Thursday 17 April 2014

Tit for tactics

Today we have a long review of the next section of the Dollar Trap by Edwar Prasad. This deals with the impact on exchange rates of US Dollar policy. It reveals that a no win war is being waged as the US tries to bully its partners into appreciating their currency values against the dollar in order to avoid making strong fiscal measures at home. But more of that later.

US market


My prediction of a stock market crash appears to be failing. After a sharp pull back the US markets are on the rise once more. I lost a bit of money by taking the middle of the day pull back as a sign of returning weakness. I was wrong and I paid. But my venture was just a toe in the water so little was lost.



Gold


I resisted the temptation to go back into gold. That decision saved me a packet of money.



GVC


And I am sticking with GVC which is doing OK and is about to pay out a 13p quarterly dividend. I am bracing myself for a fall as the share goes ex dividend on Wednesday next week.



World trade imbalances


At the heart of the Dollar's problems is serious global trade imbalance. To oversimplify, The US and most other developed economies run up foreign exchange deficits as their consumers and governments live beyond their means and they fail to export enough to balance imports. At the same time developing countries, led by China but including other far east countries and countries such as Brazil have thriving, fast growing economies driven by their capacity to export.

We have already seen what these surplus economies do with the savings they generate,and that this creates a trap for them: they seek a safe haven for their savings in US dollar bonds. But there is another side to the argument which is: what happens to exchange rates? 

In the period leading up to the 2008/9 crash the US complained bitterly that the currency policies of its trading partners contributed to the trade imbalance. Their weak currencies gave an unfair advantage to exporters.

The developing countries responded: that easy money policies used by the developed countries resulted in excessive capital inflows into their weak financial markets as funds from the developed world sought high yielding opportunities in the developing world. In themselves these funds did no short term damage but they created asset bubbles. There was also a serious risk that these funds were likely to leave precipitously when market conditions changed leaving disaster in their wake. This was exemplified by the 1997 Asian financial crisis. It is argued that currency appreciation would attract more of these undesirable funds.

Therefore the developing economies had a second reason to keep their exchange rates low. (The first being to keep growth and employment levels high).

Currency wars


A war of nerves about exchange rates had broken out. The US put pressure on China and other countries to allow their currencies to appreciate giving developed countries the chance to export more and import less. The developing countries held the line.

Immediately before the 2007/8 financial crash the IMF attempted to broker a peace. The attempt failed dismally. The US used strong arm tactics and forced the IMF to put pressure on China to avoid currency weakening tactics. The plan backfired and the IMF had to withdraw humiliated. 

The two sides retired from the battlefield hurt but determined to continue with their policies. The US continued to preserve a strong dollar to maintain cheap commodity purchases. China kept a weak currency to keep its economy strong and growing.

The reason for this impasse is that the US will not use fiscal measures to control its domestic deficit. The political costs are too high. Voters would not tolerate,higher taxes or reduced public expenditure to keep the economy on course. Therefore monetary policy continued to be lax. And easy domestic monetary policy generated cheap credit which leaked out and found its way into vulnerable developing economies. 

An example of the political problems caused by using fiscal means to ameliorate domestic problems can be seen in Germany. Gerhardt Schroeder tightened fiscal measures to help his country overcome a financial deficit. He lost the next election because of the pain he inflicted on working people. His policy succeeded and Germany is now an economic powerhouse. But the benefits were felt too late for him to survive politically.

Quantitative easing


The US kept its economy going by injecting cash. It did not have the same political implications at home, but grave problems were exported.

The bottom line of all of this, as I see it, is that FX rates are a zero sum game. If the dollar is strong, then, by definition, other currencies are weak. Persuading developing countries to allow their currencies to appreciate may weaken the dollar but the advantage to the US is minimal compared with the impact on countries which have to deal with poverty in large parts of their population. And why is the US so reluctant to allow the dollar to weaken, it is because it would have an impact on the cost of importing commodities.

Capital controls


The final result of this standoff is that emerging markets have formulated plans to control the inflow or outflow of capital. This is regarded by economic theory as a bad thing. But the emerging markets fear the effects of flows that create asset bubbles and then credit crises as they ebb and flow. The IMF has attempted to discourage or prevent such measures but has been forced to concede defeat.

The ultimate solution is for emerging markets to develop deep capital markets of their own. These would offer domestic investors a safe have for their savings and would provide more effective means for channelling foreign investment funds to the most productive or safest havens. But countries, such as Malaysia who are at the forefront of developing such capital markets find themselves overwhelmed by foreign money. They are forced back into the arms of the dollar to build reserves to help them cope with the volatility that this kind of money brings in its wake.

And what about the home front


As I read this sad tale I was struck by the fact that, as I have suggested many times, some of this money is inflating asset classes in domestic markets of the developed countries. No one seems to be aware, as developing countries very obviously are, that this type of asset inflation brings with it the inevitability of market volatility. No one is building reserves to cope with that volatility when it comes.

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