A Lesson from Twenty Years Ago

George Soros spoke on currency exchange again after the famous battle on the Bank of England. This is what he started in an essay in October 2010 on China's currency policy:

The prevailing exchange rate system is lopsided. China has essentially pegged its currency to the dollar while most other currencies fluctuate more or less freely. China has a two-tier system in which the capital account is strictly controlled; most other currencies don’t distinguish between current and capital accounts. This makes the Chinese currency chronically undervalued and assures China of a persistent large trade surplus.

Most importantly, this arrangement allows the Chinese government to skim off a significant slice from the value of Chinese exports without interfering with the incentives that make people work so hard and make their labor so productive. It has the same effect as taxation but it works much better.

This has been the secret of China’s success. It gives China the upper hand in its dealings with other countries because the government has discretion over the use of the surplus. And it protected China from the financial crisis, which shook the developed world to its core. For China the crisis was an extraneous event that was experienced mainly as a temporary decline in exports.

Most investors trade on common instruments, equity, credit, currency, and commodity. Soros and his right-hand man Druckenmiller traded against a government. This is definitely audacious as governments seem have unlimited resources. Well, they would read and found traces that a country has their weakness. Soros seems back to game he and Druckenmiller fought 20 years ago. A back view on the history appears great similarity between then and when he commented on Chinese currency. For him, he is probably doing the same thing 20 years ago. But at any sense, to bet against a country needs courage and knowledge and many other things.

Let's take a look at historical situation in 1992 and reasons they started the sterling bet. From there, there is a great similarity in China's economy and the rest of the world today.

After the Berlin Wall collapsed, it was expected German government would have large deficit to sustain many East Germans flooded into the West for better social life. Commonly, budget deficit could fuel inflation so that German currency would be weakened. It did dip after the Wall down. But after the dip, what would happen? Soros' team thought the German government would tighten monetary policy because of strong economy due to large reconstruction spending. The German central bank would raise interest rate to curb inflation. That would make German currency stronger. This logic was debatable back then because not many foresaw higher interest rate in Germany. They were reading a country before anyone else understand the situation, including the Germans. It was proved that the deutsche mark did rally after the unification.

A higher interest rate caused problems weaker European countries, representing by Italy and England. Their currency needed to be devalued because people would sell them and buy the deutsche mark. Europe currencies were regulated by an exchange-rate mechanism(ERM) to ensure all currencies were at equilibrium rate. This ERM worked well for a decade but started show constraints after the Berlin Wall fell down. Britain didn't want to see their currency devalued because of political commitment on ERM. They didn't want to raise interest rate to match to German's either because of weak economy. They were stuck at this situation. On the other hand, Italy devalued their lira so that they avoided a similar ambush on sterling.

Understanding that the British government was in a difficult situation, Soros' team figured that if they sold sterling in the market, the British central bank would buy them. However, their research showed that the British central bank didn't have enough reserve to sustain this fight. So they sold billions of pounds. This is also an audacious plan because first, the calculation had to be accurate, and second, no other countries would intervene. Magically or logically, it turned out just like they planned. The bank of England surrendered after a few days buying.

There are many open questions on the trade if we think carefully. However, this is what we know so far.

The analogue of Germany and England is China and the US nowadays. China is running at a GDP of nine plus and US is relative far behind. However, other than keep raising bank reserves, Chinese government didn't increase interest rate. Common understanding is that they eventually have to do that. They don't want to do that now is because they want to have some sorts of stress tests using bank reserves to see if their bubble real estate market would collapse. That provides time to investors so that they can buy into China. The other reason China will raise interest rate is inflation.

To counter rising pressure on Chinese currency, the government would buy US dollar or issue more currency. The later is unlikely. They have massive US dollar reserve. So this seems impossible. However, not much can be lost: strong liquidity in the US would continue for a while so that it would increase buying costs. As long as there are enough US dollar supplies, this pressure will be there. There seems not much to loose. The only thing is a trigger, a trigger that realizes this logic.

Regulation Risk

Investing regulators enforce fair competition among investors, big or small. Insider trading is under current scrutiny. Series of cases are dug out. This is great news for all investors. So far, the culprit is on hedge fund managers. Obviously, hedge funds, due to its less regulated form, are easier to violate rules, although there might have no rules yet.

Hedge funds are not as big as banks. Even the defunct Bears Stern, was much larger than the largest hedge fund. This is because banks have other income resources. Also because of their sizes, too-big-to-fail was the main consideration when problems arose. Regulation biased to dominant players' stability. This biasedness is debatable because the dominant players might have done thing recklessly. Should they be punished? But in the eyes of regulator standpoint, it is easier to keep the largest ship from Titanic. That is the case everywhere, in every system.

Understanding the priority in regulator's shoes, investors can keep a note. Raise an example, John Paulson made billions in the subprime crisis by buying CDS. His trades seemed extremely brilliant in retrospect. However, many others saw the same problems in the mortgage craziness. Many of them approached differently to short the mortgage market. When Lehman blew up, government barred short trading. Many hedge funds stuck in their positions and blew up too. Paulson's positions, in the form of CDS, were not affected by the regulation. Up to this point, you can see how smart the trade is and how lucky Paulson had picked this path. From Paulson's stand point, the reason of going with CDS was because of limited risk in this trade and lower costs than other approaches. He didn't and had no way to foresee short rule's disallowed. This seems a nuance was proved to have extremely different outcome.

When opportunities come, there may be many ways to grab them. To learn from others is the best way to excel.

A Dead Company

HPQ showed its wild side again. This time, again and again, appeared on its CEO. A memo on HP's outlook was leaked before original scheduled date. The memo was reportedly only sent to 10 highest ranked executives. Because of the dim projection, stock price slammed. Also because of wild speculation, HP moved their earnings announcement forward. That is a really mess.

Actually before price plummet, HPQ was riding upward. Obviously, the ones who enjoyed leaked information also speculated it, both up and down. Consider such highly confidential commercial information, or even illegal inside trading involved, we can see how loosely managed at HPQ. It is easy to trace the memo if it was only meant to the 10 executives. Where did it leak? There are many indicators HPQ is dead to investors.

First, speculators have an internal loop. Regular investors would be consumed without mercy. So keep a long distance from it. Second, the company is illed managed. If the new CEO can't discipline his subordinates, there is no way preventing such things from repeating in the future. There may be huge attrition at the high up. Third, this track record shows that HPQ's cruel politics culture. Such politics could distract concentration and consume power. For instance, acquisitions of Palm and 3Par didn't make any good to HPQ. These are foremost considerations for investors.

Interestingly enough, after price dropped almost 10%, some analysts proposed "it is finally cheap". Watch out.

Long established companies like HPQ can't innovate itself in meaningful way, the only way is constructive destruction, one of the most powerful mechanism in capitalism system, according to Alan Greenspan.

HPQ should be removed from all watchlists.