Amph 0410 2

THE AMPHORA REPORT
John Butler jbutler@jb-cap.com Jon Boylan jboylan@jb-cap.com VOL 1/4, APRIL 2010
IS CHINA BEING TAKEN FOR A RIDE?
Much financial market attention has focused on China of late. Frustrated by China’s apparent unwillingness
to allow their currency, the yuan (or renminbi) to appreciate, influential members of the US Senate—most
notably Charles Schumer—apparently are once again seriously considering labelling China a “currency
manipulator”. If they follow through on this threat, certain punitive US actions on trade relations with
China would follow more or less automatically, unless President Obama were to oppose them. We doubt he
would, given the rhetoric coming from his top economic advisers. Just last week, Treasury Secretary
Geithner made an unscheduled trip to China, presumably to try and reach some sort of deal which would
help to avoid an economically damaging trade war.
Not everyone is in agreement, however, that China should revalue and/or float the yuan. Indeed,
some believe that this would be economically counterproductive and potentially destabilising for both
China and the US, not to mention other countries.1 We believe that this increasingly heated debate
misses the point, for three related reasons: First, it implies that the sources of persistent US economic
weakness amidst unprecedented domestic fiscal and monetary stimulus lie abroad, rather than at home;
second, it implies that, to whatever extent the sources of US economic weakness do lie abroad, that China
is primarily to blame; and finally, it implies that China’s currency policy specifically, rather than economic
situation generally, should be the focus. However, when one looks closely, it is clear that US economic
weakness is primarily the result of US policies and that the role played by China is not only not particularly
large on its own but appears to be declining relative to other countries.
The great global credit crisis of 2008 was the beginning of a major economic deleveraging. Left alone, this
would be highly deflationary. But it is being fought tooth and nail by fiscal and monetary authorities in the
US and elsewhere with all manner of policies. Notwithstanding their rhetoric to the contrary, we
believe that US policymakers, among others, would prefer nothing more than for price inflation to
rise somewhat, eroding the real value of the massive debt overhang, thereby enabling, in time, a
sustainable recovery. But they should be careful what they wish for. When the inflation arrives, it
may arrive suddenly and possibly massively, such that policymakers will face a qualitative jump in
inflation expectations which becomes self-reinforcing and which threatens to depress the potential
growth rate for years into the future. To examine this risk in more detail, we do indeed need to look
abroad, but not just at China. We also need to consider the relationship between money and prices.
***
Long before Milton Friedman came along it was widely recognised that inflation was “always and
everywhere a monetary phenomenon”. Following a multi-decade period in which Keynesianism reigned
supreme, focusing on output gaps and employment as the primary causes of price inflation, in the 1960s
and 1970s Professor Friedman reminded us of the far older insights of David Hume and other so-called
“classical” and even “pre-classical” economists who believed in some version of what is known as the
“Quantity Theory” of money.2 It its most basic form, the Quantity Theory can be expressed as the
following equation:
MV = PQ
where M = money supply; V = velocity, or the rate at which money changes hands in economic
transactions; P = the general price level; and Q = aggregate economic output. Solving for P, you end up
with a rudimentary theory of what causes changes in the general price level:
P = MV/Q
Now, holding other factors constant, any increase in M, or money supply, results in a proportionate
increase in P, the general price level. In practice, no economist, not even a classical one, would hold for an

1
Stephen Roach, Chairman of Morgan Stanley Asia, is one prominent holder of the opinion that China should be cautious on currency
policy and that the US is ill-advised to make a major issue out of it.
2
We don’t mean in any way to belittle Milton Friedman’s achievements. Like Sir Isaac Newton two centuries prior, he may have
stood on the shoulders of forgotten giants but he too was a giant. In our view, reminding the economics profession that money didn’t
just matter, but played a decisive role, was in of itself worthy of the Nobel Prize in Economics. Indeed, it seems to us that the
economics profession is highly susceptible to collective amnesia and waking it up from one of its frequent stupors is a daunting yet
essential task. Sadly, the recent financial crisis has so far failed to shake the professional mainstream out of its neo-Keynesian fantasy.
The term “pre-classical” is used here to denote economic thought prior to that of David Hume and Adam Smith. For those curious, the
Quantity Theory appears to have originated in Salamanca in the 16th century amidst a background of rising inflation presumably
caused by the surge in supply of specie brought back from the New World.

