China CPI – February 2010

(The charts below are courtesy of Andy Rothman at CLSA. Andy is by far the most knowledgeable person I know on Chinese inflation issues.)

The worry that rising inflation in China will provoke the government to tighten sharply, which would slow growth and push commodity prices lower is unfounded.

China’s February CPI was up +2.7% from a year earlier after showing deflation for most of 2009. As the chart below shows, however, it’s all food prices. 2.06% of the 2.7% headline number came from food. Another .44% came from residence expenses, which were pushed up by a one-time increase in utility costs last year. Other goods and services accounted for only 0.2% of the 2.7% increase–about one-fourteenth of the total increase in consumer prices.

Food prices make up a much larger share of the CPI basket than they do in the U.S. or Europe. Food prices in February were +6.2% higher than a year earlier. Most of the increase was due to the 25.5% increase in fresh vegetable prices and +19% increase in fresh fruit prices, as shown in the chart below. Both were caused by severe weather and the New year holiday, which fell in February this year. Together, fruit and vegetable prices accounted for about one-third of the total CPI increase in February.

Rising incomes in China make the CPI increase negligible, as shown in the chart below. In fact, rising food prices drive higher income growth for China’s farmers. This is exactly the kind of relative price/wage pattern we expect in a country with fixed exchange rates and sharply rising productivity. Traded goods prices are constrained by global competition and rising productivity. But wages grow strongly to reflect rising output levels. It is important in this situation not to confuse rising wages with inflation when setting overall economic policy.

Internationally traded industrial input prices, however, are rising sharply to reflect the strong China growth and strong construction activity following last year’s stimulus program, as shown below. With input prices rising and end-user prices (CPI) constrained by intense competition and overcapacity the worry is not inflation, it is the profit margins of the industrial companies that make up a large part of China’s stock market.

Bottom line: China is not going to tighten policy aggressively to try to control cabbage prices. The exit from China’s stimulus program will continue in a gradual and orderly way over the next year.


The vote is scheduled for Sunday, when most people are not watching the news–I wonder why? This weekend, House Speaker Pelosi is going to try to end-run the Constitution to pass the largest piece of legislation ever enacted–multi-trillion dollar healthcare reform–without a vote. My friend and constitutional law and health care scholar Betsy McCaughey  has written two books on the Constitution. Betsy says the Pelosi gambit won’t survive a constitutional challenge in the Supreme Court. You can read Betsy McCaughey’s analysis by clicking here.

A number of House Democrats do not want to go on record as having voted for the controversial and unpopular health care bill so Pelosi has crafted a way they can vote for the bill on Sunday and tell voters they “never voted for the health care bill” in November. The tactic is called “deemed as”. Members vote on an innocent-sounding budget reconciliation bill that “deems as passed” the Senate bill (i.e., assumes the Senate Bill has already passed by the house even though it has most definitely not been passed by the house). Members then only have to vote on a series of reconciliation amendments. They then send both the Senate bill and the House reconciliation package to the President for signing.

Confused yet? Good. That was the purpose of the maneuver. They hope voters in November are to be confused too.

Betsy says the Pelosi tactic won’t suvive a constitutional challenge. ” In recent years, the U.S. Supreme Court has twice struck down attempts to abbreviate the lawmaking process required by Article 1, Section 7 of the U.S. Constitution.” In both cases the Supreme  Court ruled that neither the President nor Congress may can depart from “finely wrought procedure commanded by the Constitution to make a law.” The language of the Constution is black and white on this issue.

Article 1 of the Constitution states: “The votes of both houses shall be determined by yeas and nays, and the names of the persons voting for and against the bill shall be entered on the Journal of each House respectively.”

“The Senate health bill raises $500 billion in new taxes over the next decade.” writes McCaughey. “…if Pelosi has her way, these taxes will be “deemed” enacted without any house vote at all.”

When Ben Franklin was asked after the Constitutional Convention what kind of government the founding fathers had created, he answered “a republic…if you can keep it.” That’s the question on the table this weekend in the House of Representatives.


The Consumer Price Index for January 1020 was released today. On the surface, it showed momdest inflation of 2.1% over the past 12 months, as the table below shows. Beneath the surface, in its components, the CPI shows that the real situation is very different. There is a 45.2% difference between the highest annual inflation figure (36.8% for gasoline) and the lowest figure (-8.4% for gas utility costs). Five of the figures are above 10%. Six of them are below zero.

