Elephants in the Room! Startling New Studies Revealed!

ruggles/Wards

Two important automotive conferences were held in New York City recently in conjunction with the New York International Auto Show. The first conference was the J. D. Power Automotive Forum, followed the next day by the Driving Sales President's Club Event. The conferences had at least one thing in common. They both were launching points for two new surveys regarding what consumers supposedly want in their retail shopping experience, based on consumers answering questions to survey questions. AutoTrader released its new survey at the Power conference while Driving Sales revealed its own survey the next day at their own conference. The presentations of these survey results were rife with anecdotes. Both "studies" "proved" what some people have been trying to prove for decades, that consumers prefer not to negotiate and don't like the sales process.

...the continuation of attempts to predict auto buying behavior by asking survey questions instead of observing actions...

I was reminded of the infamous J. D. Power survey released at the NADA convention in 1993, where they showed that consumers didn't like to negotiate, which "proved" that the Saturn way of doing business was going to take over auto retail. Interestingly, J.D. Power was also selling consulting and training services to teach dealers how to implement the "new sales strategy." At the time, Saturn dealers were doing really well while GM was losing about $1500 per vehicle. Unfortunately for J. D. Power, no one taught the OEMs that for the "Saturn Method" to work over production can't be part of the equation and true "success" includes OEM profit. [The Prof adds: in the pre-internet days Saturn dealerships were also few in number and widely dispersed, which was important in limiting the ability of consumers to play dealerships off against one another]

At the same 1993 NADA convention new research was published by an Arizona research and marketing company that showed the exact opposite of what the Power survey had said. The different results were achieved by merely changing the wording of survey questions. At the time it seems that consumers really do want to negotiate, they just want to be guaranteed a win. They want to play poker with you. They just want to see your cards first before placing bets.

The marketplace ultimately proved who was right and who was wrong. Saturn proved many things. It proved that fresh product enthusiastically received by the consuming public is essential. And we know GM subsequently starved Saturn for product. After all, why give a division product unless they have proven they can move the metal? Saturn proved that some consumers prefer their business model. They also proved there aren't enough of them to make for a viable division. Saturn introduced a stellar vehicle in the Aura. Yet, consumers voted with their feet. Instead of buying the very competitive Aura and its consumer friendly sales model, they went in hordes to Toyota and Honda to get abused by the so called traditional sales model. Go figure.

Later in the decade Ford attempted to show the industry how to do auto retail based on how consumers respond to survey questions. The Ford Collection lost hundreds of millions of dollars and was one element of the underlying dissatisfaction that cost Ford CEO Jacque Nassar his job. [The Prof adds: the Explorer-Firestone rollover issue was a factor, too]

Both of this year's surveys ignored some "elephants in the room." While demonizing the "old methods," as if there is such a single thing, they failed to tell us exactly how to do what consumers want us to do while still making money. After all, new cars aren't sold for profit these days anyway. Dealers typically pay off more at their floor plan lender than the customer just paid for their new vehicle. And after paying each new vehicle's share of the overhead, our industry is selling new vehicles for about break even. And to add insult to injury, consumers still aren't happy.

I'm living proof that there is no such thing as the "old method" of selling new vehicles. I started in the business in 1970, selling in a One Price store, although it wasn't called that back in the day. We called ourselves "Moral Motors." The anecdotes related by those who try to demonize "the old ways" might describe some stores, but they certainly don't describe them all. There has never been a single way for dealers to run their sales operations. Auto retail has ALWAYS been about relationships and satisfying customers. This has never changed. As a consultant/ trainer over 20 years ago, we taught sales people to open dialogue with prospects by saying, “Before you leave, we want to make sure we provide all the information you need to make a practical purchase decision, including some numbers to think about.” Today that's called "transparency."

