2011-01-24 / Andy Xie, The New Century Weekly
China and Japan are supporting eurozone by purchasing government bonds that the market shuns today. Chin and Japan have $4 trillion in foreign exchange reserves and are capable of bridging liquidity problems that some eurozone economies are facing. What China and Japan can do is to stop market panic from leading some otherwise viable economies down a vicious spiral of rising interest rate, rising debt burden, and bankruptcy. The economies that are not viable in the first place shouldn't be helped.
China and Japan's action helps themselves in two ways. First, euro is the only alternative to the dollar for global trade, commodity pricing, and storing foreign exchange reserves. If the euro falls apart, the Federal Reserve will be further emboldened to pursue inflation to decrease the US's leverage or indebtedness at the expense of dollar holders. China and Japan hold vast dollar assets and have most lose from dollar devaluation.
Second, Europe is the largest trading partner for China and the third largest for Japan. It is in both's economic interest for Europe to avoid a vicious cycle and remain a healthy trading partner.
Stopping self-fulfilling vicious cycle
The watchword for monitoring developed economies is debt and for developing economies inflation. In this article I want to discuss the debt situation in developed economies and the implications for their currency values. The market is panicking over the sovereign debt situation in some eurozone economies and is demanding high interest rates for rolling over their debts or providing new money for financing their deficits. When interest rate rises above some level, an otherwise healthy debtor can go bankrupt. This element of self-fulfilling prophesy is a major force in speculative attack against a company or country.
China has recently pledged to support the debt issuances by Spain and Portugal. Japan has committed to purchasing one fifth of the debt issuance by the European Financial Stability Facility ('EFSF'). China's actions were instrumental in the successful debt issuances by Spain and Portugal. Japan is taking risk behind the EFST that is guaranteed by strong economies like Germany and France. This is not enough. China and Japan should work closely together in their European Project. They have common interests.
If China and Japan stick together, they can play a critical role in preventing the eurozone from suffering unnecessary economic hardship due to financial market panic and, by extension, supporting euro as an alternative reserve currency to the dollar.
The developed economies must deleverage
The developed economies suffered a massive credit bubble in the decade before the 2008 Financial Crisis. Their leverage rose roughly by 50%. Low interest rates and related rising asset prices powered the rising indebtedness, especially in household mortgage debt. McKinsey Global Institute published a comprehensive report on the phenomenon ('Debt and Deleveraging: The Global Credit Bubble and Its Economic Consequences'). Globalization brought low inflation, low interest rate, and low wage growth to the developed economies. As the supply side growth shifted to the developing economies, they used low interest rates to stimulate the demand side, which led to debt fueled asset bubbles.
When the Crisis hit, all infected countries pursued a similar strategy to stabilize the situation-extending government help to crashing financial institutions through capital injection, liquidity support, and sovereign guarantee. While it has mostly achieved its purpose, it has brought catastrophic consequences for some countries like Ireland. The resulting liability is bankrupting the Irish government that was quite frugal before the Crisis. The bailout cost has greatly increased government indebtedness in general, limiting their ability to help their economies in the future.
As the global credit bubble burst, we are seeing diverging trends in how the developed economies respond to it. The challenge is to bring down leverage. A good measurement for national indebtedness is the ratio of the total debt level of the real economy-government, non financial companies and households relative to GDP. For example, the US government debt is $14 trillion, the household sector 13.4, and the non-financial corporate sector 11. The total debt is $37.4 trillion. The US's nominal GDP in 2010 is probably $14.8 trillion. That would put the US's national indebtedness at 253%. The same indicator for the eurozone is about 250%, for the UK 280%, and Japan 370%.
In addition to the indebtedness of the real economy the financial system has leverage too. It is similar to borrowing money for buying stocks. It distorts asset prices but doesn't add to the indebtedness of the real economy. There is correlation between real economy indebtness and financial leverage. The later creates cheap money and incentivizes the real economy to gear up. One can assume that high real economy indebtedness has a financial counterpart. In the discussion here I will focus on the real economy leverage.
The real leverage in the developed economies increased by 50% in the decade before the financial crisis. Hence, one can argue that they need to decrease the leverage by one third to normalize. How fast it should happen depends on how dependent an economy is on foreign capital. And in what way it can be achieved is sometimes a policy choice.
Diverging deleveraging policies
Some are behaving like nothing has happened. Australia stands out in that regard. Its household debt has surged by 20% since the Crisis hit and recently surpassed 100% of GDP. Its household debt to disposable income ratio at 156% is the highest among major economies in the world. Australia has had 4.5% of GDP in annual current account deficit for two decades, i.e., its household debt is funded by foreign capital inflow. Its property market is still booming. When you see rapidly rising household debt, big current account deficit, and booming property market, it is a credit-cum-property bubble for sure. Australia's bubble has survived the 2008 crisis because commodity prices came back on the back of the Fed's zero interest rate policy and China's massive credit growth. The Australian bubble is very likely to burst when commodity prices fall sharply. Either a substantial economic slowdown in China or spiking US interest rate would trigger it.