AMPHORA CAPITAL LLP www.amphora-capital.com
PROTECTING WEALTH | ENSURING LIQUIDITY 1

instant that the other factors would in fact remain constant. Money velocity and economic output are
changing constantly and sometimes undergo sudden, extreme swings, most recently during the 2008
financial crisis. After all, economies are complex, dynamic systems. For this reason, there is no measurable,
mechanical relationship between changes in M, however narrowly or broadly defined, and a given measure
of the price level P. All that we can conclude with reasonable certainty from this equation or other, more
sophisticated Monetarist or neo-Keynesian variants is that, other factors equal, large increases in the
money supply are, in unknown degree, with an unknown time lag, going to place upward pressure on
at least a few, or perhaps most, prices.
With that technical discussion behind us, let’s do a little detective work. We know that, in assuming its
“lender of last resort” role during the 2008 financial crisis, the Fed more than doubled the base
money supply, or M0, comprised of cash in circulation and bank reserves. We also know that broad money
has not grown materially, implying a dramatic decline in velocity. Furthermore, we know that economic
output has contracted slightly, notwithstanding a recent bounce. As such, it is perfectly reasonable, it would
seem, that the price level in the US has not more than doubled in a proportionate response to the expansion
in base money. Yet if we focus for the moment on consumer prices, there has been essentially no
change at all. Are we to conclude that the monetary transmission mechanism, in whatever form we
choose to model it, is simply broken? If so, does this imply that there is not a material risk of a surge
in the US price level anytime soon? No, it doesn’t.
The problem with the simple analysis above is that it treats the US economy as a closed system, which
it is not. As the issuer of the world’s primary reserve currency, when the Fed creates money, this
money flows in all sorts of directions and supports all manner of economic activity worldwide. Much
of the world borrows at interest rates highly correlated to those set by the Fed. US economic activity
generally has a dramatic impact on that of the rest of the world in the form of exports and imports for all
manner of commodities, capital and consumer goods and services. It follows that US economic policy and
economic developments generally can have a dramatic impact on prices around the world.
This is where things get interesting. A look at the trend in consumer prices around the globe reveals
something increasingly obvious and potentially ominous: Beginning in Q3 2009, there has been a
clear acceleration in consumer price inflation taking place just about everywhere. First stop, India.
Following years of stable consumer price inflation in the 3-5% range through 2006, in 2006 a trend toward
higher inflation became apparent. By January 2007, the rate had risen to nearly 7% y/y. There was a brief
decline in 2008 but by January 2009, the rate had surged to over 10% y/y. As of January 2010, it had risen
to over 16% y/y. Rates of inflation this high can do tremendous economic damage, in particular if they lead
to entrenched inflation expectations.
Next stop, Brazil. Consumer price inflation has remained fairly stable in recent years in Brazil at around 4-
6%. However, a gentle downtrend in place in 2008 and most of 2009 appears to have reversed, with
inflation rising from 4.2% to 4.6% in recent months. It is too early to conclude whether this represents the
beginning of something more substantial, but it bears further observation.
Next stop South Korea. CPI in S. Korea was in a generally declining trend in 2008 and early 2009, falling
from nearly 4% y/y in January 2008 to almost 1.5% by July last year. The trend has since reversed,
however, and the rate has subsequently risen to back over 3% y/y.
Next stop, Mexico. Consumer price inflation in Mexico steadily declined from over 6% y/y in early 2009 to
just 3.5% by December. However, it has risen sharply in the past two months to nearly 5% y/y, in what
could possibly be a trend reversal.
Next stop, Turkey. CPI steadily declined in Turkey from 2007 into 2009. Over 10% y/y in February 2007,
CPI fell to just over 5% y/y by October last year. However, it has surged recently to back over 10%.
Finally, a quick look at China is in order. CPI fell to minus 1.8% y/y in July 2009 but the figures for
February 2010 show it has picked up quite substantially, to 2.7%, indicating quite possibly a trend reversal.
(Note, however, that notwithstanding this pickup price inflation in China remains below the level of all the
other countries mentioned above.)
It might be argued that we are being selective in our brief description of consumer price developments
around the world. Indeed we are. We have focused on those countries that have seen the sharpest increases
in consumer price inflation in recent months. But in doing so we illustrate an important point: There is a
growing body of evidence in a range of countries in various parts of the world with vastly different
economic characteristics that consumer price pressures are no longer declining but rather increasing.