Even though the consumer today has ready access to all sorts of information, they "know" less today than they ever did because of the complexity that exists today. Much of that complexity was created by OEMs when they curtailed dealer markup and hid gross profit behind invoice, something I seriously doubt consumers would call “increased transparency.” The vast amount of information available today is like drinking from a fire hose for consumers. Auto buying consumers have more information, yet know less. Over the last few years I have visited hundreds of dealerships. I have seen a consistent pattern of sales people attempting to deal with consumers who think they know a lot more than they do. It is an art to correct your potential buyer on their misconceptions while still maintaining a relationship to allow them to do business with you afterward. Many of our sales people fail miserably at this. [The Prof adds: with sales staff turnover, don't be too sure consumers aren't the more informed party! But remember too brand proliferation: can you name all 600 makes on sale in the US market??]

I am able to do my own research. Since it is informal I don't try to calculate a "margin of error" or use lofty terms to describe my methodology. I am regularly in front of groups of college students. My own personal study group is my 22 Gen Y nieces and nephews. Further, I am regularly in front of a large group of retired millionaires at a retiree forum in my home town. This gives me the opportunity to conduct show of hands type surveys. Example: "How many of you think an auto dealer is entitled to a return of 10% on the sale of a new vehicle?" EVERYONE in the room raises their hand. A little later I'll ask, "How many of you, after you get home after buying a new car, would be upset if you find out you paid the dealer a $3K profit." EVERYONE in the room again raises their hand!!

For those who think the Ford Collection, Saturn, and Priceline outcomes happened ages ago and are no longer valid, a Dallas company specializing in lease comparison software, Cybercalc.com, recently did extensive surveying which “proved” consumers prefer to get their deal structured and “locked in” before revealing who their identity. The initiative was called AutoBids Online and a small fortune was invested to create a software platform to enable consumers to anonymously enter a marketplace where dealers would bid for their business, thereby locking in an offer before the consumer’s identity was revealed. This would seem to prove that the AutoTrader survey results on this issue are valid, right? In talking to CyberCalc CEO Jeff Cook about his expensive lesson as it regards auto buying consumers, he says, “I have some GREAT software for sale if anyone thinks the market is now ready for this. When we did this a few years ago, it clearly wasn’t, despite our extensive surveying.” Perhaps it was the $29 consumers had to pay top enter the marketplace? One would think that would be a small price to pay for avoiding the “old method grind,” right?

This is not to say that the Internet hasn’t forever changed some things about our business. Dale Pollak and others have definitively proven that if a dealer prices his/her vehicles wrong, their inventory will never be seen by consumers doing routine searches. But this has been proven by actual consumer behavior, not by surveys.

So what are the "elephants in the room" ignored by these recent surveys? In our bid to thrill consumers shouldn't we ask them about how we answer the phone? After all, a HIGHLY valued relic from the past, Jackie B. Cooper, used to point out that the dealership telephone operator talks to more potential gross profit than any employee in the dealership. "And who gets paid the least?" Jackie would ask. These days the telephones are answered by an IVR system (Interactive Voice Response). en Y calls them "bots." AND they are universally reviled. Why are no studies focused on how our customers like the way we answer the phone?

Another elephant? Even the best sales process can turn counterproductive when executed crudely. The least polished of our sales people make up the VAST majority these days. Why? Because WE have run off most of the good talent. Our industry has cut the upfront markup, increased the holdback, increased the pack, taken away demos, cut fringe benefits, instituted full retail markup internal charges, etc., etc., and we wonder why we are left with the unpolished and unpracticed sales people? When you turn over employees it is because you either did a bad job of hiring, or a bad job of managing. Why ignore this while focusing on peripheral issues?

Perhaps the most outlandish claim "proven" by the Driving Sales survey is that our industry is losing up to 5 million new vehicles sales each year because consumers don't like our processes. This is referred to as lost "headroom." This assumes that consumers who don't like the first dealer they encounter, exit the market instead of exiting that dealership and visiting another. I have run this claim by a number of industry economists. I first started asking about "lost SAAR" when I heard TrueCar's Scott Painter claim that new vehicle retail could be doing 20 million SAAR if we eliminated the "friction" in the sales process. The unanimous responses from these numerous industry economists and other experts uses terminology reminiscent of Norman Schwartkop's reference to "bovine scatology."

