Wednesday, November 10, 2010

Bye Bye Dollar

To Hell Through QE

By Andy Xie

The world seems full of smoke ahead of a world currency war. The weapon of choice is quantitative easing (QE). If you print a trillion, I’ll print a trillion. No change in exchange rate after a trillion? Let’s do it again, QE2. If you listen to people like Geithner, the end of the world is quite near. Rich people everywhere, not just the Chinese, are buying gold for peace of mind. When the currency values vanish in a QE melee, the rich at least have the gold to stay rich.

If you listen to American pundits, politicians or government officials, it’s all China’s fault. China is far from perfect – its currency policy certainly isn’t – but it is not the cause for the world’s ills. The US is by far the biggest source of uncertainty and the initiator of the QE war. Its elite created the biggest financial bubble since 1929, even removing regulations designed to prevent it, and left the US economy in a shambles after it burst. The same people want to find a quick cure to hold onto their power. Unfortunately, there isn’t one.

The US has cut interest rates to zero and run up budget deficits to 10% of GDP. It’s shock-and-awe Kenyesian policy. But, after a few quarters of strong growth, the economy is turning down again. Unemployment remains close to 10% (and would be much higher, close to Spain’s 20%, if the data included the underemployed and those who have stopped looking for work). The stimulus has failed.

How should one interpret the result? If you were Paul Krugman, you would say it wasn’t enough. Of course, if 20% of GDP in budget deficit and another round of QE still doesn’t work, he would say again it’s not enough. You can never prove Krugman wrong.

The second interpretation is that it takes time for the economy to heal. No economy has recovered quickly after so big a bubble – during such a prolonged and massive bubble, resources become so misallocated that it takes a long time for reallocation, particularly in the labor market.

The third interpretation is that it’s China’s fault. Yes, China’s exports to the US rose sharply during its stimulus-inspired pickup, i.e., the stimulus partly went to China. But, whose fault is that? Apple makes all its iPhones in China because it costs them under USD 20 each, even after recent massive wage increases for Chinese workers. Apple’s gross margin is 30 times the processing cost that goes to China. Maybe Apple is an extreme example but the fact is that China’s exports to the US are American goods that retail for 3-4 times of the factory-gate prices. American companies want to make their goods in China to satisfy the stimulus inspired demand.

People like Geithner would argue that China should raise its currency to force American companies to move production back to the US. I suppose that that is how the whole RMB appreciation idea may work. But, at what exchange rate would the American companies want to do it? American wages are ten times China’s. Should China increase its currency value ten times?

Of course, the American pundits wouldn’t put it that way. They would talk about China’s trade or current account surplus and the rising Forex reserves, the prima facie evidence of currency manipulation. I do not want to deny that the rising forex reserves are a problem that China must tackle, but it is a separate issue from the US economy. The solution isn’t RMB appreciation either.

Everybody knows China has a massive savings rate of around half of GDP. It’s a simple equation that the current account surplus is equal to savings minus investment. If current account surplus is a problem, it is either insufficient investment or excessive frugality. China’s investment is over 40% of GDP. Even casual observers would find China’s investment too much. Are Chinese people too frugal? The household income is probably under 40% of GDP, so how could they be the source of the gigantic savings?

The problem is China’s political economy. The government sector raises money through taxes, fees, monopoly franchises, and high property prices. Property sales were 14% of GDP. If the price is normalized, i.e., halved, the household sector would have 7% more of GDP. The household savings rate is roughly one third. This would boost domestic demand by nearly 5%, wiping away the whole current account surplus.

The current account surplus is half of the forex reserve story. The other half is hot money and overseas Chinese are the main source of this. Chinese property and the dollar are their most important foreign assets. As the dollar weakens, they have poured money into China, especially into the property market. Hedge funds and other speculators have also poured money in through buying offshore Chinese assets.

I think China’s currency is overvalued. China’s money supply has exploded in the past decade, rising from RMB 12 to 70 trillion. Every currency has experienced depreciation after a pronged bout of money growth. China’s industry has risen tremendously to justify part of the growth. However, a massive amount is in the overvalued property market. When it normalizes, the money flows out and the currency depreciation pressure happens. We should see this within two years.

What is right isn’t important for now. What is politically expedient is. Americans want a quick cure for their country’s economic difficulties and want to devalue the dollar to achieve it. If it could force China to increase its currency value, then the Yen, Euro, and all the others would go up in tandem. The US, one fourth of the global economy, could export its way out of its problem.

But the others won’t follow this program. China cannot move up its currency value too much or it would trigger hot money outflow, collapsing its property market and the banking system along with it. China is between a rock and a hard place. It is trying to achieve a soft landing of its property market by incremental tightening steps while the currency appreciation expectation keeps the hot money from leaving. This combination may support a multiyear gradual adjustment, giving the banking system time to raise capital.

Japan isn’t in a position to appreciate the yen much. Its industries have lost competitiveness to Germany and even the US. Its industries haven’t had a global hit product for years. Germany and the US auto industries are gaining over Japan’s. It’s hard to see how the yen could rise significantly. The Bank of Japan is vulnerable to political pressure. It doesn’t have a good track record. If it allows the yen to destroy Toyota, Honda, etc., it’s hard to see how it could remain independent. Hence, it will resort to QE to hold down the yen.

The euro is surging by default. The European Central Bank seems to still be talking like Budensbank. But, it can’t sustain its position through the next sovereign debt crisis. When the euro is high, some euro-zone economy, though not Germany or France, will get into a crisis mode. It may join the QE crowd too.

The UK doesn’t need to be persuaded to embrace QE. It is like a big Hong Kong, all about stir-frying stocks and properties. When the bubble bursts, it doesn’t have much else to do – devaluing the currency seems the only way out.

Korea is small but always tries to join the big leagues. It is big in the automobile, electronics, and petrochemical sectors. Its government does not need convincing to watch over the exchange rate. Recently, it has been ‘investigating’ financial institutions for undesirable practices in the currency market.

It seems that nobody wants to appreciate. Most major economies will do something to keep their currencies down. That is checkmate for the US. Without the devaluation benefit on rising exports, QE just leads to inflation, first through rising oil prices. The American people are suffering from declining housing prices and high unemployment. If the gasoline price doubles, the country may not be stable. How would the elite react? Probably more of the same.

The world is heading towards high inflation and political instability. It’s only a matter of time before there is another global crisis. The first sign would be a collapsing treasury market. The Fed is controlling the yield curve through its QE program. But, it is irrational for other investors to play this game. The only reason to stay in is that the Fed won’t let the market fall. But, the underlying value is evaporating with rising money supply and the inflationary consequences. When all the investors realize this, they will run for the exits and the Fed won’t be able to stop the stampede. If it prints enough money to take over the whole market, the people with freshly minted dollars would surely want to convert their money into other assets. The dollar would collapse too.

The world seems on course for another crisis in 2012. The same people who caused the last crisis are still in charge. They’ll get us into another. Iceland is sending its former prime minister to court for causing the banking crisis. A worse fate awaits the people who are causing the next crisis.


Originally published November 5, 2010 in China International Business

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