@ TUDOR INVESTMENT CORPORATION TOWARD EQUILIBRATION February 14, 2011 Paul T. Jones IL Summary Ina research supplement last quarter titled “A Tale of Two Policies,” I described in detail how China's renminbi (RMB)/US dollar peg and mimicry by its Asian neighbors constituted one of the largest structural impediments toward economic recovery in the United States and much of the developed world Failure to address this issue—as one of the primary causes of the intractable unemployment currently plaguing the US—has led toa series of second-best policy options, such as the quantitative easing implemented by the Federal Reserve and, most recently, the extension of the Bush-era tax cuts during, a time of fiscal profligacy. Indirectly, the peg is exacerbating the United States’ large fiscal deficit while enabling our elected officials to delay the difficult spending adjustments that are inevitable The report that follows presents a detailed look at the connection between the undervaluation of the Chinese RMB and the subsequent loss of competitiveness in the US manufacturing sector. A summary of the findings / conclusions of the longer piece can be made as follows: «The Chinese RMB is 35%-72% cheaper against the US dollar than in 1993, ona productivity adjusted purchasing power parity basis. © This devaluation by the second largest economy in the world has been a major, if not the primary, contributing factor to the nearly six million lost jobs suffered in the United States’ manufacturing sector. © Because of China’s immense influence on the Asian region, Vietnam last week devalued 8.5% against the US dollar despite having nearly a $10 billion trade surplus with the US, equivalent to over 4% of Vietnam's GDP. It did this because it runs a $16.5 billion trade deficit with China Which again highlights how undervalued the RMB actually is to the US dollar. © Since 1993, foreign holdings of US Treasuries have risen from 20% of outstanding issuance to nearly 50%. History has shown that holdings of this magnitude lead to financial instability and increase the probability of both sovereign default andFebruary 14, 2011 Page 2 higher inflation for debtor countries experiencing such high levels of foreign ownership. © Since the dollar's peak in March 2009, China's RMB has appreciated the least of a multitude of currencies, further exacerbating global imbalances. * Toachieve global economic harmony, no country with a trade surplus should intervene to suppress the value of its currency unless both its growth rate and unemployment rate are substantially below that of its trading partners or unless its currency is substantially overvalued. + The undervaluation of the RMB is directly contributing to the size of the US budget deficit through reduction in domestic employment opportunities and the accompanying tax revenue that would flow from those. Indirectly itis enabling US policymakers to make poor fiscal decisions because of the inordinately low interest rate structure that is a consequence of the need for Asia to recycle surplus dollars into the US Treasury market. + The US has an easy policy tool to correct this. It could intervene in the foreign exchange market against the Hong Kong dollar, and exert its, influence on what is by definition a bilateral, not unilateral, exchange rate. This is no different from what Asia does every day to the US and would speed up RMB appreciation. Just as a matter of prudent reserve management, the US could also intervene against other Asian currency suppressors to diversify its foreign exchange reserves. + The undervaluation of Asian currencies is an invisible crisis that is creating such enormous global imbalances as to dwarf the tech bubble of 11999-2000 as well the subprime real estate crisis in the US in the middle part of this decade, To rephrase an old idiom, “It's the exchange rate, Stupid!”Fobruary 14, 2011 Too Cheap Page 3 Statistics are often used by economists to tell tall tales but the statistics in the table below, which begin in 1993, offer a painfully accurate story regarding the RMB's relative value to the dollar. “Table 1, Asio va. US- Bilateral Exchange Rates and Estimates of Valuation 19951698 2000205 2070 ‘Asia ex-dapen Nominal exchango roto (% ch)" 0 8 sata Real exchange rate (% ch)? Oo 0 Tot Real 8S adjusted exchange rae (% cb) * 7 8 Narow Big Ma absolute PPP valuation (% deviation) © 48 ‘Broad absolute PFP valuation (deviation) * oe 8S adustod broad absolute PPP valuation (% dewation or ee ee) china Nominal exchange rate (% og)” ee Real exchange rate (% cha)? os 9 4 3 Real 8S adjust excrange rate (% chg) > 7283538 Narrow Big Mac absolute PPP valuation devation)* 2 948 Broad absolute PPP valution (Ye devaion)* 86 eset B.S adjusted broad absolute PPP valuation (% deviation)® sh Momo tems ‘Asia ox-Japan current account balance (in USD blr) ee US eurent account bance (in USD bl) at 418 74867 Negative means cheaper joneiaty Fund WF), rial inialigance Aganey (GIA) and Tuaorexiulaons. 