Australia is an exception. The booming commodity market is giving it the choice not to adjust. Some economies must adjust and fast, because they depend on foreign capital for financing. Iceland, Greece, and Ireland are small economies that depend on foreign capital to fund their fiscal deficits, i.e., they run large current account deficits and don't have sufficient domestic savings to fund their government deficits.
Japan is another economy that hasn't decreased its leverage; the belt tightening in the private sector has been offset by the government's deficit spending. Japan's debt level is truly frightening. But, it has been that way for two decades. The reason for its stability is due to its high domestic savings rate. Japan has been consistently running large current account surplus, i.e., sending its savings surplus abroad, for decades. Japanese people have extremely high home bias in deploying their savings. Japan's government can borrow at extremely low interest rate. Hence, it has no incentive to change its behavior.
Only sustained current deficit would change Japan's dynamics. An aging and declining population is slowly bringing down Japan's savings rate. But Japan's investment need is declining too. Hence, it is still running a significant current account surplus. The situation will change in a decade or so. Japan is unlikely to change without an external constraint. I suspect that Japan would look the same a decade from now.
Many economists think that Greece and Ireland are suffering because they don't have their own central bank. This is an erroneous observation. Small economies cannot use monetary policy to deal with a financial crisis with a large foreign debt component. When the crisis hits, foreigners want their money back. One must tighten belt to pay up or at least to demonstrate convincingly its ability to do so soon. Printing money will surely lead to currency collapse and foreign debt impossible to service, making bankruptcy inevitable.
Eurozone is pursuing belt tightening to address their debt overhang in general. It is not due to market pressure. The Maastrich Treaty of 1993 that laid the foundation for the euro implanted the DNAs of responsible fiscal and monetary policies in the eurozone. The up limit on fiscal deficit to 3% of GDP, though violated frequently, centers policy conversations on the 'right' level. Further, the mandate for the ECB is just price stability, unlike the dual mandate of price stability and employment maximization for the Fed.
The US is pursuing a different strategy to bring down its leverage. It is trying to grow out of it. It is adding more and more monetary and fiscal stimulus to accelerate the economy. Even though the approach leads to rising indebtedness, its advocates believe that the economy would grow faster on its own and bring the leverage down and employment up on its own.
The US's approach hasn't worked well so far. Its government debt has risen to $14 trillion now from $8 trillion in the third quarter of 2008 when the Crisis hit. The increase is equal to 40% of last year's GDP. The Federal Reserve's balance sheet has bloomed to $2.6 trillion from $900 billion during the same period and is likely to rise to $3.2 trillion on QE 2 early next year. Yet, the US's unemployment rate is at 9.4%. If including the people who stopped looking for job or are underemploymend, one sixth of the US's labor force is unemployed.
Euro is better than dollar
The dollar has been firm since the Obama Administration introduced a new tax cut package. The dollar index ('DXY') has hovered tightly around 80 lately. It was as low as 74 mid last year. Its long cycle high was over 120 in 2002 and low was 71 in 2008. The dollar's strength is due to market's optimism over the US's economic growth outlook for 2011. The double kick from QE 2 and the Obama tax cut could lead to strong growth.
I do believe that the US's economy would have a growth spurt in the first half of 2011. But it would sputter later on. Beyond the government stimulus the economy doesn't have an engine to sustain fast growth. The household sector has 100% of GDP in debt and cannot support consumption through borrowing like before. The US's corporate sector is sitting on record cash. Hence, the Fed's QE 2 is unlikely to change their investment behavior. Indeed, they are investing aggressively in emerging economies. They would invest aggressively in the US when either its consumption grows on a sustainable basis or the US becomes a low cost producer. Neither is likely in the foreseeable future.
When this round of stimulus-inspired growth spurt peters out, the US doesn't have room for more fiscal stimulus. The Federal government already borrows $4 for every $10 that it spends. If it wants to increase the deficit, it runs into two constraints. First, the treasury market could get spooked. The government is adding $1.5 trillion to its $14 trillion debt stock. When the interest rate normalizes, the short-term policy rate should be 5% and 10Y treasury 6%. The interest payment for the government could rise to over $1 trillion in five years. The government finance would be in a vicious cycle. Hence, the market would pull back from more financing for the deficit spending.
The Federal Reserve would be left to support the economy on its own soon. It has only one instrument-printing money to devalue the debt and cheapen the dollar. The former works through inflation. But, it is a high risk strategy. When the market panics, the treasury market may crash, causing the US's interest rates to spike, defeating the benefit of inflation for bringing down the debt burden. A cheap dollar may generate more income through boosting exports. But, a cheap dollar can generate inflation that offsets the dollar weakness in cutting cost.