The job of the Fed is price stability–to keep prices stable so people will be able to predict their revenues and expenses and make long-term decisions. No rational person could look at these figures and make any long-term decision.

This is important to keep ttrack of because the direction of future inflation is the wild card for the economy and the stock market. The Fed’s bailout efforts have increased the stock of bank reserves by more than 1200% in the past 18 months, which screams future inflation. The Fed’s announcement this week represents that inflation is under control and they will be able to extract the reserves from the market before inflation shows up. I am skeptical of their qbility to do that.


I recently sat down with Wallace Forbes to discuss investing in China and other emerging markets—the interview is now up on The text of the article follows below:

Using ETFs To Play China
Wallace Forbes 03.01.10, 5:00 PM ET

John Rutledge, founder and chairman of Rutledge Capital, discusses with Wallace Forbes investments in China and other emerging markets.

Rutledge: Needless to say, this is a tricky time for people trying to forecast the economy since there are so many policy changes in the wind. I think what we’ve got to realize is that last year, 2009, was really dominated by an undervalued or broken market that came back to life. In March 2009 we had the opportunity to buy a dollar of equities for 50 cents, and we captured most of that value by the end of the year.

The problem is that now we don’t still have a free lunch. We’re going to have to earn our money by finding things to buy that can actually generate profits and cash flow, and have rising values. To begin with, the global economy this year, like last year will be driven by China, which is responsible for more than half of the growth of the entire world economy.

What’s driving that growth is the reform and opening of China along with technology change that has allowed capital to flow very quickly into high return areas like China. Where the U.S. will grow by, say, 2% this year, China will grow by 10%. And over the next 10, 20, 30, 40, 50 years China will continue to have a dramatic growth advantage over the old economies in Western Europe and the U.S.

The way I like to look at equity investment is to use a metaphor from meteorology, which is really like the evening news covering today’s weather. We all know that when we see a storm on a weather map something’s going to happen. Storms take place when high and low pressure regions come together, and they make rain, snow, thunder, lightening, tornados and hurricanes. In economics the equivalent situation takes place when high and low return capital comes together, and investors take advantage of that gap to redeploy their assets from low to high return situations.

I use that metaphor to invest a pool of capital in Switzerland, and on my weather map we have three storm systems. One is the end of the credit crunch. Very clearly the financial markets now are coming back to life, and the blackout that happened in the credit markets is ending.

That means it’s late to make money by owning banks and financial stocks. The one exception to that I would make is that I’m very interested in the Blackstone Group. That’s because in the private-equality business the general partner, which is Blackstone, makes almost all of its money for the decade in the two years following the end of a credit crunch. When companies’ trailing histories show low profits, their owners are impatient in waiting for a sale.

Their creditors are forcing sales, but the prospects going forward look good and banks are again beginning to make leverage loans available. I think Blackstone at today’s price of about $14 is vastly undervalued compared to where it will be in a year or two year’s time. Plus, it has a dividend yield of 8.7%. So I have a sizeable whack of money today invested in Blackstone and the leveraged buyout or private-equity sector.

A second storm system, to use my initial analogy, is the growth of emerging markets led by China. The trick there is that Chinese property rights, audits, financial statements, courts are all very weak. So if you want to gather in the value created by the growth of China, which is really the only top-line growth happening in the world over the next 10 years, you’re going to have to do it by investing in somebody that makes money from China but whose governance is located in a safer place.

There are several examples of that. The typical one people talk about is FXI, which is the exchange-traded fund for the Shanghai stock market. It is not bad. It’s actually invested in Chinese companies. But when China grows, it buys its technology from North Asia, especially Korea, and Japan, and Taiwan.

China buys its natural resources from South Asia, in particular Australia, New Zealand, Indonesia, Malaysia. And it buys its money by going to the capital markets increasingly from Hong Kong and Singapore. And so this is one way to play these dynamics.

Forbes: Interesting combination.

Rutledge: Absolutely. There is one stock that captures four of those markets. The ticker is EPP. It is the collection of the stock markets of Australia, New Zealand, Hong Kong and Singapore. And within Australia you have coal and natural gas. The same with New Zealand: You have the capital markets in Hong Kong and Singapore, both of which have been rated as more open and free economies with easier business conditions than the United States.

