Why does China finance US fiscal deficits and bailouts

I read the news (here) on China is financing US stimulus package by financing the US treasury bonds. Currently, China is the biggest creditor to US in term of USD 1 trillion.

But here come the plead by the China premier to US ,"Do not devalue your currency through reckless spending". The reason given by the China premier is that he wanted his asset (credit given to US) to be safeguarded. Simply, it means that if US dollar devalues, then the USD repatriated back to China is devalued to the stage that does not gives any return.

This is a paradox. It seems that the China premier is doubtful about US investment return which may bust when and if US goes bankrupt.  But China is willing to become a lender.This shows that China as the previous banker of US have no way other than to continue financing USA in order not to let it goes bankrupt. IWhy ? If, US goes bankrupt, then all the money currently tied in the US treasury and bond will melt together with the USA banking system. It looks like China is really-really tied up with USA, no matter which direction US goes, China has to bow.

There is another problem. Previously, China and other countries are willing to finance US because US is the buyer of their goods. By buying US treasury, yuan or remimbi are converted to USD. When this is done, the value of USD will appreciate. Once the value of USD appreciates, China made goods becomes more competitive than US made goods and hence will be bought by US consumer. This type of arrangement provides a big market for China and Asian countries. 

However, in the wake of the biggest economic crisis of the world, how much more  these type of arrangement can be done in the future ? US's consumer is very laggard nowadays. They have losses their home and now can't even own a car.

More so, one of the reason of the existance of US economic problem is it's very big trade deficit with China and one of the way which US can overcome this problem is through devaluing it's currency so that the trade deficit is narrowed. This is the most orthodox but effective way when we look at trade balances.

My thoughts about this matter is that the best way to help US to regain it's feet back ( and help China to sell your goods in the longer term) is to let Yuan appreciate in the short term ( a few years). Once the bond has reach it's maturity, it is better for China to purchase other types of assets (physical or stocks) in USA. Only when US economy has become stronger, then Yuan can slowly depreciate compared to USD and hence a more healthy trade quantum can be achieved in the future.

If China insists to keep on financing and also keep on ensuring that US trade deficit is balooning, sooner or later this bubble will bust and this will be very-very bad for the whole world.

Is the economy getting better ?

The world looks in bad shape now, very bad..but there is some light in Citibank even though the bank's share value has dropped to around 1 USD per share.

For all the bad things that we know, now the CEO of Citigroup said that the bank had an operating profit for January and February 2009. The first, since the 4th quarter of 2007. It gives the first shallow sign that the bailout in US is working.

Well, when "everyone around" whispers and says things are doom and gloom, it signals that it is time to invest. But, the investment suitable during this period is investment on value and not on growth. Therefore, it is important to select the company which will give the highest value on our investment with respect to the entry price. During recession, "value" is important since this ensure that the company gives a margin of safety for investor.

There are a few criteria that is looked at when investing in a company by value investing. Basically, it means buying shares which appear under-priced by fundamental analysis. For the news of Citygroup... see below.

AP
Pandit: Citi operating at profit through February
Tuesday March 10, 7:43 am ET
By Stephen Bernard, AP Business Writer

Citi CEO says bank had operating profit in first 2 months of year

NEW YORK (AP) -- Citigroup Inc. has been operating at a profit through the first two months of the year, according to a letter that the embattled bank's chief executive sent to employees.

In the letter sent Monday, CEO Vikram Pandit said Citi had an operating profit of $8.3 billion before taxes and special items through February. Pandit said the first-quarter performance so far has been the bank's best since the last time it recorded net income for a full quarter -- that was in the July-September period in 2007.

Provisions that could offset all or part of the operating profit include credit losses, write-downs and additions to loan-loss reserves. Pandit did not disclose the size of any potential provisions.

Citi has been among the hardest hit banks by the ongoing credit crisis and recession. It has been forced to take tens of billions of dollars in write-downs and loan losses since late in 2007 as the value of its investments plummet and more customers fall behind on repaying loans.

The New York-based bank has posted five consecutive quarterly losses, including a fourth-quarter loss of $8.29 billion.

During January and February, operating revenue was $19 billion, just $2 billion shy of the full-quarter average during 2008.

The letter was written to reassure employees as Citi's stock has taken a beating in recent weeks and as it has embarked on a plan that will increase the government's stake in the bank.

Citi shares closed Monday at $1.05, down 84 percent since the beginning of the year.

Late last month, Citigroup and the Treasury Department agreed on a deal that will give the government up to a 36 percent stake in Citi. The government, along with other private investors, will convert some of their $45 billion in preferred stock into common shares. If the maximum amount of preferred stock is converted, current common stockholders will see their ownership stake fall to about 26 percent.

That plan comes after the government provided Citi the $45 billion in capital in two installments late last year. Part of that $45 billion will be the capital converted to common stock. The government also previously agreed to cover a portion of losses on hundreds of billions of troubled assets and loans as Citi looks to right itself.

Government officials are drawing up contingency plans just in case Citigroup stumbles further and needs more support, according to a report Tuesday in The Wall Street Journal citing anonymous sources. The Journal said the discussions are preliminary and wide-ranging for possibilities that government officials do not expect to occur.

The stock conversion by the government and private investors is aimed at stabilizing and strengthening key capital ratios for the bank. Stabilizing a bank's financial strength has become vital in recent weeks as the government runs stress tests on banks to determine their long-term viability under various economic conditions worse than the current recession.

In the letter, Pandit said Citi has run its own stress tests for the bank at levels worse than those being used by the government. He said he is confident in the bank's capital position based on those tests.

