US-China Relations: The Rift Is Growing at its Fastest Pace In Decades

"It's not you, it's me. Nobody ever says it's them, not me. If it's anybody, it's me!"

George Costanza

 

Conclusion: The political rift between the U.S. and China is growing, expediting on the margin the U.S.’s secular decline as the world’s superpower. This does not bode well for U.S. Treasuries. In addition, as a result of its economic outlook, capital is pouring into China like never before.

 

Position: Long the Chinese yuan via the etf CYB. Short the U.S. dollar via the etf UUP.

 

In the last 24 hours, China has been having the “the talk” with its largest debtor. Yesterday, via its state-run newspaper, the People’s Daily, China issued some alarming commentary regarding Sino-U.S. relations. Notable excerpts from the article read:

 

Lip service is far from enough to boost the development of Sino-U.S. relations. If Washington cannot find a way to recognize and accept China's peaceful rise onto the world stage, bilateral ties will be like a roller coaster full of ups and downs… Issues such as arms sales to Taiwan, Google censorship, RMB exchange rates as well as finger-pointing about economic responsibility show [that] Washington still seems confused and inpatient about relations with China.”

 

Furthermore, the articles cites Ian Bremmer, an American political scientist specializing in U.S. foreign policy, saying: , "America and China will have more than ever to gain from closer political and commercial ties, and must take steps to avoid a Cold War, or worse."

 

China continues to move counter to U.S. foreign policy wishes. In conjunction with yesterday’s People’s Daily article, China signed an economic and technical cooperation agreement with North Korea – one week after U.S. Secretary of State Hillary Clinton announced further trade sanctions targeting government officials and foreign banks that help sustain North Korea’s weapons policy. This is the latest step in a growing list of actions taken by the Chinese government this year to exert its dominance over the Asian region. Those actions have included cutting off high level military exchanges with the U.S. in January and refusing to back the U.S. in blaming North Korea for the sinking of a South Korean warship in March. Just last week, China’s Foreign Minister, Yang Jiechi, described Clinton’s comments on making sovereignty in the South Sea a “leading diplomatic priority” as “virtually an attack on China”.

 

Today, Sino-U.S. relations took a decisive turn to the worse, as China declared  its “indisputable sovereignty” over the South China sea and held naval drills in the waters, pushing back against growing U.S. influence in the region. In conjunction with the drills, China’s Ministry of Defense released the following statement:

 

“China has indisputable sovereignty of the South Sea and China has sufficient historical and legal backing to underpin its claims. It opposes efforts to internationalize the issue and will resolve differences through “friendly negotiation… China opposes any planes or warships that engage in activities that will compromise China’s security either in the Yellow Sea or other seas near China.”

 

Today’s drills and statement follows joint U.S.-South Korea naval drills from earlier this week in the Sea of Japan, which were designed to deter North Korea. Further drills are planned in the Yellow Sea – off China’s eastern coast. Judging by the statement above, China is not likely to let that happen without consequence. China considers its neighboring seas “its own”, dismissing claims from other Asian countries to islands such as the Spratlys. Recently, China told Exxon Mobil Corp and BP Plc. to halt exploration in areas that Vietnam considers part of its territory. China, aware that actions like this may push its neighbors into U.S. arms, is in the process of building its ocean fleet to extend its military influence far beyond its borders – should the U.S. try to intervene. All told, the South China Sea sees about half the world’s merchant fleet by tonnage each year and it is home to potential untapped oil and gas reserves, so “winning” the Battle of the South Sea is very important for the Chinese economy and its future growth outlook. Some $867 billion in U.S. Treasury holdings suggest that China may have the upper hand.