Forbes: Now this is an ETF that trades on the New York Stock Exchange?

Rutledge: It is. The ticker is EPP. There’s a second one that captures the bulk of China’s IT and communications technology needs which is the Korean ETF, EWY. The largest company in that ETF is Samsung. And Samsung is responsible for something like half of all of the mobile phone technology finding its way into China.

For people who don’t like ETFs but like a little more bravado in their portfolios, the most interesting one to me right now is Freeport McMoran. That stock has been weak recently because they’ve had an issue with a government permit in Indonesia. But Freeport McMoran produces gold and is also is a very dominant producer of copper.

When China grows, it does infrastructure spending in real estate. There are 150 million migrant workers in China, all on scaffolds. The government there is very interested in keeping them on the scaffolds and off the streets. And when they build buildings, of course, they use copper.

At the moment, many, many more buildings have been started than have been completed over the last 6 to 12 months. So, there’s going to be a surge in copper demand from China happening in the next six months, which I think will show up in the price of FCX.

That stock is currently trading in the market at about $74. The trailing 12-month price-earnings ratio is 12.9. The dividend yield is just under 1%. But earnings, which were $5.86 last year, this year look like they’re going to approach $8, and next year $9, almost all of which comes from the increase in copper prices that happened over the last year.

Forbes: That’s a fascinating set of items to be suggesting, John, as always. We go from Blackstone to a couple of specialized ETFs in the Far East and then down to Freeport as a single way to play that opportunity, or at least as a driving force in it. John, that’s terrific. I appreciate your taking the time to share your thoughts with us.

The Reid Bill ($15B) is better than either the December House bill ($154B) or the Baucus/Grassley Senate Finance bill ($85B) simply because it has a smaller price tag. But, like the other bills, it will have very little impact on jobs.

The central piece of the bill is the temporary payroll tax cut (employer portion 6.2% of the 12.4% payroll tax) for the rest of 2010 if a company hires a person who signs a statement they have been unemployed for at least 60 days, with a $1000 bonus if the worker is still hired at end of one year. The 60 day unemployed requirement is both troubling and counterproductive. It creates tremendous incentives for fraud and abuse. It will force the government to create an enforcement mechanism, potentially going after both workers falsifying statements (including those legitimately unemployed for less than 60 days) and the companies that hire them. It favors some workers over others. It tries to influence who a company hires, not just whether it hires a new worker. And it will be an administrative nightmare, forcing the government to create an enforcement mechanism, potentially going after both workers falsifying statements (including those legitimately unemployed for less than 60 days) and the well-intentioned companies that hire them.

We need jobs–all jobs–not just jobs for certain people. The government has no business telling companies who they should hire.

The temporary, selective payroll tax reduction will have very little impact on jobs. In my experience, companies don’t hire people based upon a small, temporary tax break. That means most of the money will go to companies that already had plans to hire and most of the impact, if any, will be to influence who the company hires, not how many people they hire. But don’t take my word for it. Let’s look at the estimates from the Congressional Budget Office (CBO.)

CBO Estimate of Cost per Job of Stimulus Measures

The CBO released testimony today to the Joint Economic Committee (JEC) on impacts of different jobs measures. You can read the full testimony by clicking here. The chart above is from their report. CBO analyzed impact of the same payroll tax cut for 2010 but applied to ALL NEW HIRES (not just > 60 day unemployed).

Each dollar of government spending will increase TOTAL GDP (including the $1 of govt spending) by $0.40 to $1.30 over the next 5 years, only half of which will happen this year. That means each dollar of govt spending will impact private spending by $-0.60 and $+0.40, an average of $-0.10 over the full five years.
Conclusion: Somewhere between no bang for the buck and negative bang for the buck. Would be better off handing the unemployed guys $100 bills.

That makes the net cost per job between $100,000 -$200,000 for 2010. These are jobs that will pay $30-$50K per year. Very wasteful use of taxpayer money.

And remember, these CBO estimates are for cutting payroll taxes on ALL NEW HIRES, not just those > 60 days unemployed. The Reid bill have a much smaller impact than that because not all new hires will qualify for the tax cut. If half of new hires do (half of new hires have been umemployed for at least 60 days)–a gross overestimate–the cost would be $200K-$400K per job.

