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.


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.

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.

I hope you read Mary O’Grady’s great piece in today’s Wall Street Journal Argentina Seizes the Central Bank. When you read it, think of the parallels with recent events in the U.S. I bet you feel a chill up your spine just like I did.

Argentina’s nut-job President, Cristina Kirchner (wife of former president Nestor Kirchner) decided she didn’t want to use the tax money in the treasury to pay foreign debts but would simply seize the reserves of the banking system for the purpose. Martin Redrado, President of the central bank, refused to hand over the keys so she fired him last week. In his place, she appointed Mercedes Marco, a young Yale-trained economist, who thinks the idea that central banks should be independent of politicians is very old-fashioned. Goodbye bank reserves; hello inflation.

This is the same Presidential couple who confiscated private pensions in 2008, fired the head of the government statistics office because he refused to cook the books on the inflation numbers and passed a law punishing media companies for publishing stories critical of the government.

The Kirchner government has tons of money to buy votes. They tried to tax the rich to pay for them but aren’t collecting much revenue. Inflation is already 17%. International creditors want to be paid. The only way out is to seize control of the central bank and print the money in bales. That’s what this story is about.

When your currency is fixed to nothing but the good behavior of the central bank it is crucial that the bank have at least a semblance of protection from political pressure. Argentina now has none. Unfortunately, here in the U.S., the Fed has lost some of its hard-won reputation for independence over the past few years.

Wait a minute. Huge increase in government spending. Fast-rising debt. Tax the rich. Appoint political advisors to run the central bank. That’s us! Last week Moody’s warned they would have to review the U.S. credit rating in light of the information in the new budget.

There goes that chill up my spine again.


I don’t often write about government policies that I like. It’s not that I’m crabby; it’s because they are so scarce. But today I will make an exception. Today, the Fed and the Treasury, along with several other financial regulators, correctly identified the cause of the small business lending problem–themselves–and took steps to fix it. It’s about time.

Today the financial regulators passed the grown man test by “manning up” to what we have known all along; banks have been effectively redlining loans to small businesses due to fears of regulatory reprisal. You can read the statement by clicking here.

They have made a start at addressing the problem by instructing banks to look at the health of the borrower, rather than computer models, when assessing loans. And they have gone on record that banks who do their homework and make loans to healthy small businesses will not be subject to criticism from the regulators.

The purpose of the directive is “to ensure that supervisory policies and actions do not inadvertently curtail the availability of credit to sound small business borrowers.”

minus $300B in loans last 12 months

Banks have loaned U.S. small businesses minus $300B over the past 12 months

As you can see from the chart above showing bank lending to business borrowers. it would have been helpful if they had started ensuring that this wouldn’t happen 15 months ago when banks slammed their doors shut for business borrowers. But let’s not quibble. I’m happy they are taking action now.

Longtime readers will know that I believe non-price credit rationing to be the principal trigger for downturns in employment. It happens when regulators get over-zealous and lay their heavy hands on lending standards. I called it a credit crunch in a series of articles I wrote for the Wall Street Journal in the early 1990’s and again in 2001, which prompted a vicious response from the then Comptroller of the Currency, who denied it ever happens. The fact is, business customers don’t decide how much money to borrow based upon the interest rate; it’s the availability of credit that matters.

This time around, non-price credit rationing has fallen especially hard on small businesses–the source of almost all new jobs. In the dotcom bust, only 15% of the drop in loans hit small businesses. This time it is almost half.

The facts are simple. Employment can’t increase until small businesses can borrow the money to meet payroll. Today’s step just might be a nudge to make that happen.

Bravo to the regulators for taking steps to fix the problem they created in the first place. Now it’s time for banks, large and small, to respond to this statement by giving small business owners the loans they need to do what they always do best–make more jobs for people who want to work.


This week is jobs week. Not Steve Jobs–last week was his, with blowout Apple earnings and the announcement of the slick new iPad. Real jobs–remember those? Where people actually get to go to work and earn a paycheck.

This week’s data include the ADP report, today’s initial unemployment claims number and Friday’s payroll employment report along with several other reports (ISM manufacturing, ISM non-manufacturing, and factory orders) that give further color on the subject. Add them all together and what do you get? Blah! Positive but crappy growth–not enough to meaningfully increase employment. That will still have to wait for the banks to start lending to small businesses. And no, they haven’t started yet.

The ADP National Employment report, released yesterday, estimates that January nonfarm private employment fell by 22K jobs, the smallest drop since January, 2008. 19K of the 22K lost jobs were at large firms; small ones did better (-3K). Goods producers lost jobs (-60K); service companies added jobs (+38K). Manufacturing lost 25K jobs, the smallest in two years. Take this with a grain of salt, however. ADP reports have overstated the Labor Department’s estimate of private payroll job losses by 500K in last six months of 2009.

Friday’s employment report is likely to show no loss, or even a small gain of 10K jobs or so. That’s better than getting poked in the eye with a sharp stick but don’t expect any parades. That’s because on Friday the Labor Department is also going to release one of their strange revisions for the year from April 2008 to March 2009. It’s going to be a whopper. They will report that March 2009 employment was actually 824K lower than they had previously reported.

The culprit is the faulty business birth/death model the Labor Dept. uses to correct for a bias in their data collection method. They collect establishment employment data by calling a list of known businesses. That list shrinks over time by attrition, however, as some companies die from natural causes. Others came into business too, of course, but they didn’t get the phone call because the Labor Dept. doesn’t know who they are, which would tend to make the job numbers shrink even if employment didn’t. So they “correct” the data by assuming that, more or less, the births offset the deaths causing them to add a fudge factor (+55K jobs/month from April 2008 to March 2009) to the data to make up for the missing new company jobs.

Unfortunately, it doesn’t always go that way. Shockingly, more companies die during recessions that are born (duh). So they are going to take all those fudge factors out in tomorrow’s number. Hence, the -824K revision. But wait, as they say on the infomercials, there’s more. This revision only takes us up to last March. The Labor Dept. gurus added another +900K in fudge factors in the months since then.

Confused yet? (I certainly am.) Bloomberg has a very elegant and easy to understand graphical explanation of this on their website. The real issue, of course, is how many people will understand all this when the number is released at 8:30AM EST tomorrow morning. My guess is not all of them will, which is not good news for tomorrow’s stock prices.

Take all this together and you get a picture of an economy that is growing, but not by enough to light the job market on fire. As this week’s ISM Manufacturing and ISM Non-Manfacturing reports show, the strong recovery in manufacturing has not yet shown up in the service sector. I don’t think that can happen until the banks are open for business again later this year.


Interesting article today. More than 40 former lobbyists work in senior positions in the Obama administration, including three Cabinet secretaries and the CIA director. Yet in his State of the Union address, Obama claimed, “We’ve excluded lobbyists from policymaking jobs.”

You can see a list of the hires and who they lobbied for by clicking on this link.

The reporter asked the White House if he chose his words poorly, but the media affairs office defended the president’s statement: “As the President said,” a spokeswoman wrote in an e-mail, “we have turned away lobbyists for many, many positions.”

So, the country may have heard, “we haven’t hired lobbyists to policymaking jobs,” but the White House tells us Obama meant, “we only hired some of the lobbyists who applied for policymaking jobs.” In other words, they’ve excluded some lobbyists.

Almost as good as Bill Clinton’s famous “I did not have sex with that woman” defense.

This President certainly gives good speech, as we saw last week. I wish he also gave good policy.