Currencies | May 26 2009
By Greg Peel
As the Global Financial Crisis plays out amidst unprecedented monetary and fiscal stimulus packages across the world, economists and commentators are quietly shifting towards two polarised points of view. On the one side is deflation, and on the other inflation, more specifically of the “hyper” variety.
The deflation school has little concern over just how much money is being “printed” across the globe. It believes that such an enormous credit bubble was created in the world, from a period realistically beginning in the eighties, that its unwinding will be of such magnitude and duration that you could print all the paper money you like and throw it at the system and still not be able to stem the tide of asset price deflation that should endure for a long time. The catch-cry of the deflation school is “Just look at Japan”.
The Japanese post-war miracle ended at the beginning of the nineties when its stock and property market bubble burst. Japan then entered a period of deflation which it is still in. The Nikkei reached 39,000 at its height and is now around 9,000. The Japanese cash rate was lowered to zero in 1994 and is at 0.1% today, having never reached higher than 0.5% in the meantime. Japan is accused of making many mistakes in initially addressing its problem, including waiting four years to lower the interest rate and propping up insolvent banks rather than letting them fail. Sound familiar? Note that the US housing market peaked in late 2005/early 2006 and the Fed eventually dropped to a zero interest rate in December 2008.
Mistakes were also made ahead of the Great Depression, given interest rates were raised rather than lowered in order to stem the flow of gold out of the US (in a period of currencies being fixed to gold). The US government eventually seized all public holdings of gold (be warned). Ben Bernanke is a student of the period, and a proponent of the Friedman monetarist theory that you can “throw money out of helicopters” with impunity if you need it to fight against deflation. It is with this in mind that Bernanke earned the nick name “Helicopter Ben”, and why he is currently living up to the name by adopting quantitative easing – buying US Treasuries with money printed by the US Treasury in order to halt asset price contraction and restart economic growth.
The inflation school will argue that all the Fed and the US government – and the central banks and governments of the UK, Europe, Japan and even Australia - are doing is replacing the mountain of debt the world created, which got us into this trouble in the first place, with government debt, rather than actually letting the overblown credit bubble deflate. This is merely a strategy which delays the inevitable rather than addresses it. But the plan is to halt global economic contraction first and then address the issues. At stake are the livelihoods of pretty much everyone across the globe.
Governments create this new debt by “printing” money, which largely means running massive fiscal deficits. If the money was simply printed and nothing else happened, then the devaluation of currency would lead to a Zimbabwe-like result. But what governments are doing is attempting to borrow that money from the world by issuing government bonds. Buyers of those bonds are “neutralising” the printed money. The US government needs to raise US$2 trillion in this fashion in order to pay for its stimulus packages and bank bail-outs. US$900bn is needed by September.
But across the globe, everyone is doing the same thing. Australia has re-awakened a dormant government bond market by choosing to run an A$57bn fiscal deficit after many years of surplus. It looks like small beans compared to the US, but certainly enough to get the Opposition fired up. Over in the UK, the levels of debt being issued are enough to force Standard & Poors to consider reassessing the UK’s AAA credit rating. This news caused the US to look inward, and suddenly worry that it might be next.
The inflation school will argue that while asset-price deflation is still occurring, the printing of money is a safe bet. But this needs to be carefully controlled, because the risk is that as soon as the economy does begin to stabilise (green shoots?) the sheer weight of fresh money supply will very rapidly turn deflation into inflation. If central banks don’t act quickly to start pulling money back out of the system (raising interest rates) then the next step is a spiral into hyperinflation.
The inflation school will further argue that the “helicopter” theory is not infallible – even before economic contraction stops the printing of too much money can debase a currency to the point where inflation begins to set in. This would result in central banks needing to raise interest rates in order to fight inflation and in so doing completely derail economic stimulus. The result is stagflation, and we’re back in the seventies.
We can look at it another way. Governments across the globe need to borrow money from (sell bonds to) the rest of the world in order to prevent the debasing of currency and resultant inflation. The more bonds they sell, the more the lenders are going to require commensurate payment – the interest rate. The risk is that if governments keep issuing more and more and more bonds then they will need to raise interest rates to attract more lending and prevent currency collapse.
In March, the Fed announced it would also buy US bonds of various maturities. This “quantitative easing” effectively means the Fed is using printed money to neutralise printed money. While this seems absurd, it can work to stabilise markets in the short term. The trick is to get the money back out again quickly in the medium term in order to prevent inflation. When the Fed made its announcement, the yield on the 10-year US bond dropped from 3% to 2.5% as traders set themselves ahead of the central bank. “You can’t fight the Fed,” is the adage. The Fed suggested at the time it would buy US$300bn of US bonds over time, and to date has bought only US$116bn worth. The minutes of the last Fed meeting revealed discussion of possibly raising that US$300bn limit.
But despite knowing the Fed will be in the market for some time, buyers of US bonds have begun to back off. The yield on the 10-year bond has drifted back up 90 basis points since the March announcement, including a 33bps jump last week following the UK AAA scare. There is some element of bondholders selling out to reinvest in a healthier stock market, although the “safe haven” players tend to camp in the short-end Treasuries. Realistically, the appetite for US bonds is waning. The US dollar has, as a result, fallen 11% since March.