's based on relative GDP price deflars, Mis expressed as percent change relative 1299, 43, The real Galacea-Semvelton agusted exchange rate takes ito account productivity erential. Its expressed as @ percent change relave to 1993. Negative means eneaper ton rom abso purchasing power party. Negative means undervalued ive producivydiferntile, Negative 4, Valuation s expressed as a percent de 5, Broad absolste PPP valuation sdusted for Aalassa Samuelson 1 Undervalued. ‘The first line of each panel on Table 1 shows nominal exchange rates relative to their average 1995 level. That year, the US had approximately 17 million manufacturing jobs. Notice how, on average, Asia ex-Japan has a nominal exchange rate which is 21% cheaper than 17 years ago, when the USFebruary 14, 2011 Page 4 unemployment rate was 6.4% compared to 9% today. China’s nominal exchange rate is 15% cheaper than 17 years ago. Looking at nominal exchange rates over long periods masks changes in relative value. We therefore have included on Table 1 percent change in the real exchange rate (RER) relative to 1993. The RER is simply the nominal bilateral exchange rate adjusted by relative GDP price levels. Asia ex-Japan and China have RERs which are, respectively, 21% and 30% stronger today than 17 years ago. This real appreciation is driven by recent inflation in Asia and nominal appreciation relative to the US since 2006. ‘The problem with looking at RER percentage change is that absolute levels of relative prices matter. For instance, in 1993, China's average manufacturing earnings were $577 per worker versus $24,960 per worker in the US. Today, however, average manufacturing earnings in China have risen to $3,883 versus $38,813 in the US, but still remain barely 10% of that for a US worker. So, yes, China’s RER has risen, but the starting base was so low as to render this statistic as almost irrelevant. We offer more on absolute levels in a moment. When looking at RERs, itis also important to consider relative productivity differentials. The third line of each panel on Table 1 adjusts the percent change in RERs since 1998 for the productivity differentials that have ‘occurred since then. These are called Balassa-Samuelson adjusted exchange rates, or BS RERs.? As we note above, for Asia ex-Japan asa whole the simple RER suggests that those currencies today are 21% stronger than 17 years ago. But looking at the B-S RER tells a strikingly different story. On average, Asian currencies are really 30% cheaper today than in 1993. The 51% difference relates to a massive cumulative productivity gain by Asia over the US since 1998. For China specifically, the simple RER suggests the currency is 30% stronger today. But the B-S RER suggests the currency is really 35% cheaper than in 1993. There has been an immense 65% cumulative productivity gain by China over the US since 1993. Ignoring this gain by looking only at a simple RER gives an incomplete picture, Perhaps even more important than changes relative to 1998 are absolute valuation levels. The fourth and fifth lines of each panel of Table 1 show how * The Balassa-Samuclson effect suggests that real exchange rates should appreciate in proportion to the differential in tradable sector productivity growth and therefore in proportion to real CDP growth differentials between countries. See Obstfeld and Rogoff (1996), Foundations of International Macroeconomics, MIT Press, pages 210-216, Table 1 deflates real bilateral exchange rates by relative real per capita GDP. It calibrates and also estimates the share of tradable goods in the economy.February 14, 2011 Page S undervalued Asian currencies are relative to two simple and well-known price- based long-term valuation metrics: the Big Mac index, published by The Economist, and absolute purchasing power parity (PPP), published by the International Monetary Fund (IMF). Based on the local US dollar price of a McDonald's Big Mac burger versus the burger’s prevailing price in the United States, the Big Mac index broadly suggests that the Asia ex-Japan under- valuation situation has not changed appreciably since 2000 and is about 43%. In China's case, the Big Mac index suggests the RMB is 48% below fair value, versus 52% back in 2000. A broader measure of absolute PPP based on the local US dollar price of a large basket of goods (beyond just a Big Mac), tells a similar story. Asian currencies remain about 43% below fair value and close to the 44% undervaluation of 1995. In China’s case, whereas the RMB was 60% below fair value back in 1995, it now appears less misaligned at 43% below fair value, but still remains at an unhealthy discount. The final line of each panel on Table 1 shows what may be the true degree of absolute undervaluation of Asian currencies once price differentials and productivity differentials are taken into account. This is the B-S adjusted broad absolute PPP valuation metric. It may well be that Asia ex-Japan currencies are on average 61% cheaper relative to the US dollar. It may also be that the Chinese RMB is 72% cheaper relative to the US dollar. There is some debate between economists as to whether long-run absolute valuation of currencies should be done by looking at PPP or B-S adjusted PPP? So there is some uncertainty to contend with when assessing absolute valuation. Even