Citi has been working in recent months to return to profitability. Among its plans, the bank is shedding assets and reducing staff to streamline operations. Citi has already announced a plan to sell a majority stake in its Smith Barney brokerage unit to Morgan Stanley.

Citi is also pursuing a plan to split its operations, separating the traditional banking businesses from the riskier operations that have been the primary driver of losses in recent quarters.

Uchi Tech Shares

I was having a debate with Moola and HCC on the "Where Ze Moola" blogspot  regarding Uchi Tech prospect. 

They have rightly pointed out that :-

a) Uchi was giving out too many ESOS in 2007.

b) Growth in revenue is slowing and thus earning is slowing.

c) Dividend payout is getting smaller. 

The picture painted was gloom and doom for Uchi. It's price in 2007 was RM 3.14 and at last Friday it was traded at RM 0.90, already an increase of 16 sen after it announces it's second dividend for last year financial result. 

The reason that I was interested in this share is due to it's dividend yield at current market price. Total for 2009 dividend is 12 sen which carries a yield of 12% at cost price of RM 1.00

However, those people over there argued about it's yield for next year at today's cost price. The questions posted by them are 

•  The yield cant be sustained for next year as the recession looms.
  
• Earning will be reduced.
  
• Prolonged recession may hurt Uchi's earning in the long run.

While it is true that recession do in affect Uchi's earning, the magnitude of this effect is unknown or uncertain. Currently we have 2008 quarterly data and an estimation of Q1 2009 for analysis.

First, let me help to derive an equation to calculate the dividend of the company

The calculation of dividend of any company is detailed as below :-

Div.= (Dividend payout ratio)(Revenue -Operating Expense )(Tax)

                                        Number of shares.

For Uchi, assuming dividend policy of 70% payout ratio is continued and no change in tax structure , as well as no change in number of shares (since ESOS cant be exercised at this price),

then all three component's above are  constants .

Let me denote the constant as K, 

where K = (Dividend PayOut Ratio)(Tax)

                               Number of shares

This lead to the above equation simplifies to :

DIV = K (Revenue - Operating Expenses)

Operating expenses consist of fixed cost and variable cost and it can be expressed in revenue. 

In term of revenue vs operating expenses, the distribution of revenue against operating expenses shall be studied before assuming the relationship between revenue and expenses. It may have a sigmoid relationship, exponential relationship, quadratic relationship or linear relationship.

For example, if the relationship is linear, then earning can be expressed in term of revenue by a linear equation. Let R = Revenue and E = expenses, this derives :

   E = m R + C 

So, by substituting E into the above equation, we have over here :-

DIV = K (R - mR- C) = K [ R(1-m) - C]

The variables that influence R are quite abstract and unknown. Though, many in technical analysis uses time series, I prefer not to use time series because there is a high error due to the fact that time series ignores the variables that influences revenue. It is simply too simplified..

In this article, I am using GDP growth and exchange rate as the independent proxy variables for calculation of revenue (dependent variable).

Assumption can be made by using GDP growth and exchange rate. (If you know any other variables that can be thought of, please do share).

 GDP growth reflects the economic situation and directly correlated with the market growth, whether the market will inflate or contract. A positive GDP growth inflate the market and negative GDP growth deflate the market. Since Uchi's product is sold in the UK, then GDP growth of UK is nearer to Uchi's revenue and a good proxy to be used in the calculation.

Exchange rate have a 100% correlation with Uchi's revenue due to the fact that Uchi's sales is quoted in term of USD.

More variables should be used if data permits to reflect the competion in the market, bargaining power of supplier, bargaining power of buyer, new product entry by competitor and product substituton. But this data is hard to be obtained unless one focussed 100% on this work.

Basically in this case, I am assuming only GDP growth and exchange as the variables, and their correlation with revenue can be expressed as below:-

Then R = (Sales in USD)*( Exchange Rate USD/RM) + GDP + Constant

A multiple linear regression method can be attempted. 

This comes to the final equation of 

DIV = K [ (Sales in USD)*(Exchange Rate) + GDP + constant) (1 - m) - C]

The final equation managed to express dividend in term of sales in USD and exchange rate.

Let us use a case study based on Q3 and Q4 GDP growth and RM/USD exchange rate in 

At 2008, Q4, the GDP contracted at -1.5% and exchange rate of 3.4 (average), the revenue is RM 25.8 million. 

At 2008, Q3, the GDP growth  is at 0% and exchange rate is 3.226(average), the revenue is RM 26.7 million.

It is clear that negative growth affect the revenue negatively even though the exchange rate work the opposite effect on revenue.

At 2009, Q1, the UK's GDP growth is estimated at -1.9% and the exchange rate is 3.7.

For 2009, UK's GDP is expected to be within -0.75 to -1.25 GDP growth overall for 2009. Based on that, at Q1 2009, the revenue is expected to be the least in 2009.  And slowly rebounding in Q3 and Q4 2009. 

As per conversation with a personal in Uchi, at end of February, the revenue stood at roughly USD 6 million. At 3.7 exchange rate, this contribute to an earning of RM 22.2 milllion. A clear statement that earning will reduce again in Q1 2009.

But looking ahead, for estimation of the above overall GDP growth in 2009 to be true, the negative growth shall be less in Q2,Q3 and Q4 or perhaps we shall see positive growth in Q4.

Shall this mean, earning will increase in Q2, Q3 and Q4 compared to Q1 ? It is yet to be seen and proven.

Nevertheless, with the above typeof expected revenue, my target for this year Uchi's EPS is 12 - 13 sen, with that type of EPS and dividend policy of 70%, I am hoping for a dividend of 9 sen to 10 sen per share. And at today's current price, this dividend yield is quite lucrative.