At least we all got to listen to Warren Buffet and Larry van Tuyl at the J. D. Power conference and Maryann Keller at Driving Sales. Maybe it’s just that I take comfort in listening to common sense from people closer to my age bracket, or maybe I just like listening to common sense from whomever it comes from.

Some high points, or low points of the conferences, depending on one’s perspective follow. According to the AutoTrader study:

Consumers want a change in the car buying process, but they failed to define either “old process” or “new process.”

There is no such thing as “the old process.” Dealers used to compete with other dealers to provide an experience acceptable enough to consumers to gain their fair share of sales and gross profit. It seems like any new process would work the same way. If there is a single universally acceptable new process that would accommodate the 30% of buyers who are in the Buy Here/Pay Here or subprime credit category, as well as the near prime tiers, and would take negative trade equity into consideration, as well as “fast track” credit buyers, AND allow for dealer Return on Investment, we’d all like to hear about it.

Consumers want to test drive new vehicles at a central location without sales people present.

What they failed to ask is how much more consumers would be willing to pay for this.

Consumers dislike the process as it is today...

...yet that process sells 14 million plus new retail units per year. Perhaps consumers would prefer if the FTC would allow dealers to fix prices so everyone could pay the same price? Why not ask consumers how they would like that?

Consumers prefer to remain anonymous until they lock in a deal.

Of course they do. So what?

Dealers have always been free to adapt to whatever they believe consumers really want.

A lot of money has been invested in attempts to do business based on what consumers say they want in surveys with Saturn and The Ford Collection being the best examples. Maryann Keller mentioned the Priceline experiment, which didn’t work. She should know. She ran it and is completely upfront about the experience. Who better to tell us about the difference between what consumers say and how they actually behave than the world’s leading auto analyst who also spearheaded a well financed attempt to appeal to consumers based on their stated preferences? What has changed since those expensive experiments failed? Why are people still continuing to try to prove that consumers behave the way they say they would on surveys?

From Driving Sales: Rachel Richards, listed as Vice President and Chief Marketing Officer from Sonic Automotive, the country’s fourth largest automotive retailer, gave a presentation on their new retail initiatives called “One Sonic - One Experience.”

One would think that Richard’s previous career experience with Ford Motor Company might have provided some insight on the difference between what consumers say on surveys and how they actually behave in the real world. As I understand it, the new program is still in pilot stage and has not been rolled out across their system. My understanding is that they have 15 sales people at one pilot store who also do their own F&I. When I asked if they would all be AFIP (Association of Finance and Insurance Professionals) certified, she told me she didn’t know what that is, and that a different department was responsible for the F&I element. I can only imagine the regulatory vulnerability associated with having 15 sales people all trying to do their own F&I. I’m sure time will tell, as it did with the Ford Collection.

What seems to be inevitable is the continuation of attempts by some to predict consumer auto buying behavior by asking them survey questions instead of merely observing their actions. After all, we have many talented and experienced experts who are in the trenches on a daily basis. Why not just ask them?

Notes from the International Car Rental Show April 2015

Ruggles/Wards/Bobit Media

I was recently privileged to attend the International Car Rental Show, held at Bally’s Las Vegas. I have attended this show in previous years and always came away with something noteworthy. This year, for the first time, the show included a break out track for auto dealers. While my primary interest was keeping up with all things car rental as they impact residual values going forward, I felt compelled to attend the car dealer sessions. And was I in for a shock.

It turns out that many things I thought were settled, aren’t. It seems that many dealers still send their customers to 3rd party car rental companies for loaners and rentals, even when the rental is being paid for by warranty or a service contract sold by the the dealership. Last I knew these third party car renters also sell used cars. Shouldn’t those car renters be paying dealers for introducing them to new prospects, not the other way around. A dealer doing a good job selling service contracts should be penetrating at least 60%. That’s a lot of rental car days paid for and the customer is as happy as if the dealer actually paid for their “loaner.”. Why send that revenue stream elsewhere? It turns out that many dealerships are too lazy to “do the paperwork” each time they roll a car on a rental or policy adjustment “loaner.” After all, if the rental car isn’t charged out to a specific department, a service contract company, policy adjustment, or to the customer, the sense that the car rental business doesn’t make money takes over the dealership.