The jobs problem in America is concentrated in small businesses, which are always where new jobs come from. Their problem is that they have no access to working capital to meet payroll, buy raw materials and hold inventories and receivables. The reason is that banks have effectively red-lined small business loans in America ever since the government stimulus plans started compensating banks for doing certain things (e.g., loan modifications). Jobs won”t return until banks start lending to small businesses again. That’s where policy makers should concentrate their efforts.


Fed discount rate yesterday not a big policy event and good to do. It is part of their sweeping up exercise, trying to encourage banks to repay some of the $1 trillion (1100%) increase in bank reserves they added to banking system during crisis a year ago. You can read the Fed’s press release here. Worth noting–the quarter point increase, times today’s reserve base,  will reduce bank earnings by about $3 billion over 12 months.

It is imperative that the Fed extracts those additional l reserves this year before they show up as inflation down the road. Left as is, the reserve increase is more than enough to than double the US price level.
What they are trying to do is a little like putting a genie back in a bottle. I don’t think they can do it without knocking something over but sure hope I am wrong.

You have to see this. My friend Mark Swenson, Arizona Deputy Treasurer, has shown me their new website. Arizona State Treasurer, Dean Martin, has put Arizona’s financial system online for all to see. Dean’s purpose was to provide Arizona taxpayers with a searchable, user-friendly website that discloses all revenues and expenditures for Arizona State government.

The site has daily cash balances the the entire state government (the figure above is from today’s front page) plus detailed information on all outlays and revenue sources as you can see below. It is the most transparent government site of any kind I have ever seen.

Arizona's Transparent  Government Finances site

Now all we need is to get Washington to do the same. And Mr. Geithner, if you are going to say we can’t afford it, I’ll pay for it myself. My friend Mark Swenson in the Arizona Treasury tells me they did theirs for 5 weeks of programming and $13,000.

Three cheers for Dean.


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Whether China will continue to own/buy our bonds or not is a story that shows up in the media every few months. It makes good copy but most of the people who write about it have little direct knowledge of the situation.

Bottom line: China is not going to stop buying U.S. securities but they have become our biggest creditor–too big to ignore what they are thinking.

I have spoken with the Chinese leaders personally about this issue in recent months. They are concerned that the U.S. government is spending too much money, that our budget deficits are too big, that our debt is growing too fast, and especially that the Fed has printed so much money in the last year we will have significant inflation in the future. A Chinese Vice Premier, asked me privately if these dangers were real (yes they are) and what China can do to protect itself (not much.) I have also spoken with the head of China’s central bank, the head of their social security fund, and the head of their sovereign wealth fund. All are of the same view.

China has had a more or less fixed exchange rate against the dollar since 1995 (except for the 2 years following July, 2005, when they caved to U.S. political pressure and tried to gradually increase the value of the yuan, inviting speculators to bring floods of hot money into China). They keep the rate fixed for one reason–they believe their economy, and therefore their political system, will be more stable with a fixed rate than with a floating rate. Chinese history is riddled with peasant revolts taking place during times of sudden inflation. A fixed exchange rate is essentially the same as tying the Chinese price level to the U.S. price level, in effect delegating their monetary policy and inflation control to the Fed.

Chinese leaders were greatly impressed by two recent crises.
1) Japan’s deflation and recession/depression, starting in 1989 and lasting over a decade, following the major appreciation of the yen against the dollar. During Japan’s lost decade, the price of land in Tokyo fell by more than 90%. This is one reason Chinese leaders do not want to appreciate they yuan, as Obama’s team is pressing them to do. They do not want to be Japan deflation II.
2) the Asian financial crisis of 1997, when Thailand, Korea, Indonesia, Malaysia and other Asian economies were wiped out when speculators attacked their currencies. (China escaped the crisis because their currency was both fixed to the dollar and not freely convertible in the markets.) China’s leaders do not want to participate in the next currency crisis either.

China has accumulated more than $2.4 trillion in foreign reserves (foreign securities) as of 12/31/09, shown in the chart below. (More than double Japan’s $1,1 trillion in reserves.)Their precise allocation is a secret but my information suggests they now hold about 70% of the reserves ($1.7 trillion) in dollar denominated securities. (The rest, about $700 billion, is mainly held in Euros.)