taking this uncertainty into account, and accepting that Asian currencies might have been closer to fair value in 1993, rather than severely undervalued, the respective degree of undervaluation for Asia ex-Japan and for China today would be 30% and 35% ‘This leaves us with a potential undervaluation range for Asia ex-Japan of 30%- 61% and for China of 35%-72%. This magnitude of absolute misalignment is materially higher than common wisdom, which tends to be at the bottom of these ranges and often even lower. ‘The consideration of productivity gains in our analysis is essential because if foreign exchange markets were freely floating, one would typically expect that large productivity gains in the home country would be met with attendant capital inflows and an appreciated nominal exchange rate or a much stronger, RER. This is relevant because of the impact on the US manufacturing sector. Chart 1 below tells the sad story. 2 Moreover, there is some debate as to whether B-S adjusted PPP holds in levels or in rates of change.February 14, 2011 Page 6 The Invisible Crisis (Chart 1. US Manufacturing Employment Relative to Trend 9008 4000 5000 e000 00 shoo PERRATTLGTRAGTG Tas Sources US res ofatr Susi) ree eetone ‘China's exchange rate unification and 43% devaluation over 1994 did not have any immediate impact on US manufacturing. China's economy was only 6% of the US economy at the time (versus 40% today) and, as such, was not impactful. However, China was a huge competitor to its Asian counterparts and ultimately, the 1994 devaluation was a contributor to the 1997-1998 Asian crisis. Essentially, Asian currencies depreciated to a level from which they regained competiveness against their ever-growing neighbor, China. It took US manufacturers approximately two years to understand that these depreciations ‘were permanent. And as they came to this realization in early 2000, jobs began fleeing to Asia by the millions. The critical difference this time was that Asian countries began actively intervening in foreign exchange markets to suppress the value of currencies and to extend the new-found and increased competitive advantage over US manufacturing counterparts. This is the critical factor. This happened almost invisibly and with little protest from US authorities. It is interesting to note that the United States continued to lose manufacturing jobs beyond the recession years of 2001-2003 and even into the recovery from 2004 until 2007. A glaring recent reminder of the RMB's gross undervaluation and the consequent exacerbation of global imbalances occurred on February 11"* when ‘Vietnam devalued its currency by 8.5% against the US dollar. This occurredFebruary 14, 2011 Page 7 despite Vietnam's $10 billion trade surplus with the United States, the equivalent of 4.3% of Vietnam’s GDP. One might rationally ask why they would do this, and Table 2 below explains it. Table 2, Vietnam 12-Month Rolling Trade Balances as of September 2010 usp in millions) % GDP Australia 1357 06 Canada 6880S Euro Area 2744 12 Germany 530 Oz United Kingdom 921 04 United States 976843 China 16520 -73 ‘Goures’ IMF Direction of Trade Siatiscs, DalaStveam, General Statstes Ofioe of Visinam This table illustrates Vietnam's $16.5 billion trade deficit with China (-7.3% of Vietnam's GDP). Vietnam devalued to try to reduce the trade deficit it runs with an increasingly more competitive China. Despite running a massive trade surplus with the United States, and smaller ones with Australia, Canada, Germany, Eurozone and the United Kingdom, Vietnam felt compelled to devalue against the dollar in an effort to find relief. It is the same story we saw in Asia in 1997 and 1998 and will simply accelerate job loss in the US to Asia, but on a much smaller scale. My guess is that this will barely make the front page of the Business Section much less the regular news. However, these unnoticed but important movements in exchange rates over time have ultimately contributed to our 9% unemployment. To rephrase a well-worn idiom, “It's the exchange rate, Stupid!” ‘The next chart is a breakdown by investor class of the US Treasury market.February 14, 2011 Page 8 Chart 2. Holdings of US Treasuries by Agentas a Percent of Treasury Debt Outstanding" — 60% 50% 40% 30% 20% 10% ow SELERREESESESEREESERSESEERRE ereinss etueune ont teens ines Mio ‘Source: Federal Reserve Soar (FRB). 41 The foreign share has irendedtighe, crowding out the major domestic holders 2. The aceuteraton of forekn ownership coincided wih the 50% Chinese devaluation of RMB/USO in erty 1908, Notice how foreign ownership stayed rather static between 15% and 20% from 1971 all the way until 1994. After China's 1994 devaluation, foreign ownership of US Treasuries rose starkly to 50%, around where it currently stands. This share of foreign ownership is equivalent to about 30% of US GDP. There is no surprise here, as China and the rest of non-Japan Asia intervenes almost daily in the foreign exchange market buying dollars to suppress the values of their currencies, But make no mistake, this is potentially a financial stability threat. History is replete with examples under which rollover