What does it cost to NOT have a rental car operation? What does it cost the dealer when he/she is at the end of a stair step program and needs a few unit sales to reach a plateau, especially one that is retroactive? What does it cost to not have those units registered in your market for MSR (Minimum Sales Requirement) purposes? What does it cost to not have off rental units available as organic pedigreed pre-owned inventory and you have to go out and buy inventory at wholesale? What does it cost for the lost pre-owned sales when third party renters sell YOUR customer a pre-owned vehicle because YOU introduced them? What does it cost when your customer becomes impatient at the time it spends to be transported to the third party car renter. What happens when you customer has a beef with your third party car rental company?

I discovered there are still dealers who hang a dealer plate on a piece of used vehicle inventory and put it out as a loaner. What does that cost? What are the insurance ramifications?

Well, I found out a lot of things at this most valuable conference. I found out that despite the fact that dealer garage keeper liability carriers have policies for rental units, they tend to NOT accept a mixture of DRAC (Dealer Rental Car) units and rental units they insure. I also discovered that there is an increase in guaranteed value rental units, known as factory program vehicles as opposed to rental risk units. This allows automotive OEMs to have better control of rental units and cycle them when it benefits them. This could be the beginning of some of the bad behavior that caused used vehicle values to crater in years past, especially with the tidal wave of off lease vehicles heading our way in the next few months.

Bottom Line: This was a VERY beneficial conference to attend and one I highly recommend to auto dealers now that the break out track sessions for dealers exists.

Pardon the Sarcasm

ruggles/Wards

I am astonished that the new “hot trend” in auto retail is thinking that a car deal should be accomplished in an hour or so. Hell, it takes almost that long to explain how the infotainment system works, let alone the other gadgets in a new vehicle.

How long does it take to go over all of the forms demanded by government regulation, or do we just have the customer sign them without reading them? After all, we want our customers to be happy, right?

If you sell “product,” there are forms associated with those too. Or perhaps we should give up selling product because the most important thing is speed? If you sell product, you’d better damn well get declination forms signed or you’ll eventually find yourself in all sorts of hot water. And those take time too.

However, there is no doubt that on a busy day, we might not be staffed to handle buyers expeditiously if those darn consumers decide to buy in bunches instead of evenly spacing themselves.

It IS possible to do most of the deal with some customers before they come to the showroom IF the deal has no complications or hair on it. They keyword in the previous sentence is “some.”

If time is the most important element we could send all of the tough deals down the road to competitors to keep our average elapsed average time low. We could limit customers to credit scores of say 680 and above and send the other ones packing. Those low credit scores take much too long and would ruin our average. And about those people with negative equity, who have no cash, a false vision of what their trade is worth, and want to buy way more than any lender would advance... what do we do with them? They fewer of these we have the more likely we can average one hour transaction. There! Problem solved.

I thought our business was still about gross profit. I thought our mission is not so much to give the consumer what they want, but to get them to like what we give them. Of course, we want the highest customer satisfaction possible. We also want and need repeat business and referrals. But let’s stop with the silliness.

The 6 Fluids

As a car owner, the best thing that you can do for your vehicle is to keep it properly maintained. You don’t need a mechanic to check the fluids in your engine, nor do you need a degree to be able to top them off when necessary. By taking a few simple measures and making sure that these six fluids are within proper levels, you can prolong the life of your car. Your owner’s manual will have everything you need to know about maintenance schedules and recommended fluids. For a great running vehicle, here are the six automotive fluids you shouldn’t forget to check.