 

Three Charts Geithner and Bernanke Don’t Want You To See

 

Chart One – China Growing; U.S. Slowing:

 

US-China Relations: The Rift Is Growing at its Fastest Pace In Decades - 1

 

As the charts points out, China continues to take share from the U.S. as a destination market for European exports, which will continue to lead to greater investment and capital inflows from Europe to its growing economy. This is exactly what we are seeing as it relates to the recent earnings and guidance commentary from companies across the globe: 

  • Publicis Groupe SA is targeting China and working with Chinese companies to help make China “one of its most important” advertising markets.
  • Sony Corp, the world’s third-largest television maker raised its full-year earnings forecast, citing continued evidence of strong demand in China.
  • Volkwagen AG, Europe’s largest carmaker, reported its largest quarterly profit in two years on higher demand in China (profit in China up 168% Y/Y); The CEO recently announced plans to build two new plants in China to double production capacity, which would help it offset “stagnating sales in Europe”.
  • Volvo Cars’ success will “hinge on building a manufacturing plant in China”, according to its CEO; Volvo’s 1H10 sales grew 88% in China vs. 20% globally.
  • Rival PSA Peugeot Citroen, Europe’s second-largest carmaker, recently signed a joint venture China to boost production in sales in the country.
  • Nissan Motor Co., Japan’s third-largest automaker posted a first quarter profit, aided by “growing sales in Asia” (sales in the region, excluding Japan, grew 62% Y/Y in 1Q10 vs. only +23% Y/Y in North America); The company plans to raise annual production capacity in China by 70% in two years. 

All of these plans for increased investment are occurring in spite of China’s passenger car sales slowing to its slowest growth in 15 months in June, in addition to a looming negative backdrop for U.S. GDP growth. Should the U.S. slow, it would no doubt have a negative effect on the Chinese economy (the U.S. is China’s largest export market). Luckily for China bulls, China Finance magazine published a report on July 3rd suggesting that spending under the government’s 4 trillion yuan stimulus packages aren’t yet fully allocated and adjustments can be made based on future economic conditions. Conclusion: China is likely prepared to weather a slowdown in the U.S. economy.

 

Chart Two – China Dumping U.S. Treasuries:

 

US-China Relations: The Rift Is Growing at its Fastest Pace In Decades - 2

 

As this chart points out, China has been a net seller of U.S. treasuries in the period from July ’09 – May ‘10. Since August 2009, foreign holdings of U.S. Treasuries have increased from $3.5 trillion to $3.9 trillion, which is growth of 11.4%.  In the same period, Chinese holdings of U.S. Treasuries have declined from $936.5 billion to $867.7 billion, or 7.7%.

 

While the math doesn’t lie, the Chinese certainly have been. China has been using market concern over E.U. sovereign debt and the world’s “flight to safety” as a great selling opportunity to unload treasuries an talk them up at the same time. In a recent publication by China’s State Administration of Foreign Exchange the Chinese talked down any implications of mass selling, suggesting that market concern that China may consider “nuclear option” of dumping its Treasury holdings is “completely unnecessary”.

 

Chart 3(a) and 3(b) – Dollar Down; China Up:

 

US-China Relations: The Rift Is Growing at its Fastest Pace In Decades - 3

 

US-China Relations: The Rift Is Growing at its Fastest Pace In Decades - 4

 

The two charts above highlight both the secular decline in the U.S. Dollar as the world’s reserve currency and the cyclical decline of investor confidence in the U.S. Dollar. The Bubble in U.S. Politics combined with burgeoning U.S. debt and deficits has given China its best opportunity to advance its goal of making the yuan a global currency and reducing its reliance on the dollar. Since December of 2008, China’s central bank has signed at least $650 billion yuan of swap agreements with countries around the world, ranging from Argentina to South Korea. Its most recent swap agreement was a three year deal with Singapore (which we are long of) worth 150 bilion yuan ($22 bil). The agreement, which may be extended, aims to facilitate trade and investment between the two nations, according to the People’s Bank of China. Market demand for the yuan continues to grow as well. On Wednesday, China sold 28 billion yuan of 30-year debt which drew bids for 1.91 times the amount on offer (up 35% from the last offer on 6/18).

 

At the end of the day, China is a big country with a lot of people (1.3 bil. to be exact) that is increasingly on its own track towards further economic development. And based on recent and long-term market dynamics, any attempts for the U.S. to stand in her way will likely  be futile. As Warren Buffet once said, “Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.” Keeping that in mind, Hedgeye is long the Chinese yuan and short the U.S. dollar.

 

Darius Dale

Analyst


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