risk is absolutely more dangerous when debt composition is significantly held by entitics outside domestic borders. Table 3 below shows the likelihood of higher inflation and sovereign default based on various levels of public debt. The data clearly suggest a greater probability of higher inflation and default with higher public debt levels. With US public debt expected to reach 69.4% of GDP at the end of 2011 according to the CBO 3, the probability of higher inflation in 2012 appears to be in excess of 13%, and the probability of sovereign default appears to be in excess of 6%. But this may be an over-estimate. The market is pricing a 0.6% probability of default in one year, and this seems more accurate than the table estimate. The table is nonetheless instructive in showing an increased probability of default and of inflation for higher levels of public debt. 2 Buiget and Economic Outlook: Fiscal Years 2011 through 2021, Congressional Budget Office (CBO), January 2011.February 14, 2011 Page 9 ‘Table 3. Cumulative One Year Ahead Probability * Public debt (% GDP) 020 40 60 80 100 120 >120 Probability of higher inflation 0 4 8 13 18 19 22 26 Probabilly of sovereign default 0 1 3 6 9 13 15 15 ‘Sour Vineart Raina, AEI Economie Oulook, Oath ZOTO and Todor caTouaions, 1) Sample of 71 coun 1945-09 in Carmen Renna (2010), Ths Time's Deen’ Chartbook ‘Country Histories on Debt, Detauit end Financial Crises, NBER Working Paper 15816. Finally, Chart 3 below highlights just how slowly China has allowed its currency to appreciate against the dollar relative to the appreciation rates of other world currencies. Chart 3. Currency Changes (in Percent) ‘Agata! US Dalla (USO) fom USD Peak (March 9, 2008) February 9, 201% 00 100 m0 x00 400 00 ao bala eu Anes eran ‘sous Korea coats Mexioe Tetey ae ‘Sources: Bloomberg and Tudor calculations. Itremains a puzzle as to why China—faced with a growing inflation problem as a result of its tie to the dollar —does not allow its currency to appreciate more, thereby fully utilizing one of the more powerful policy tools it has at its disposal. Although it is the second largest modern economy in the world, its economic prescriptions seem drawn from textbooks that are centuries old. The recent popular uprisings in countries across North Africa are instructive because they are partly triggered by food price inflation. This may mark a turning point in how Asia views the continued merits of currency suppression, For a decade now, Asia has enjoyed the competitive fruits of undervalued currencies. But the domestic consequences of tying monetaryFebruary 14, 2011 Page 10 policy to the US, a foreign entity in a diametrically opposed macroeconomic situation, are evident, The vastly different secular economic environments, aggregate debt levels, and differences in income profiles of the populations, almost demand the breaking of this monetary linkage. As Table 3 suggests, the more Asia continues to accumulate US dollars and enable the US to increase public debt levels, the higher the probability that, rather than being repaid, Asia's claims on the US are more likely to one day be restructured or inflated. Clearly, it is in Asia's long-term interest to call a halt to continued accumulation of US debt. Toward a Solution Officials in both the Bush and Obama Administrations have for years decried their ability to impact the Chinese interference in our bilateral exchange rate because of the lack of a deliverable spot market for the RMB. Interestingly, just within the past year this is beginning to change, as there is a growing amount of cash RMB accumulating in Hong Kong as China prepares to internationalize its currency. It was recently estimated by the head of the Hong Kong Monetary Authority that there is approximately $50 billion worth of RMB circulating in Hong Kong right now and that number is growing by $10 billion per month. This provides an opportunity for the US to make a statement that would be highly symbolic if only slightly impactful. It would do so in the following way: ‘The Administration could first state its desire for the RMB to appreciate at least 10% per year in nominal terms for the next three years. Then the Administration could prepare for, and announce, countervailing targeted intervention by purchasing cash RMB at a premium to spot, say 10%, using the ‘Treasury's Exchange Stabilization Fund financed by Federal Reserve debt purchases. It would be a good investment and could continue until RMB was at an appropriate level. A more direct approach would be to intervene in the Hong Kong dollar which does have both spot and forward deliverables. Countervailing intervention in the Hong Kong dollar may not require a 10% premium to spot. ‘This exchange rate has been determined unilaterally for too long and while it may have been appropriate 20 years ago, it is not appropriate today. Inevitably, the Hong Kong dollar is going to have to adjust to an appreciating RMB and intervening in this market is tantamount to intervening in the RMB itself. Targeted intervention in other non-Japan Asian currencies also would help reduce the growing imbalances between the US