Motor Oil

This fluid is essential to any internal combustion engine. The purpose of motor oil is to lubricate parts. Oil also prevents rust from forming inside your engine by blocking oxygen from reaching the metal. It even takes particles out of your engine and deposits them in the oil filter, keeping your engine clean. If oil is too old or gunky, the engine will start to destroy itself. If it goes on too long, the engine will completely lock up and become useless.

Outside of gasoline, motor oil is the most important automotive fluid. Most of us learned how to check the oil when we got our first cars. Whether that time was decades ago or just a few days ago, the process is pretty much the same. Open the hood, pull up the oil dipstick and wipe it clean. Then dip it again and pull it out and you'll see your oil level. If it's below the safe level, then just add more. Get it completely changed every so often depending on how much you drive and the mileage rating for your oil.

Transmission Fluid

Like motor oil, transmission fluid provides lubrication and cooling to the transmission. Automatic transmissions also use transmission fluid to provide the hydraulic pressure necessary to shift gears. Unlike motor oil, the level of transmission fluid should never change unless there’s a problem.

Mechanics look at the quality of the transmission fluid. It should be red in color and not smell burned. If it has a burnt smell to it or has turned brown, it's time to change your transmission fluid. This should be checked about once a month.

Coolant

Sometimes known by its other name, antifreeze, coolant transfers heat away from the engine around so nothing gets too hot or too cold. It moves from the engine to a radiator where the heat can be dispersed safely. If your coolant level gets too low, the car will overheat. Coolant mix is normally a light green color.

Coolant is usually a 50/50 water and antifreeze mix, for those cold winter days (and nights). Antifreeze lowers the freezing temperature of water so the inside of your car doesn't become a block of ice. Remember when changing coolant that your car needs to be cold so there is no steam inside the system.

Washer Fluid

While your car won't break down without washer fluid, you will definitely miss it if you run low. Without it, your windshield wipers will just smear around dust or bugs or whatever else happens to be currently blocking your view of the world outside. Washer fluid is basically liquid soap, but that doesn't mean it can be replaced with soap and water. It also contains special ingredients that help dissolve any bugs stuck to the glass and lower the freezing temperature of water so your washer fluid won't solidify if you happen to live in a place with cold winters. Washer fluid is normally a bright blue color.

Brake Fluid

Brake fluid is absolutely essential. It is used to create hydraulic pressure which forces your car to stop. If your brake fluid starts leaking or air gets into the brake line, it will get a lot harder to bring your vehicle to a stop. Like transmission fluid, brake fluid is part of a closed system. If you find that your fluid is leaking, it’s best to take your vehicle to a mechanic rather than try to replace it yourself.

However, you can check the quality of the fluid yourself. You can check the brake fluid reservoir every time you check your oil levels. So long as your brake fluid looks golden, it's good. If it’s brown, it’s time to have it replaced by a certified technician.

Power Steering Fluid

Power steering fluid not only lubricates the steering mechanism, but it uses hydraulic pressure to help turn your vehicle. When it starts to run low, you’ll most likely hear it when you start to turn the wheel. Strange noises or difficulty in steering is an indication to take a look at the levels of power steering fluid. Check the reservoir. If it looks like it’s running low, then take your vehicle to a mechanic.

While these fluids remain quietly working in the background, they are vital to the operation of your vehicle. Pop the hood and check them every once in a while to try to catch any possible problems when they’re small. Keeping these maintained will keep your car running smoothly for years to come.

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Emily Hunter is a SEM Strategist and Outreach Supervisor at the Marketing Zen Group and is working closely with ZAK Products. She loves designing strategies with her team and is excited about spreading the Zen gospel. In her spare time, she cheers for Carolina Crown and Phantom Regiment, crafts her own sodas, and crushes tower defense games. Follow her on Twitter at @Emily2Zen

The PACE of Automotive Innovation

Suppliers are integral to new technology in the auto industry to an extent not true since the early years of the 20th century, when ventures such as Ford began as mere assemblers, not manufacturers. That will be highlighted on Monday, at the 21st PACE "academy awards" for supplier innovation. (For those not in the know, Monday's the opening night of the SAE [Society of Automotive Engineers] in Detroit.)