Tonight the US Treasury will attempt to sell US$40bn of 2-year notes. On Wednesday it’s US$35bn of 5-year bonds and on Thursday US$25bn of 7-year bonds. Rarely does a bond market face such a flood of offerings. So far no US Treasury auction has failed, which cannot be said for recent auctions in the UK and Germany. The London Daily Telegraph’s Ambrose Evans-Pritchard notes “traders are watching closely to see what share is being purchased by the US government itself in pure “monetization” of the deficit”.
The US cannot rely on its own private sector to purchase its government bonds. The US is a debtor to the world, and the manufacturing export nations of Japan and China together hold some 23% of America’s US$6,369bn federal debt, the Telegraph notes. Japan and China have sold their products to Americans for years and recycled their receipts back into US bonds – effectively lending Americans money to buy the goods in the first place. What would happen if Japan and China stopped buying US bonds or worse – sold the ones they have?
The export economies of both nations have collapsed. Japan itself is now in deficit, and Japan’s public debt is expected to reach 200% of GDP next year. The Bank of Japan is also conducting quantitative easing. Asian central banks and Middle Eastern oil exporters have cut back their purchases of both US and European bonds, the Telegraph reports, as their export receipts slow. Russia has cut its holdings by a third to support growth at home.
That kinda just leaves China. Evans-Pritchard writes, “Fed chair Ben Bernanke has long argued that central banks can bring down long term borrowing rates by purchasing bonds [quantitative easing] at ‘essentially no cost’. His frequent writings rarely ask whether foreign investors – from a different cultural universe – will tolerate such conduct”.
It is America’s greatest fear that China will abandon its US bond holdings. The potential for disaster is not worth contemplating. China is very angry at the US for its rampant money printing and basically the situation the US got itself into. Never mind that China was lead lender to the US and sold its goods at deflated prices by virtue of pegging its currency to the dollar. But now China is firmly between a rock and a hard place.
China cannot realistically sell the US bonds it holds because it simply holds too many. If the US Treasury itself is struggling to find willing buyers who on earth would China sell to? China would be shooting itself in the foot as US bond prices collapsed causing massive losses on China’s existing holdings. The US dollar would collapse and take the renminbi with it (unless China decoupled) and China’s biggest export market – America – would never recover. Indeed, China cannot even afford to stop buying more US bonds. The risk of a US dollar collapse still exists if China doesn’t provide support.
While Chinese premier Wen Jiabao has repeatedly voiced his concern that US stimulus policy could lead to a collapse in the US dollar and subsequent global inflation, the London Financial Times reports China is still buying US bonds – and in record numbers. China itself admits it is in a “dollar trap”. In March alone China bought US$23.7bn of US bonds to reach new record holdings of US$768bn. (There’s your TARP right there). The composition of China’s US$1,953bn of total foreign reserves is estimated to include 70% of US dollar assets of one form or another. China and the US are like Siamese twins who cannot be separated because both would die.
So perhaps Americans need have no catastrophic fear right now. It is nevertheless apparent that China is not prepared to be lender of the last resort to the US for any policy it decides. Were the US dollar to collapse well there goes China too, if for no other reason that the prices of commodities China so desperately needs to fuel even its domestic economy will go through the roof in dollar terms. It is thus of little surprise that China, while keeping a tenuous prop below the US bond market, has turned to buying “hard” commodities as well.
China’s initial plan to quietly diversify itself away from an overweighting of US dollar assets was to shift some money in euro, yen and other currency reserves. That would currently be a case of good money after bad. But at the end of the day, what is money? Simply a means of buying what you really want – “stuff” (as Dennis Gartman would say). So China has been embarking on a policy of stockpiling commodities (eg copper, iron ore, soy beans), buying stakes in foreign producers of commodities (OZ Minerals, Rio?), and doing direct swap deals with commodity producing nations (funding Brazil’s deep-sea oil and gas project in return for guaranteed supply, all in direct currency terms which cuts out the reserve currency).
As an old-fashioned paper-money inflation hedge, the world learnt not long ago that the Chinese government had also surreptitiously acquired a rather vast amount of gold without moving the global gold market. This was possible given China is now the world’s largest producer of gold.
The Financial Times suggests over the long term, Beijing hopes to reduce the size of its enormous reserves and reduce its exposure to US bonds by encouraging state-owned enterprises to take foreign currency out of the vault and use it to acquire competitors and suppliers abroad. In 2008, Chinese outbound direct investment close to doubled from 2007 to US$52.2bn. Last week Beijing announced a plan to ease restrictions on domestic companies to make it easier to buy and borrow government foreign exchange holdings for offshore investment.
A “Western official” speaking anonymously to the Financial Times suggested last week that China’s State Administration of Foreign Exchange, in deciding where best to invest its reserves, was “very negative on sterling because of renewed weakness of the UK currency but neutral on the euro and bullish on the Australian dollar”.
While there may be two polarised schools of economic view – those of either deflation or hyperinflation – the global government and central bank intended plan is one of ”just right” – in the middle. Just the right amount of debt will be issued to stem deflation but prevent inflation. But while the world contemplates the possible sudden demise of the US dollar, the Telegraph points out that the US is not alone in facing a debt crisis. Governments worldwide have to raise some US$6 trillion on debt this year, with huge demands in Japan and Europe.
Who is going to buy all this debt?
In the meantime, China – master of the softly-softly approach, is quietly taking over the world. Fortunately, Australia stands to be a beneficiary, as long as China’s intentions are purely capitalist.