The Fed probably wants to pull off an impossible task-creating enough inflation to cut debt burden and weakening dollar enough for boosting exports but without panicking the treasury market. I call it an impossible task because the US depends on foreign capital to fund its deficit. The US is likely to run 4-5% of GDP in current account deficit for the foreseeable future, i.e., half of its fiscal deficit needs to be funded by foreign capital. It would be insane for foreigners to continue to buy the treasuries while the Fed is trying to weaken the dollar. It is working now because the dollar is the dominant currency in the global economy. Hence, the US can abuse the dollar and get away with it.
Even if the Fed pulls off the impossible, it wouldn't be rewarding for the dollar. The current dollar strength is likely to be short-lived. When the Fed starts to talk about QE 3, possibly late in the year, the dollar would resume its decline.
Eurozone is pursuing belt tightening to decrease its indebtedness or leverage. It is painful in the short term. The risk to growth scares away euro buyers and attracts short sellers. Hence, euro has been under pressure. But, short-term growth difference has no bearing over the long term value of a currency. Competitiveness and money supply ultimately determine a currency's value. Japan's economy has stagnated for two decades. But, yen against dollar has appreciated from 140 to 80.
In today's world an economy's competitiveness derives from technology, resource endowment, and brands. While the whole world is focusing on technology, its benefits tend to spread out quickly and don't bring much competitiveness to the country of its origin. The US is very strong in mobile internet. Its benefits, however, have quickly spread around the world. The technology may have boosted productivity globally but without conferring a unique advantage to the US.
We need to distinguish between corporate and national competitiveness. The two no longer overlap closely. Apple is highly competitive. It reaps billions in profits from global sales. In terms of unique benefit to the US, it is to the small number of programmers based in the US and Apple's US shareholders. The US is full of companies that are very competitive but don't benefit the US much. This is why I'm optimistic on the US corporate earnings, but not the US economy or the dollar.
Brands and resources, on the other hand, are sticky relative to the countries of their origins. French luxury brands, German cars, and Italian tourist attractions bring benefits mostly to themselves. Southern European countries have lost their competitiveness in labor intensive manufacturing. The rest of eurozone's tradeable sector is quite sticky.
The eurozone has stronger macro fundamentals than the US's also. Its current account deficit is about 1% of GDP and fiscal deficit 6.5%, compared to 4.5% and 10% for the US. The ECB is worried about inflation, as the eurozone's CPI is increasing above its up limit of 2%, while the Fed is explaining away energy and food inflation by focusing on the so-called core CPI. The former is more likely to tighten than the later. It would be good news for euro. Indeed, without short selling euro would be quite strong today.
China and Japan are right to support euro
While euro's fundamentals are much better than dollar, market panic could push the eurozone down a vicious cycle and make euro crash self-fulfilling. Eurozone doesn't have a central fiscal authority. The small economies in the zone are vulnerable to market pressure. When market panics, it pushes interest rate sky high and makes the borrower bankrupt. If some buyer is willing to step in to replace the market, it gives the borrower time to restructure. The result could be a happy situation for both borrowers and lenders.
IMF exists for that purpose. But, it is clearly not big enough for eurozone's problem. China and Japan have $4 trillion foreign exchange reserves and are much more powerful than the IMF in steadying the market's nerves. Of course, if a country isn't viable, it shouldn't be supported. Debt restructuring-a form of bankruptcy should be pursued. I suspect that Greece falls into this category. Ireland may need some restructuring too
Spain is undoubtedly the key battle. It is large, suffering from 20% unemployment rate, and, if given time, capable of paying off its debts. As long as enough resources are marshaled to maintain liquidity for Spain's debt market, euro is quite safe. China and Japan can play a decisively role in the area. China is already providing direct support. Japan should too.
Supporting euro is in China and Japan's best interest. They hold more dollar assets than anyone else and have strong vested interest to safeguard the dollar's value. The only viable alternative to the dollar is euro. If it is discredited, the Fed would be emboldened to print more money. Euro's value in that regard is worth enough support from China and Japan to provide sufficient liquidity to Spain.
Down the road, China and Japan should work with the OPEC countries to prepare for the post-dollar world. The three hold most dollar assets in the world. If they don't prepare an alternative, they are always at the Fed's mercy. When the Fed stimulates the economy by printing money, it dilutes their wealth. If they prepare a credible alternative, the Fed will have to think twice before it starts the print press.
The key step for replacing the dollar is for oil to be priced in a different currency. For now euro is the only possibility. China, Japan, and the OPEC should begin to discuss on trading oil in euro. Oil is mostly traded in London and New York now. Euro-denominated trading systems could be created in Dubai, Shanghai and Tokyo.
It's time to prepare for the post-dollar world.
Monday, January 24, 2011
2011-01-24 / Andy Xie, The New Century Weekly