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Sunday, June 30, 2013

Dollar collapse....finally?

The key dynamics of the most recent global macroeconomic paradigm (e.g. the last 40 years) can be summarized in a few points:

1. In 1971 the US dollar was taken off the gold standard, enabling America to issue unlimited quantities of new currency at will. The United States has been running a deficit on its balance of trade since then, accumulating debt to foreigners. In 40 years, the dollar has not once depreciated enough to allow for the trade-balance to turn into a surplus.

2. The early 1970s was also when China followed Japan, Taiwan, Hong Kong and others in adopting an economic growth strategy based on exports, mainly to the United States. The main component of the strategy was having their central banks matching cash flows from the exports of goods with purchases of financial assets in the United States (e.g. government bonds) to avoid their currencies from appreciating (which would hurt the exports).

3. The impact on the US and Asian economies of the above policy choices has been two-fold:

(i) Asian central banks placing their dollars balances drove the 30 year bull-run in the market for government bonds, pushed yields below levels needed for the preservation of the purchasing power of money invested, helped creating the US asset bubble in housing, as well as pushed up US stock market valuations. Currently, total financial assets held by foreigners amount to more than 9 trillion dollars, nearly 2/3rds of all government debt and almost 60% of US GDP.

(ii) Avoiding appreciating domestic currencies required the Asian central banks to issue new currency to pay for the dollars that were bought. As the proceeds from exports went to domestic producers who redeployed it in the economy, the policy resulted in increasing the domestic monetary supply, creating significant inflation and massive credit expansion in Japan in the 1980s (leading to the largest asset bubble the world has ever seen), and massive inflation and credit expansion in China in the last decade (and another huge asset bubble, the full consequences are yet to be seen). 

Now, all that's in the past. How much longer can the current paradigm be extended, e.g. what about the future?

It is highly relevant to note that the two economies that have played the largest role in supporting the value of the dollar for the past 40 years currently are in the process of experiencing dramatic economic reversals, which are directly related to the long-term consequences of their past policy choices.

After a decade of deflation, Japan has recently resorted to a policy of hyper-aggressive monetary and fiscal expansion ("Abenomics"), aimed at stimulating the public to spend and invest as their cash holdings will yield negative returns when inflation increases. This policy has sent the currency down 20% vs the dollar, boosted consumer spending (+3.5%) and stock market valuations (up 55% for the year).

China's domestic inflation problems have eroded the competitiveness of Chinese producers, as dollar denominated wages have doubled between 2008 and 2013 to currently averaging around $8000 p.a., nearly 20% above wage levels in for example Mexico. Simultaneously, the shadow banking system, which has managed the majority of Chinese savings, is collapsing due to falling real estate valuations, implying China is going from rapid credit expansion to rapid credit contraction. Money is being pulled out of the shadow banking system and invested into gold and other assets that still allow an escape from the tax man, a major factor contributing to China becoming the largest buyer of gold globally in the first quarter of 2013.

In other words, Japan has already stopped supporting the dollar. With its domestic sector collapsing, China is becoming even more dependent on exports for growth, and is likely to continue with asset purchases in the United States off-setting export cash flows, whilst pursuing aggressive domestic monetary policies to bail out it's banks (like Japan did in the 1990s).

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