China foreign exchange reserves

Just under half of that ($755 billion) of their dollar holding is U.S. Treasury securities, as you can see in the chart below. the rest (about $900 billion) is held in dollar denominated securities that are NOT Treasury securities, for example, government agency securities (like FNMA), corporate securities (like GE commercial paper or U,S, stocks) or private equity. They divide their dollar holdings among dollar assets based on returns, just like a pension investor. Chinese holdings of Treasury securities have increased sharply over the last 2 years, reflecting their increased worries over the credit risk of other U.S. securities.

China’s $755 billion holding of U.S. Treasury securities is about 10% of the roughly $8 trillion of Treasury securities held by the public today. Big, but not gorilla big.

China has 2 worries about U.S. economic policy.
1) Huge US spending and borrowing will push U.S. interest rates up, which is the same thing as saying push the prices of U.S. securities down. They don’t want to lose money on their $1.7T of dollars.)
2) Rising U.S. inflation would push China’s price level up too, which could lead to economic and political stability there with, perhaps, the government losing power. They REALLY don’t want that to happen.

Although they are worried about U.S. policy, they really do not have the option of selling their holding of U.S. securities. The obvious reason is they would be driving down the price of the dollar securities they own. More importantly, if they were to sell their dollar securities, they would drive down the value of the dollar against the yuan, wrecking the fixed exchange rate they have worked so hard to preserve, and inviting possible economic and political instability.

Over several years, of course, Chinese authorities cold reduce their dollar holdings to, say, 50% of their total reserves by buying Euros. As you can read int he news, however, they are not going to do that right now because the potential default of Greece had made the Euro even riskier than U.S. securities.

Long-term it is imperative that we get our spending, deficits, debt, inflation and interest rate risks under control. American companies need Chinese factories and Chinese markets as much as China needs U.S. securities. (More than half of the profits of the U.S. companies in the S&P 500 this year will be earned offshore, much of it in greater China.)

Bottom line: Chinese leaders are not going to dump their dollars in a hurry. But we can’t keep doing this forever or they will own the place. We must get U.S. spending, deficits and debt under control. And we must prevent the massive Fed stimulus of the past 2 years from creating a big inflation increase over the next few years.


New reports from S&P and Moody’s indicate housing crisis has 3 more years to run, that Obama’s HAMP loan modification program has been a flop and will drive down home prices by 8% this year, and that 70% of the modified loans will re-default. This is one more reason why we need pro-growth policies–not phony stimulus spending plans–now.

The “shadow inventory” of bank-repossessed properties, as well as distressed mortgages facing foreclosure, will take nearly three years to clear at the current sales rate, according to a report from the credit rating agency Standard & Poor’s (S&P). The “shadow inventory” of homes includes all delinquent loans and real-estate owned (REO) property that has not reached the market. Estimates are 3-7M homes.

One of the problems is that government programs that pay banks to modify loans are backfiring, by distracting bankers from dealing with the foreclosure problem. Moody’s, showed that the underwhelming performance of the Home Affordable Modification Program (HAMP), which the US Treasury Department launched in March 2009 to give incentives to servicers for the modification of loans on the verge of foreclosure, will drive down housing prices another 8% from Q409 to the end of 2010.

$400B in distressed real estate loans

-S&P analysts predict that 70% of the loans that have been modified will re-default. The total balance of these re-defaulting loans and the current amount of serious distressed loans will reach $473.4bn, nearly 30% of the total outstanding balance on all privately securitized loans.

No, the U.S. should not bail out Greece or the other PIGS that are being punished by the bond market. It doesn’t pass the grown man test. After two years of picking taxpayers’ pockets to solve one crisis after another, we have to draw the line somewhere–lets get started now.

Greece’s financial crisis is a self-inflicted wound. Their government simply spent them into the poorhouse while Greek voters cheered them on. They need to learn from their mistakes so they don’t keep spending in the future. And the banks and other investors who loaned them money knew they were taking a risk. No Way should the U.S. taxpayers pay the price.

If Greece defaults on its debt the world will not end; adult investors will just lose some money. Don’t let anyone scare us into another TARP mistake.

It MAY make sense for the Europeans (Germany) to bail out Greece because they have skin in the game–they have admitted Greece into the EU and their currency (the Euro) is at risk. Greece is only 2% of EU economy. They can handle it.