and these trading counterparties,February 14, 2011 Page 11 While these may seem like radical suggestions, they are actually no different than the deleterious actions taken by China and our other Asian trading counterparties every single day of every year in the foreign exchange markets. ‘The problem is global, but the solution is a bilateral one. To achieve global economic harmony, no country with a trade surplus should intervene to suppress the value of its currency unless both its growth rate and unemployment rate are substantially below that of its trading partners or unless its currency is substantially overvalued. This concept particularly applies to the negotiation of bilateral trade agreements, such as that being, contemplated between the US and Korea, or these agreements will just exacerbate bilateral imbalances if the exchange rate is not free to adjust to them. Admitting China into the World Trade Organization in 2002, without insisting ona freely floating exchange rate, was a huge error. Broader appreciation of Asian currencies against the dollar would have consequences, China should experience a significant boost in domestic demand which it needs to balance its economy. But it must be vigilant, for the disinflationary impact of an appreciating exchange rate could fuel a credit boom as was the case in Japan in the late 1980s. Hopefully, the People’s Bank of China could be one of the first central banks in a century to place aggregate debt growth on par with inflation and unemployment as equal and important determining variables for monetary policy. In the US, certainly growth would occur in the manufacturing sector. As illustrated in our October 2010 "A Tale of Two Policies,” the US would probably regain somewhere between two-and-a-half million and three million of the jobs lost. Higher interest rates would be another consequence as we clearly would be losing a very significant buyer of US Treasuries. In the short run, many would fear this; but in the long run, it would unequivocally benefit federal finances in two ways. First, the supply side impact of an initial increase of three million jobs, with the attendant increased tax revenue, would reduce our deficit from its destructive path. Second, as stated, inflation will bring higher interest rates. Although it's counterintuitive, higher interest rates would actually be a good thing, particularly since they enforce fiscal discipline on our elected officials. Recall that it took substantially higher interest rates in Europe before a variety of European nations addressed the really difficult problems that came with unsustainable entitlements. Isn't it better to address the entitlement crisis immediately with the tailwind of a reviving manufacturing sector and rising employment? Or must we suffer the same type of inevitable economic depression pummeling many southern European countries today? Such pummeling, as we know, resulted from bond yields that skyrocketed afterFebruary 14,2011 Page 12 concerns about creditworthiness outweighed any connection to the business cycle. Low interest rates are encouraging our political representatives to engage in bad fiscal behavior, reminiscent of behavior in Japan that quietly but inexorably led Japan to become the second largest debtor in the world while being zero-bound in rates for over 13 years. So yes, it appears the price of money directly impacts fiscal spending across countries, and this is but another argument for allowing the free market to more efficiently allocate resources. China's currency manipulation, and that of its neighbors, is an invisible crisis that is directly affecting the employment level in the United States as well as its growing budget deficit; it also contributes greatly to the unwillingness of US politicians to address entitlement issues. Its sinister, “feel good” nature is no different from the NASDAQ bubble of 1999-2000 or the subprime real estate crisis in the middle part of this decade, but it does differ from these two financial disasters in one key respect: it is much larger. This can be avoided if demonstrative policy action is taken now. That policy could be an agreement between the United States and China to allow for a 30% nominal appreciation of the RMB versus the dollar over a three-year period - if and only if the free market takes it there, which it will if these trade imbalances persist. The enactment of such a policy would go along way toward bringing about needed equilibration between the United States and its Asian trading partners. And the three-year timeframe gives public and private agents ample time to prepare and adapt in order to achieve a more sustainable trade relationship between the countries involved. But delay will just continue the buildup of global imbalances that can only end in disaster. To crib, ironically enough, from Confucius: a country that commits a mistake and does not correct it is committing another mistake,February 14, 2011 Page 13, Important Notes ‘This document includes information about Tudor Investment Corporation and investment funds under its management. 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