Indeed, if we use the aggregate global CPI data compiled and weighted by the OECD, since July
2009, the global inflation rate has risen from minus 0.6% y/y to 1.9%, and that even when excluding
the so-called “high-inflation” economies it has increased from minus 0.8% to 1.7%. And these figures
exclude India and China, which are not members of the OECD! 3

Global CPI has already bounced dramatically (OECD weighted CPI)

5.0

4.0

3.0

2.0

1.0

0.0

-1.0
Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10

Source: OECD
Therefore, it would seem quite incorrect to conclude that highly expansionary US monetary and
fiscal policies have had little or no impact on consumer prices. They have. Even in the US, CPI has
risen from minus 2.1% y/y in mid-2009 to plus 2.1%— a 4.2 percentage-point rise in only half a year. In
other circumstances, such a sharp rise in the rate of CPI would cause serious concern the Fed. But as their
top priority is fighting deflation and, by implication, eroding the real economic debt burden, they are not
inclined to respond. Not yet, at any rate.
The problem however is the following: Whereas the sharp reversal in consumer price inflation is
welcomed by the Fed and by US policymakers generally, it is difficult to imagine that it is welcome in
India or in any economy that is not actively fighting price deflation. As we point out above, an
increasing number of countries are entering this group. This implies that, as a result of current, higher
rates of growth, a growing number of countries are going to be tightening monetary policies, possibly quite
substantially. Naturally, assuming that the US is far from doing the same, this is going to place upward
pressure on the currencies of those countries tightening credit and downward pressure on the dollar.
Moreover, the US still runs a huge current account deficit but, by definition, most US trading partners do
not. History suggests that the combination of a large current account deficit and a widening interest
rate gap versus other currencies can result in dramatic currency depreciation.
Now consider that India and certain other Asian economies with growing price inflation problems
are also important trading partners with China. If their currencies are appreciating versus the
dollar, the same is occurring versus the yuan. Other factors equal, a depreciating yuan will reinforce
the trend toward rising inflation in China. There is also a political angle to consider: Food price inflation
in China is already over 6% y/y. Given that food is still a substantial portion of the average household’s
budget, high and rising food price inflation could be politically destabilising. In this regard, we note that
during the recent economic downturn, large numbers of Chinese workers chose to return to family farms
rather than remain in the cities without work, as at least they could produce some food by doing so. Now,
however, as the economy has rebounded, factories are finding it difficult to lure workers back to the
restarted assembly lines without offering higher wages. There is also serious discussion at the regional
government level about mandating large increases in the minimum wage. While the economic merit of such
policies is debatable, that they are currently under serious consideration implies that inflation is moving
from the edge to the centre of Chinese politicians’ radar screens.
Most commentators on China’s currency policy fail to see things this way. As the largest economy in the
region, they assume that China is a leader, not a follower; a price-setter rather than price-taker. But when it

3
For a complete set of these figures please refer to the OECD statistical tables available at http://stats.oecd.org/index.aspx


comes to food and other commodities, China is mostly a price-taker, meaning that even if China’s economy
remains relatively weak for whatever reason, price inflation pressure can still be transmitted to China from
other regional economies growing more strongly. (One possible sign that this might indeed be the case is
the March trade data showing the China ran a small deficit, rather than a large surplus).
We believe it is a mistake to evaluate the outlook for China’s currency as if China and the US are the
only economies that matter. As we have shown above, this is not the case. Viewed in this way, China
could well be taken along for the ride in a general revaluation of Asian currencies versus the dollar,
rather than leading the way. So whereas we heavily discount the possibility that China will respond
to US political pressure, including even the threat of a trade war, the possibility of a significant
revaluation of the yuan is rising alongside the accelerating rise in consumer prices visible not just
throughout Asia but in most of the world.
***
The market implications of a general revaluation of Asian currencies versus the dollar are likely to
be substantial and reach all major asset classes. Beginning with the dollar itself, were Asian countries
in aggregate to allow their currencies to move in a more-or-less free-float versus the dollar, current
Purchasing Power Parity (PPP) estimates would justify increases of anywhere from 20-50%.4 While
revaluations of this magnitude might seem unlikely in the near-term, the probability certainly increases as
inflation picks up. Looking out two or three years we would not be surprised to see cumulative moves of
this size. However, it is also possible depending on country-specific economic and political
considerations that a significant portion of the adjustment comes through relative wage growth
rather than through currency appreciation. (This would have the effect of raising the real rather than
nominal effective exchange rate.) Investors anticipating a general revaluation of Asian currencies should
diversify accordingly unless they have a particularly strong view about one or more specific countries
favouring currency appreciation over domestic wage growth.