Caveat lector: your not-so-humble author has been a judge from the competition's beginning.

General Motors began as a conglomeration of existing firms, both suppliers and assemblers. As it grew – and as Ford stumbled – it added more suppliers while dropping brands. By the 1960s it was highly integrated, with suppliers relegated to trying to make parts to GM's blueprints. Now that strategy had unintended consequences, as the route to the top became finance, with other functions such as making and selling cars treated as an afterthought. Be that as it may, come the 1970s, first emissions controls, then fuel efficiency mandates, and finally safety regulations forced car firms to engage with non-traditional, outside suppliers. Meanwhile, new entry meant that the comfortable Big Three oligopoly could no longer ignore the challenge of actually making and selling cars. One response was to spin off internal parts operations, and with it the ability to do the relevant component-specific R&D. Finally, alongside this demand-side story were two technology revolutions, those of materials science and of electronics and sensors that enabled these suppliers to turn to innovation as a way to build their businesses and preserve margins. The bottom line was that suppliers became central to automotive innovation.

This supplier-centric industry has lots of implications. For one, it may facilitate new entry; Aptera, Fisker, BYD, Chery, Geely, Great Wall, Tesla, Bright Automotive, Edison2 and others could buy drivetrains, transmissions, sensors and controls from existing, auto-tech-savvy suppliers. Not all have survived, due to a combination of undercapitalization, poor product strategy and bad luck. However none could have started had suppliers not controlled – and built their businesses around selling – core technologies. Exploring such implications, including for investors, is however a topic for subsequent posts.

Here let me briefly note the role of suppliers, using engines are an example. (My apologies to Europeans for focusing on gasoline rather than diesel engines.) Drawing from among PACE award winners, we see the following areas dominated by suppliers: fuel tanks, fuel pumps, fuel vapor recovery, injectors, injector electronics, spark plugs, valves, camshafts, pistons, piston rings, bearings, seals, sensors of many types, turbochargers and turbocharger escape valve technologies. There are other areas (engine block castings, machining) where car companies continue to dominate, but even there suppliers provide the machine tools that are critical to these operations. In short, while car companies may work on the configuration of the engine and the integration of these various components, the advances come from supplier technology.

It's not just engines. A wide array of vehicle systems are dominated entirely by suppliers, such as clutch components, transmissions, differentials and driveshafts, HVAC systems, lighting, ESC systems, tires, tire sensors, suspensions, ECUs and most other sensors and vehicle electronics, airbags, seatbelts, hot stamping, hydroforming, paints, structural adhesives, sound-proofing materials, water pumps, radiators, headliners, instrument panel surfaces and underfoams, starter/alternator systems, belt and pulley systems, timing chains, windshields and glass, wiper motors, wiper blades, radar, lidar and ultrasound sensors, cameras and image recognition systems, infotainments systems, and on and on. More important for Monday, you can find examples among the two decades of PACE finalists and award winners.

I've been privileged to judge this competition since its inception, thanks to the entre provided by my own research (my PhD dissertation was on automotive suppliers in Japan). As a result I've been able to visit 2-4 suppliers a year for in-depth presentations on technologies and their business case, and to sit with the judging panel to hear their summaries of similar visits. Along the way I've earned my PE degree as well. [P.E = pretend engineer] Now the entire process is under NDLs (non-disclosure agreements) so I have to be careful, but I have tried my hand (with co-author Peter Warrian) at analyzing the finalists using publicly available information for lessons on technology. You can find our initial paper here and a more recent analysis (incorporating 2015 finalists) here. photo: Federal Mogul's IROX engine bearing

Anyway, watch Monday night for the stream of press releases from the winners, and the Automotive News coverage of the entire award ceremony. I'll be there, in my tuxedo, enjoying the food and drink, and the celebration of innovation. It's a fun and thought-provoking event!

China's Pending Depreciation

As I prepare to begin grading final exams from my course on China's economy, let me start a series of posts stemming from my teaching this term, and from a lecture (ppt here) that I prepared for the Asian Studies program at James Madison University to my north, in Harrisonburg VA. (It's also my son's alma mater.) Here I focus on China's exchange rate.

