Russell is one of my favorite economists and this post is heavy on economic fundamentals. He talks about a new and emerging world . A world in which companies having dollar liabilities will find it difficult to pay back their Dollar loans as US look to reduce its current account deficit .This will lead to much higher Dollar v/s other currencies. This post ties up with what Peter Zeihan writes on world without US protection in “The accidental Superpower”. After all if the only bully in class leaves then everybody wants to be a bully
By Russell Napier
The USD will rise as US growth slows. That is clearly not a consensus view. The consensus believes that the strength of the USD rests largely, if not solely, on the prospect for increasing interest rate differentials between the US and other key jurisdictions. Most investors expect that this has to be higher growth in the US, leading to higher interest rates that must underpin a further rise in the USD. Almost always investors seeking to profit from exchange rate movements focus on growth/inflation/interest rate differentials in planning where to place their bets. Thus, in recent weeks the USD has fallen on the international exchanges as concerns have grown about the President’s ability to deliver on his growth agenda. It is almost always correct to focus on growth/inflation/interest rate differentials in assessing the outlook for exchange rates, though it is a pursuit fraught with difficulties. Sometimes, if rarely, it is the wrong business to be in and the consequences are disastrous. Those who spent 1970 speculating as to whether the newly appointed Fed Chairman, Arthur Burns, was brewing one or two rate rises are not remembered kindly by history. That myopia led them to miss an event that determined investment returns for at least the next decade – the collapse of the global monetary system/Bretton Woods Agreement. Investors focusing on growth/inflation/interest rate differentials today are missing the fact that, once again, the global monetary system is breaking down. The continuing breakdown of our current system, driven by the inability or unwillingness of developed world nations to run current account deficits, will continue to push the USD higher as growth in the US falters.
In previous quarterly reports The Solid Ground has focused on the key structural changes that have led to a US economy that grows without a worsening current account deficit. These key forces include a shift in the consumption of services from goods by the baby boom generation, a rising savings rate – albeit rising at a glacial pace – and the shale oil and gas boom. These three factors are pushing the US economy towards a current account surplus even as the economy grows. Should the economy slow, then the normal cyclical forces would rapidly quicken the pace of that current account contraction. Based on recent market reaction, some investors would sell the USD as US growth slows and the likelihood of interest rises decline. However, this Pavlovian reaction ignores the fact that such a growth slowdown would further reduce the US current account deficit with profound negative impacts for Emerging Markets (EMs) and the stability of the current global monetary system.
A profound US economic reality has changed without investors paying it much attention. From 1992 to 2006 there was one economic certainty – if the US economy grew, the country’s current account deficit, relative to GDP, would also increase. A growing economy combined with a current account deficit that grew even more quickly produced large and growing current account surpluses elsewhere. Where those surpluses occurred in countries managing their exchange rates relative to the USD, they forced domestic liquidity creation through the process of the accumulation of foreign exchange reserves. Of course the capital account, whether in surplus or deficit, also played a role in determining the scale of liquidity creation in those jurisdictions managing exchange rates. As we have now seen in many cycles, capital, particularly short-term capital, is pro-cyclical in nature and tended to flow towards those countries witnessing high growth, boosted by their success in trade. The alchemy forced money creation in EMs while their central banks financed the US current account deficit by buying ever more Treasury securities. This ability of the US to run ever larger current account deficits as it posted high levels of domestic growth was the cornerstone of a global monetary system that was stitched together post the Asian economic crisis. That cornerstone has now collapsed, as the US current account deficit has collapsed, and that is the key to calling a bull market in the USD. That is a bull market that intensifies as US growth slows, the current account contraction accelerates and the stress on the current global monetary system becomes ever more apparent.
Our current monetary system, based upon EMs managing their exchange rates relative to the USD, was constructed in a very different age. It was an age when higher US growth meant higher US current account deficits but that age is over. The last US economic contraction ended in June 2009 – almost eight years ago. By June 2009 the US current account deficit had already collapsed from 5.94% of GDP in 3Q 2006 to just 3.6% of GDP. In 4Q 2016 the US current account deficit was just 2.55% of GDP. After almost eight years of growth the US current account deficit, relative to GDP, is smaller than it was when the economic expansion began. This is a new way for the US to grow and it has profound impacts on global financial stability and the outlook for the USD. With Euroland and Japan also running surpluses, the global monetary system, as currently constituted, is bringing tighter monetary policy to EMs and, more importantly, is structurally redundant. This matters in a world where EMs accounted for 79% of world GDP growth from 2010-2015 and the world’s debt to GDP ratio has reached new all time highs. The prospects that the lack of developed world current account deficits creates a global growth slowdown and a debt crisis are thus high.
That tightness of monetary policy in EMs is not necessarily steadily applied as sometimes EMs receive bursts of net capital inflows that offset the problems associated with the lack of developed world current account deficits. Sometimes it works the other way, as net capital outflow exacerbates the tightening of EM monetary policy as central banks act to defend their exchange rates. However, the condition of EM current account deficits goes to the robustness of the system and determines the extent to which EMs are impacted by shifts in capital flows. The deterioration in EM current accounts since 2009 has been marked. In 2009 EMs posted combined current account surpluses of US$238bn, but by 2016 this had become a combined current account deficit of US$79bn. That combined deficit stops the creation of more EM money through the mechanism of foreign exchange intervention, unless they are recipients of more than offsetting net capital inflows. As the US produces an annual current account deficit close to US$500bn, any contraction in that deficit can lead rapidly