The Consequences of a Strong Dollar
By Andy Xie
Emerging countries including China should remember the lessons of the Asian Financial Crisis as the U.S.’ currency heads into a bull market
Since the end of the Bretton Woods system in 1971, the U.S. dollar has experienced a bull market twice. The first one in the 1980s was due to Paul Volker’s high interest rate policy to cure chronic inflation. The second began in the mid-1990s as the IT revolution sucked investment into the United States. The coming dollar bull is due less to the United States’ strengths than the weaknesses in other major economies.
Since depegging from US$ 36 per ounce of gold, the dollar has been in bear market 70 percent of the time. The reason is that the Federal Reserve has a dual mandate of maintaining price stability and full employment. Hence, the Fed is more tolerant of inflation than other major central banks. Its dual mandate is helped by the dollar’s unique status as a global reserve currency. Its loose monetary policy doesn’t trigger capital flight like in an economy with a normal currency.
Regardless of economic strength, a central bank more tolerant of inflation tends to produce a weak currency in the long run. Germany and Japan were vigilant against inflation. Most of the appreciation of the yen and mark against the dollar could be explained by the inflation differences with the United States.
Paper money not anchored to gold is a recent phenomenon. During its 40-year experiment, paper currencies have depreciated greatly against gold. When we say a currency is in bear or bull market, this is relative to other currencies. Paper currencies as a whole have been depreciating in value due to inflation. This is why gold is up 45 times against the dollar since the gold standard was abandoned four decades ago. While gold fluctuates in price and enters bear or bull markets alternately, its value will appreciate against paper currencies in the long run because, without a firm anchor, central banks inevitably expand money supplies to fix short-term problems and worry about inflation later.
The dollar bull market ahead is one of those episodes that will see the dollar outperform other major currencies. In the long run, the dollar will still underperform, and paper currencies in general depreciate in value.
The Weak Euro
The euro crisis has been raging for three years. The focus is on debt sustainability in southern European economies. The solution so far is (1) transfer of money from the north to the south and (2) fiscal retrenchment in the south. It is not working because the measures don’t deal with the competitiveness gap between the two. Fiscal retrenchment addresses the competitiveness issue by forcing deflation in the south. But, deflation worsens their debt problems. It is a vicious cycle.
The only solution to the euro crisis is more inflation in northern Europe to balance the competitiveness problem of the south. The rising property price in Germany is the beginning of this process. The underlying force is the European Central Bank’s monetary expansion. When it is recognized that the solution to the euro crisis is inflation, not deflation, the euro will decline to address the competitive consequences for the whole euro zone. The chances are that the euro will be a weak currency during this process, possibly for five years.
The Yen’s Bear Market
The Japanese yen is in its own bear market independent of the dollar situation. The yen has been a strong currency for the past four decades, quadrupling in value against the dollar. Low inflation, a savings surplus and competitive industries have underpinned the yen’s strength. The situation now is quite different.
The strong yen has pushed Japan into deflation for the past two decades. Japan’s nominal GDP has been declining, while its national debt has skyrocketed due to fiscal stimulus to offset the impact of deflation on demand. The two trends will trigger an explosion sooner or later. Weakening the yen is the only way out, which would decrease the need for fiscal stimulus and boost fiscal revenue. The Japanese government is weakening the yen now for that reason.
A rapidly aging population is turning Japan into a savings deficit country. Its trade deficit is likely to last. Its current account could run into deficit within two years, as income on foreign assets becomes insufficient to offset the trade deficit.
Lastly, Japanese companies are stuck with yesterday’s products and suffer price erosion. Automobile and electronics are Japan’s main industries. Japan has pretty much lost its competitiveness in the electronics industry. It has become a burden for the economy due to its massive negative earnings. The auto industry has chronic overcapacity around the world. Even though Japan’s auto industry is still strong, it is unlikely to earn high returns on capital or have significant growth.
All three factors point to a fundamental change in the yen’s direction. Its recent 12 percent decline against the dollar is the first step in its revaluation. After the Liberal Democratic Party wins the upper house in the mid-year election, the Bank of Japan would take further steps to weaken the yen, possibly to 100 against the dollar.