China, as typical of many developing countries including in their day Japan and South Korea, engaged in financial repression, holding bank deposit interest rates low so as to hold bank lending rates low and thus to encourage investment. As initially capital-poor economies there's a certain logic to this, and it fit with the 1950s-1960s model of "Big Push" industrialization. This of course transfers resources from savers, who earn little on their accounts (often less than inflation), to investors. Maintaining the policy requires closing off foreign capital markets to domestic savers (and was typically accompanied by an exchange rate pegged to the US$). It also required restricting domestic options that would allow disintermediation. (In Japan, for example, domestic bond issues were severely restricted, and various policies discouraged the growth of the stock market.)

The early empirical work of Phyllis Deane and others on the British industrial revolution – with better data, now known to be wrong – seemed to show that it was accompanied by a big upturn in investment. That flawed view was carried over to W.W. Rostow's 1960 book, The Stages of Economic Growth: A Non-Communist Manifesto [which in fact employed a Marxist framework!], and was taken up across the "developing" world.

One side effect is the growth of "shadow" finance, and a quest for real assets that might offer returns commensurate with real GDP growth. (Think real estate!) That and related distortions are a topic for a later post. Here I focus on another side effect, undiversified portfolios.

Japan's case is a good example. As of the late 1970s, Japanese life insurers sat on a portfolio comprised of domestic stocks and long-term corporate loans (plus a dollop of primarily JGBs, government bonds). The issuers of these assets – and the people for whom they'd sold life insurance policies – also sat on top of a major tectonic fault, the source of the earthquake that leveled Tokyo in 1923, killing 110,000 people. They obviously had an incentive to diversify their investment portfolio against the next Big One. As Japan moved toward financial market liberalization (with major legislation passed in 1980), these insurers were initially allowed to move 5% of their portfolio into British and US government bonds. The timing was great: the initial handful of staff in London and New York bought bonds just before interest rates fell in those markets, generating wonderful returns that were amplified by a massive capital outflow that caused the yen to depreciate, giving them even better returns [my memory is that the first set of investments earned 50% – and being sent to open these overseas offices was already a signal that those people were on the radar screen of top management as up-and-coming executives]. To reiterate, the bottom line was capital outflow and yen depreciation: the yen briefly strengthened to Y180/US$ in 1978 fell to an average of ¥230/US$. Capital outflows eventually slowed (and US interest rates fell), and the yen began slowly appreciating (from ¥260 in February 1985 to ¥230 in September) and then shot up following the Plaza Accord to peak at ¥120 in December 1987 (by which time Japan's domestic real estate and stock market bubbles were building, another legacy of the end of financial repression).

China is poised to repeat Japan's experience. Shadow financing is collapsing; tales of ponzi schemes and other frothy behavior are rife. The stock market is ... stratospheric. Real estate prices are falling. And US interest rates are poised to rise. Furthermore, while the RMB has depreciated slightly against the US$ (the red line in the chart), the appreciation of the dollar against the Japanese yen and the Euro means that the "real" RMB (the blue line in the chart) has actually appreciated relative to its trading partners – to China the Euro zone matters slightly more than the US. This is the setting for a perfect storm, a scramble for the exit, which means the US dollar. If Japan's experience is any guide, the shift could be large (Japan's was 50%) and last for a half-decade.

Jeffrey Frankel points to evidence that the race for dollar assets is underway (his full blog post here, and his Project Syndicate post). China's foreign reserves are down from their peak (US$3.99 trillion to US$3.84 trillion, despite a continuing trade surplus), a current account outflow, with the Bank of China selling dollar assets to domestic holders of RMB. Absent this additional supply of dollars, the value of the dollar would rise – I append a basic S&D graph to illustrate the impact of this intervention.

As I've long warned [an earlier post], Congress should be careful what they ask for. If the Chinese stop intervening, all the forces point towards depreciation!