Richard Medley: Can You Teach Old Commies New Tricks?

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This has not been a good week for recovering Communists.

Russia

and

China

have been taken to the cleaners this week for one central reason: They have no idea how to communicate to the market. From large strategic mistakes about when to announce major political transitions to smaller tactical mistakes about when not to announce rate cuts and bond refunding schemes, Russian and Chinese officials found themselves on the short end of the speculative stick and markets in both countries careened through new year lows at the end of the week.

The Russians were busy making the tactical mistakes. After a successful blackmail of the

IMF

and U.S. in July, followed by a blowoff euphoria buying panic, the

Yeltsin

goverment quickly found itself back on the defensive as enthusiastic optimists looked around from the top of a 40% rebound in stock prices and found that they were pretty much all alone. What tipped the scales was an announcement that the Russian

Ministry of Finance

was going to cut interest rates and start issuing one-year bonds again, only one week after the IMF had rushed in to stabilize a situation that had been within days of forcing the Russians to devalue.

Market players looked at the Russian rate cut announcement like the American press looked at

Gary Hart's

challenge to catch him cheating on his wife. Both of them were challenges too juicy to ignore. Funds started flooding out of the Russian market on that day two weeks ago and by the end of last week IMF First Deputy

Stanley Fischer

was winging his way back to Moscow for another crisis meeting with the Yeltsin leadership. Our clients called us and asked, "Are these guys nuts?" To which we responded, "No, they're Communists. What do you expect?"

Moscow's problem is very complex. Look at it this way. For governments to gain market confidence, they need to get a few things straight. They have to have reliable sources of revenue that aren't too far out of whack with what they're spending. They need to have inflation below runaway levels. They need to have some prospect of economic growth. They need to have a stable and transparent financial system. And they need to be in reasonably firm control of the levers of power in their country. To cut to the chase, Russia has none of these.

What it does have is 30,000 nuclear missiles that are not (yet) trained at the U.S. That's why we call Russia "Indonesia With Nukes" and that's why the

G-7

forces the IMF to rush in and bail them out with new loans each time it looks like they're about to run out of money again. In the process, the IMF has lost all credibility as a Good Housekeeping Seal of Approval for markets that used to believe the IMF when it declared a government was doing the right thing. Now we basically believe if the IMF says good things about a government, it's because

Treasury Secretary Rubin

told them to say so.

So that's the pattern in Russia. The underlying fundamentals of no growth, no stable revenue sources, dependence on foreign money for bridge financing and a government perpetually on the brink of losing control assure that bouts of optimism on the back of IMF funding announcements (they'll get another $15 billion this week) can't last forever. And Russian inability to think in market terms guarantees that sooner rather than later, they will say or do something that forces the market to return to the economic and political fundamentals that are driving Russia today.

The Chinese

The Chinese are in a very similar situation. And like the Russians, less than a month ago they were congratulating themselves on having outfoxed the goofy Americans. Now they might wish they hadn't fooled us idiots so completely. In June, the Chinese as you will recall, essentially forced the U.S. into a joint intervention with Japan to drive the dollar down by threatening to devalue the yuan if the dollar hit 150 against the yen. In fact, internal politburo documents refer to that intervention as "the beautiful victory," meaning they had won a war without even being a combatant.

The laughing and backslapping has stopped in Beijing and

Hong Kong

this week. With the dollar drifting toward the 150 level, but without the panicky feeling of the last run up to this area, markets are remembering the threat to devalue the yuan at that dollar/yen level. In fact, Hong Kong officials are livid about the "beautiful victory" in June, because their crashing stock markets (new lows today) are a direct result of the Beijing threat to devalue two months ago. Everyone knows that if the Chinese were to let the yuan go, it would take the long-suffering Hong Kong dollar peg with it.

Again, the Chinese do not understand the reality of communicating with world markets today. If you make a threat, it goes into hundreds of analyst databases and sits there ready to be keyword searched anytime in the future. Then when new problems emerge, we go back, find the previous threat and rebroadcast it; asking if it still applies. Of course, conditions may have changed since you made that threat and being reminded of it may not be exactly what you want. But markets don't care about feelings.

Of course, there is a particularly beautiful historic irony to China's problems today. Bad as the speculation against Hong Kong and the yuan had been through Friday morning, it got amped up 10 times higher when the Vietnamese devalued their currency known as the dong (make your own jokes, we're too busy). Traders said, oh my God, it's a new Asian devaluation round underway; this will put pressure on the Hong Kong dollar, etc., etc. Although we don't believe the Hanoi think tank cut the dong rate simply to amplify China's problems (remember, they're Communists too, so what do they know?), knowing that their currency move hurt China caused no tears to flow in the Hanoi Hilton tonight.

Richard Medley is managing partner of Medley Global Advisors, a New York-based firm that provides political and economic advice to hedge funds and investment banks.