China’s real effective exchange rate 1994-present

130

120

110

100

90

80

70
1994 1996 1998 2000 2002 2004 2006 2008 2010

Source: BIS
As Asian purchasing power increases, commodities in general are likely to rise in price. Some,
however, are likely to rise by more than others. Amidst significant areas of lingering economic weakness
around the globe, including of course the US, cyclical commodities might not do as well as those that are
less directly linked to business activity. Gold, for example, is likely to rise, as gold is considered a form of
savings in many Asian countries. As their wealth grows, they are likely to want to hold more of it. Other
precious metals are likely to be pulled along. Commodity inputs for basic consumer items such as food and

4
PPP is used to compare the cost of living across economies by looking at prices for the same basket of goods. For example, consider
two theoretical economies: In one, the price of a loaf of bread equals one hour’s wages. In the other, the price of the same loaf of
bread equals two hours’ wages. Now if workers are mobile, over time they will move from the latter economy to the former. As the
supply of labour shifts, relative wages adjust such that the price of the loaf of bread becomes equivalent to the same amount of labour
in both economies. Now apply such thinking to the world of exchange rates: If the cost of living is higher in one country than in
another, over time the exchange rate should adjust such that the costs of living converge.
As labour and capital are not perfectly mobile, PPP does not have useful predictive power except at long (5y+) time horizons.


clothing might rise by even more as much of Asia is still relatively poor and unable to save much, if any of
their income. Staples and necessities still consume the bulk of the overall Asian consumer budget.
When considering the impact on US interest rates it is essentially irrelevant whether or not Asian
currencies appreciate outright or whether real effective exchange rates increase as a result of higher
relative Asian wage growth. With US wages stagnant or declining and Asian wage inflation in some cases
in the double-digits, the US is going to be competing with stronger Asian demand. Imported goods from
Asia will become more expensive. And because Asia is, in most cases, the lowest cost producer, there will
be few if any options to move production to more competitive locations.
As a result, US inflation expectations are going to rise, placing upward pressure on interest rates. We
may be seeing this already in the recent spike on US Treasury yields but the magnitude is likely to be
much greater in future. If US economic growth remains relatively weak in a historical comparison, as we
expect it will due to the debt overhang and credit impairment, the Fed is unlikely to tighten monetary
conditions materially until headline CPI rises to around 5%. The longer the Fed waits, however, the greater
the risk that investors around the world begin to demand a higher risk premium to hold US debt, placing
even greater upward pressure on rates. If the Fed doesn’t respond with significantly tighter policy at that
point, it will place the dollar’s reserve currency status at risk. The last time it appeared that the dollar was at
serious risk of losing reserve currency status was in 1979-80. At one point, the Fed hiked rates to over 20%
and long-term Treasury yields reached 15%. A similar situation could happen again.
Moving on to corporate bonds and shares, the outlook is mixed. In particular, we need to distinguish
between financials and non-financials. For the financials, whose profits are strongly correlated to the
level of rates and slope of yield curves, once the Fed’s hand is forced by rising inflation and risk
premium and the yield curve begins to flatten, profits are going to take a hit, perhaps to the point of
threatening weaker firms with insolvency. Policymakers may need to consider another round of bailouts
at that time but, with the Fed tightening policy, it is the Congress and the Treasury that will need to do the
heavy lifting. Given the political climate it may be difficult to push through another generous financial
bailout package. Financial share prices are likely to fall sharply, perhaps giving up most of the post-crisis
rally. But bondholders should beware: With a bailout uncertain, subordinated and possibly even senior
financial debt will be at risk of default. Prices will decline accordingly.
For non-financials, the key is whether they have globally diversified revenues, in particular the
ability to export to Asia. Following a general Asia-US revaluation, the terms of trade will improve for
US exporters. But what goods will Asia want to consume? Given that, on average Asian populations
are still relatively poor by western standards, we would emphasise food, clothing and shelter as the
most obvious growth areas. As for shelter, some US construction firms have a global presence but, for the
most part, Asian countries have their own building materials and construction champions who have strong
political connections and are likely to see most of the benefit of increasing demand for homes and retail
business space. With respect to clothing, the US has lost most of its textile manufacturing base and is
unlikely to see much benefit from increased Asian demand for clothing.
Food is a much different story. The US has massive capacity in food production, processing, storage
and transportation. This includes products such as rice, soybeans, poultry and pork products which
together form a significant part of the diet in much of Asia. The trend toward urbanisation, a critical
factor in the growth of a manufacturing economy, can only be sustained if workers are willing to forgo the
economic benefit of maintaining family farms and smallholdings of poultry and/or livestock. It is highly
probable that, as Asian urbanisation continues, domestic food production struggles to keep up. The US is
well-positioned to fill in the gap. By implication, if US food producers find global demand for their
products rising faster than their capacity to produce, they are going to raise prices. US consumers
will no doubt notice.
Other industries that might stand to benefit would be those providing certain capital goods, including
power plants, industrial machinery and also technology. However, Asian countries have made dramatic
progress in these areas in recent years and western firms now face stiff competition for such business. One
area in which they have made less progress is in aeronautics and defence systems. These are politically
sensitive, to be sure, but it is probable that, as Asian countries become wealthier they will choose to
spend more for modern defence systems, including aircraft and helicopters. There will also be
increased demand for commercial aircraft of all types. Western firms are well-positioned in these areas,
as are Russian producers.
***


