officials who adamantly supported this approach.

Yesterday, we also got the US trade deficit number for the month of January which improved 6.5% to -37.3 billion. The breakdown by region in billions tells the entire story: LatAm 0.0, E.U. -2.8, Japan -3.3, Canada -3.9, Mexico -4.6, and China -18.3. Even with a weak Euro, the trade deficit between the EU and the US fell over 56% from December to January. Overall, the US trade deficit fell between LatAm, E.U., Mexico, and Japan. However, the deficit between China and the US increased 1.1%.

The President took the dragon by the horns and addressed the currency issue. “As I’ve said before, China moving to a more market-oriented exchange rate would make an essential contribution to that global rebalancing effort,” Obama said in the speech. “We all need to rebalance. Countries with external deficits need to save and export more. Countries with external surpluses need to boost consumption and domestic demand.” Without question, this was the most direct and formal attack on the Chinese currency regime to date from the Obama administration.

Over the last several months, the Chinese have made it clear that they have no intention of allowing Yuan appreciation and resent having it as a political issue. However, there have been reports in the Chinese press that a manufacturing stress test has been administered to see how this sector would respond to an appreciation of the currency. China will act when it’s in their best interest. With inflation quickly accelerating and their trade position strong, the Chinese are nearer to allowing the Yuan to appreciate further. Over the last week, big financial heavyweights like the IMF and Nouriel Roubini have said they are anticipating a move by China on the currency soon. Most likely, these folks don’t say things like this unless they are getting information from the source.

There are other areas the administration could do to help boost export related jobs. Free trade was a mantra under the Clinton administration and NAFTA was and is still a resounding success. Study after study shows that if you break down trade barriers, you increase trade between countries. Currently there are free trade agreements with Panama, Colombia, and South Korea that remain stalled in the US Senate and have been that way ever since they were proposed under the Bush administration. While these would not be on the scale of NAFTA, they would help create jobs in all of the countries should the agreements be passed.

Lastly, the US needs to resolve the trade dispute with Mexico over trucking. In 2007, there was a pilot program between the US and Mexico that allowed Mexican trucks to travel into the US beyond the commercial border zone. According to the WSJ, this program was aimed at satisfying a component of NAFTA. Mexico has retaliated by placing $2.4 billion of tariffs on US agriculture and manufactured products that has cost the US 25,000 jobs according the US Chamber of Commerce. The Journal reports that the job losses may increase as most companies have eaten the tariffs without raising prices.

Like Guantanamo Bay and the Afghanistan surge, the President has to make a decision that goes against what he has promised his base to improve trade and jobs. While the health care fight and unemployment are dominating the headlines, a shift towards free trade and creating jobs would be a welcome sign from the chief executive. It certainly would be an issue that both Democrats and Republicans can support and may begin a shift towards seeking common ground between the parties.

A signing of the free trade pacts and resolving trade issues with Mexico (and Brazil) would allow the US to reassert themselves as the leader on trade. It would also allow the US to lead the world when it comes to putting pressure on China. Given that it may already be in China’s interest due to inflation, this last push may be the defining factor to get them to move.

Jobs are clearly on the minds of those in Washington, D.C. The Temporary Extension Act of 2010 allows for another 14 weeks of jobless benefits to be extended to those out of work which would cost a CBO estimated $8.6 billion.

By now, most of the United States is familiar with the Jim Bunning story and how he held up a vote on jobless benefits. Bunning was pilloried by Democrats and the Huffington post for stalling funds from going to help unemployed people. But did it? The Chicago Tribune carries an interesting story that asks due, “Longer jobless benefits cause longer unemployment?

“As of mid-2008, unemployment benefits ran out after 26 weeks. Under two presidential administrations and a more-than-willing Congress, however, they kept growing and growing.First, they expanded by 20 weeks, then another 13, then 20 more and then 13 more. One additional week got added to the first 13 to make 14. Finally, another six got tacked on….Add it up, and that’s 99 weeks of unemployment benefits available to Illinois residents who qualify. Other states have different rules, but many also run to 99 weeks at the maximum.”

“Given the rotten economy, it’s easy to imagine why politicians keep pumping quarters into the jukebox. It takes time to get a job, so the long duration of benefits is not a sign of deliberate malingering. But those government checks come with an unwanted side effect, especially for workers at the low end of the economic food chain. They go a long way toward explaining why 40 percent of jobless Americans have been out of work for at least 27 weeks, the highest level since the government started keeping score in the 1940s.”

“Those programs subsidize unemployment,” explained Robert Shimer, economics professor at the University of Chicago. “There could be good reasons to do it, but we should be clear on the cost. It has a pretty substantial impact.” Shimer estimates that the current level of benefits probably accounts for 1 to 1.5 percentage points to the 9.7 percent national unemployment rate.

If true, it’s a fascinating behavioral dilemma for politicians.

If they cut the benefits (like Bunning asked), then they run the risk of being seen as Potter-like bad guys with no compassion for the unemployed. If they don’t cut the benefits, the jobless rate stays artificially high heading into the fall mid-term elections and the voters turn them out. Political expectations effect economic decisions. While Democrats may believe that they have a Faustian choice over health care, they will be staring down another one with unemployment.

These decisions matter for the markets. Consider this scenario for the 2nd half of the year: the economy continues to improve and begins to create jobs; the government is hiring census workers and will also be creating jobs (temp, but jobs); and Congress stops extending the jobless benefits which drops the headline unemployment rate 1 full point. In turn, this will prompt the Fed to act sooner than the market is anticipating now and begin to raise rates to take out the massive monetary stimulus.

Under this scenario, we could get the unemployment rate to drop below 8% before the end of 2010 and the Fed Funds rate to be above 1%. While I give this a 20% probability, it’s vastly different from what the market is anticipating and therefore provides an opportunity.

Yesterday, I wrote about Jim “Man a La Mancha” Bunning’s attempt to enforce the Pay-Go rules of the Senate and his failure. Last night, the US Senate voted 60-37 to waive the Budget Act (Pay-Go) rules for the tax extenders amendment and add almost another $100 billion on to the US deficit. While even Greece appears to be addressing its overspending ways, the US Congress continues to pour it on. The train wreck gathers speed.