Reagan for President...of China!

Axel Merk, Portfolio Manager, Merk Funds

February 3, 2011

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With Ronald Reagan’s 100th birthday around the corner, it seems fitting that the world may need another President with the same level of foresight. This time it’s not the U.S., but China that may need a President Reagan.

When Reagan became the 40th President of the United States, he gave the U.S. a vision that inspired an entire generation. Not only was he a charismatic leader, but timing was on his side, allowing him to be a catalyst for change. The economy was suffering from the effects of push-cost inflation of the 1970s; perceived political weakness inherited from the Carter era and a post-Vietnam demoralized military also held back the country.

Reagan has many supporters, but also many critics. One point of contention are the massive fiscal deficits that Reagan introduced. Others believe that because “Reagonomics” worked, supply side economics (government spending) must be the cure to all economic slowdowns. We take issue with both sides: in our view, the key to Reagan’s policies was the fact that he unleashed energy that had been held back for a decade. Americans are inherently entrepreneurial, but the environment had made it difficult to pursue the American dream. It’s in this context that Reagonomics may not be a cure for all problems: in today’s environment, an exhausted consumer needs a break, not a stimulus.

What does this have to do with China? Few would call the Chinese demoralized or the economy in the doldrums. However, a key challenge with China’s growth has been the overt focus on exports and infrastructure investment. It’s great to provide jobs through construction, but someone has to occupy those buildings, which may be jeopardized by the government’s attempts to cool the economy. China is an export powerhouse, but the Chinese government is concerned exports could suffer should the artificially low exchange rate of the Chinese renminbi versus the U.S. dollar be allowed to appreciate. The trouble is that these policies are fostering inflation, and lots of it. Historically, inflation has led to social unrest and uprising, and ultimately toppled governments in China and around the world. In the Middle East, people have shown that they can put up with autocratic governments, but only if they can afford to eat: food inflation throughout the Middle East and Asia are, in our assessment, a key contributor to the growing instability. Commodity inflation has been exacerbated by loose monetary policy in the U.S., a policy exported to the Middle East and Asia as those regions peg their currencies to the U.S. dollar, or are otherwise reluctant to pursue substantially tighter monetary policies than the U.S.

China needs to balance its economy, making it less dependent on exports and infrastructure spending, while at the same time addressing inflationary pressures. American policy makers would love China to hand out credit cards to all its citizens to bolster domestic consumption. That is not what China wants, nor needs.

 

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To foster domestic consumption, China needs a Ronald Reagan. Many in China think exporting goods to U.S. consumers is the most important driver of Chinese economic growth. This is wrong – exports to the European Union exceed those to the U.S. Beyond that, driving domestic consumption by driving Chinese citizens into debt will not lead to sustainable growth, especially not in an environment that’s already inflationary. Instead, China should consider unleashing the entrepreneurial spirit of its people to further build the domestic economy. Instead of focusing on infrastructure spending to drive economic growth, Chinese policy makers should foster entrepreneurialism. That’s why China needs Reagan. What we call charismatic leadership in the U.S. tends to be referred to as propaganda in China; and while most may have a difficult time imagining Reagan running China, few have a problem imagining China leveraging its ability to promote a unified message.

By promoting domestic growth, a strong currency is welcome, as it dampens inflationary pressures. Commodity prices in local currency go down as the currency strengthens. Given that China is a major importer of commodities, a strong Chinese renminbi will help tame inflationary pressures. China has been reluctant to allow its currency to rise, mostly because of the feared negative impact on exporters. We are not as pessimistic, as our analysis shows that Chinese companies have pricing power: China has long given up competing on price, as the goods and services exported from China are at the higher end of the value chain. Think about it from a U.S. corporation’s point of view: to remain competitive, more outsourcing needs to take place at a time when just about everything is outsourced already. As a result, ever more complex processes are being outsourced. China is best positioned in the world to accommodate complex outsourcing projects.

The weak renminbi has allowed some businesses to operate that would not be able to compete should the Chinese currency strengthen. Because of the fear of an economic slowdown as the renminbi rises, we believe it is quite likely that any currency appreciation may be accompanied by another stimulus. If that is correct, and if China wants to avoid the inflationary fallout, unleashing the entrepreneurial spirit to focus on developing the domestic middle class may best help China be prepared for the next growth phase. Hence, figuratively speaking, we are calling for Ronald Reagan to become the next President of China. Incidentally, China’s next President will be Xi Jinping, who comes from a well known political family – at times compared to the Kennedy’s in the U.S.; together with his wife Peng Liyuan, a glamorous Chinese folk-singer more famous than her husband, he just might have the charisma necessary to rebalance China’s economy and place the world economy on a more sustainable footing.

Ensure you sign up for our newsletter to stay informed as these dynamics unfold. We manage the Merk Absolute Return Currency Fund, the Merk Asian Currency Fund, and the Merk Hard Currency Fund; transparent no-load currency mutual funds that do not typically employ leverage. To learn more about the Funds, please visit www.merkfunds.com.

Axel Merk

Manager of the Merk Hard, Asian and Absolute Currency Funds, www.merkfunds.com

Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered an authority on currencies.

The Merk Hard Currency Fund (MERKX) seeks to profit from a rise in hard currencies versus the U.S. dollar. Hard currencies are currencies backed by sound monetary policy; sound monetary policy focuses on price stability.

The Merk Asian Currency Fund (MEAFX) seeks to profit from a rise in Asian currencies versus the U.S. dollar. The Fund typically invests in a basket of Asian currencies that may include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.

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