The yen has been a strong and safe haven currency. The dollar has been weak but also a safe haven currency. There is plenty of liquidity still parked in the yen. As the dollar becomes a strong currency and the yen a weak one, the reversal in liquidity flow would strengthen the dollar’s appreciating trend.
Crises in Emerging Markets
The first dollar bull market in the 1980s triggered the Latin American debt crisis, the second the Asian Financial Crisis. Neither was a coincidence. In a dollar bear market, the liquidity goes into emerging economies, causing their currencies and asset prices to appreciate. The double gains attract more inflow, eventually causing inflation. These economies lose competitiveness along the way. It is not noticed when asset appreciation supports domestic demand. When the dollar changes direction, so does liquidity. The virtuous cycle on the way up becomes a vicious one on the way down. The emerging economies already suffer inflation. The liquidity outflow leads to currency depreciation, which worsens inflation.
During a prolonged dollar bear market, dollar debt tends to rise in emerging economies. The weak dollar decreases the debt service burden, which emboldens the debtors to borrow more. Extrapolation is a recurring phenomenon in financial markets. Hence, over borrowing by emerging economies is inevitable in a dollar bear market. When the dollar turns strong, the debt burden becomes unsustainable. Hence, no lenders want to roll over the loans anymore. A liquidity crisis ensues. This is what occurred in Latin America in the 1980s and Southeast Asia in the 1990s.
The Vulnerable BRIC
In the dollar bear market of the past decade, the BRIC countries have been the darlings of international speculative capital, like Southeast Asia fifteen years ago. Even though they have little in common, just a phrase has launched numerous funds in their name. Whenever there is a hot concept like BRIC, there is a bubble. There has never been an exception.
The BRIC countries exhibit all the symptoms of binging on cheap credit: high levels of indebtedness, inflation and strong currencies. In the past decade broad money has risen by 17.2 percent per annum in India and 18.2 percent in China, while their real GDP rose by 7.5 percent and 10 percent respectively. The faster money growth has turned into inflation. The broadest gauge for inflation is the difference between nominal and real GDP growth rates or GDP deflator. It averaged 7.5 percent per annum in India and 7.3 percent in China.
High inflation and a strong currency have propelled demand for foreign capital. It is essentially to arbitrage the difference in the cost of capital on and offshore. High inflation makes the real cost of capital onshore low or negative. The strong currency gives foreign capital providers high returns offshore. This arbitrage is self-fulfilling in the short term. Foreign capital inflow supports their currencies, increasing their money supplies and inflation.
In recent months the BRIC countries no longer receive strong inflows anymore. Their currencies have been under downward pressure. The BRIC economies now are similar to Southeast Asian economies in 1996. Wrong policy moves could aggravate the situation and trigger a full-blown financial crisis.
Loosening or Tightening?
India just cut interest rates. Its latest inflation rate is 7.2 percent. Though it is at a three-year low, the level is still high. The moderating inflation gives the central bank the excuse to cut interest rates. Its goal is to stimulate growth. However, declining interest rates could speed up capital outflow. The resulting currency depreciation could worsen inflation again.
The real angle to the rate cut is the confidence game. Foreign capital, especially the footloose kind, plays the bubble game. It needs growth to embolden its risk appetite. The rate cut may increase capital inflow in the short term. The wrong policy in a conventional sense could work in a bubble environment.
The confidence game works when speculators want to play. It requires the global environment to be supportive. The most important supporting factor is the weak dollar. The chances are that the market consensus on the dollar will change within three months. The dollar index has fluctuated between 76 and 82 for two years. It is now at 80. Within three months, it would break through 82. The market consensus will follow then.
The confidence game doesn’t work when the dollar is strong. The BRIC economies need to shift their priority from growth at any cost to financial stability. The biggest mistake that Southeast Asian economies made fifteen years ago was their reluctance to sacrifice growth despite the inflation challenge. The right policy for the BRIC countries would be tightening now, ahead of the curve. Unfortunately, all policy-makers are oriented to the short-term oriented nowadays. Some emerging market turbulence is quite likely within the next 24 months.
The author is a board member of Rosetta Stone Advisors Limited