The world is changing, fast. Relative Asian purchasing power has been growing for years and the global
financial crisis of 2008, and western policy responses thereto, are accelerating the trend. It is inevitable
over the coming few years that Asian currencies and wages are going to rise dramatically in some
combination, placing upward pressure on global commodity prices and, in time, interest rates.
Western consumers will face higher prices domestically even though their own wages are unlikely to
keep up. For many, standards of living are going to remain stagnant or even decline.
It doesn’t have to be that way. Expanding trade and division of labour are fundamentally good things for
global economic growth which, in principle, makes consumers the world over better off. But many
countries have borrowed too much. Most western economies are borrowing more than ever. Policymakers
are favouring generally inflationary policies rather than downsizing inefficient government programmes.
Most refuse to make the hard choices necessary to allow their consumers to benefit properly from what is
going to be a stronger, more dynamic global economy. Someday, perhaps long after Asia has revalued
substantially and the US, among other countries, has been forced, yet again, to face the consequences
of inflationary and inefficient government policies, the US will re-emerge as a primary engine of
global growth. But don’t hold your breath.


The Amphora Liquid Value Index (through April 9th 2010)

AMPHORA: A lateral-handled, ceramic vase used for the storage and intermodal transport of various
liquid and dry commodities in the ancient Mediterranean.

AMPHORA CAPITAL is dedicated to helping clients preserve wealth in a highly uncertain global
environment by developing products protecting against both inflation and deflation
John Butler jbutler@jb-cap.com
John Butler has over 16 years experience in the global financial industry, having worked for European and US investment banks
in London, New York and Germany. Most recently he was Managing Director and Head of the Index Strategies Group at
Deutsche Bank in London, where he was responsible for the development and marketing of proprietary, index-based quantitative
strategies. Prior to joining DB in 2007, John was Managing Director and Head of European Interest Rate Strategy at Lehman
Brothers in London, where he and his team were voted #1 in the Institutional Investor research survey.
Jon Boylan jboylan@jb-cap.com
Jon Boylan is a global capital markets professional with a 16-year record of trading and selling fixed income securities and
interest rate derivatives for US and European investment banks. He specialises in all facets of the G-10 interest rate markets.
Most recently he was a Director in the Macro Sales group for Dresdner Kleinwort based in London. Prior to that he spent 10
years in charge of USD trading and risk management for Dresdner Kleinwort and Societe Generale in London. Jon began his
career working as a market-maker on the US Treasury desk for Credit Suisse First Boston in New York.

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