A Snowball in the Making: China's Basket of Currencies
China's announcement to abandon its U.S. dollar peg in favor of a basket of currencies has to be seen like a snowball in the making: initially, there will be little impact, but seismic shifts have been initiated. China's initial revaluation of the yuan by 2% versus the U.S. dollar is small, but its repositioning versus a basket of currencies puts in place a mechanism that allows China to respond to both internal and external pressures.
Like any nation, China foremost has its own interests in mind. China is interested in social stability as 10-15 million new jobs have to be created each year accommodating workers joining the labor force. Formidable challenges lie ahead as thousands of new cities are built; China is undergoing its fastest and largest transformation ever. It has been China's policy to support that growth by subsidizing its exchange rate to foster exports. Any tightly managed economy faces internal pressures as free market forces are suppressed; some of the void is filled by corruption as artificial barriers are avoided. A subsidized exchange rate is akin to an artificial boost to an economy, leading to domestic inflationary pressures (e.g. raw material prices are near record levels) and capital misallocations (nowadays, we call them bubbles) as investments take place into projects that would not be profitable in a free market.
External pressures have been well documented: U.S. manufacturers have had to deal with high raw materials prices, as China's overproduction impacts world commodity prices; and at the same time, U.S. companies have had to deal with little pricing power on consumer goods as a flood of imports from China and the rest of Asia have kept prices low. These pressures on corporate profit margins have kept a lid on U.S. employment growth as U.S. corporations need to accelerate their outsourcing to retain margins. This has contributed to a heated political environment blaming China for dumping its goods on U.S. markets. While China has certainly done their share in supplying the U.S. consumer with cheap imports, highly accommodative U.S. fiscal and monetary policy have created an environment that has crushed the already small U.S. savings rate in favor of consumption. U.S. households have been extracting equity out of their homes to finance their consumption. We now face the greatest imbalances in world financial history, as manifested by the current account and trade deficits; it is politically only too convenient to squarely blame China, even as these imbalances could have never been driven to such extremes without the support of U.S. fiscal and monetary policies.
China's shift to a basket of currencies allows it to address these pressures. A stronger yuan will have a dampening effect on its export-driven economy as the Chinese government would like to see its Gross Domestic Product ("GDP") growth "slow" to what it deems a sustainable 7% annual growth rate (we like to point out that such "slowing" will not eliminate the long-term pressures on global energy and raw materials demand). China can now respond to external pressures by stating it is no longer exclusively targeting the U.S. dollar; it can now also use its basket to subsidize exports to other countries.
We have been asked whether our Merk Hard Currency Fund was a microcosm of China's basket of curencies. Our Fund may indeed have a lot in common with the currencies China is diversifying into. While China has shown no inclination to publish its basket of currencies, we believe China (i) will focus on countries with which it has a trade surplus as it naturally accumulates their currencies and (ii) has an interest in stimulating exports to countries whose central banks do not have a history of active currency intervention. For example, countries with highly liquid currencies where Chinese activities will not cause a turmoil in the markets and not cause an immediate political uproar. China may also park some of its money in gold. In addition, we see China becoming more active with direct investments, notably in their efforts to secure natural resources for its insatiable and growing appetite.
Studying the parameters given above, the euro is likely to become a prime beneficiary of China's diversification. China is very eager to diversify more heavily to the European consumer; China has a significant trade surplus with Europe. The ECB has welcomed China's step to a basket of currencies. Note also that foreign central bank purchases are stimulative to a domestic economy -- just as the U.S. has long enjoyed the benefits of being the world's reserve currency, other regions, notably Europe, may become a beneficiary.
While China has a trade surplus with the U.S. and Europe, it has a trade deficit with much of Asia due to its tremendous appetite for raw materials. China is also by far no longer the lowest cost producer in the region and is moving up in the production chain, thereby importing goods for further assembly in China. As many speculate, the rest of Asia will also see stronger currencies as a result of China's revaluation, let us not forget the motivation that all these countries have is to foster their exports to the U.S. So far, China has been singled out by American politicians; we believe the rest of Asia will see China's revaluation as an opportunity to try to take market share. We have already seen Japan being very vocal that they will not accept currency moves that are not in their interest. Japan is very much worried about a return to deflation, which may well be the case if imports from China become more expensive and their own exports to the U.S. are less competitive. In the past, Japan has shown that it is willing to engage in monetary intervention that puts its currency at serious risk of destruction -- to us, the Japanese Yen, despite its speculative potential, is too much of a risk; we believe that if a country acts as if it wants to destroy its currency, one day, it might just succeed. Similarly, many countries in the 'Tiger' economies have no history of mature monetary history, and their reactions may be erratic when their economies slow down as their exports become more expensive. South Korea and Malaysia together have the third largest foreign currency reserves after Japan and China; we are talking about countries with turbulent exchange rate histories -- for the speculator, these may be worth targeting; however, we much rather focus on currencies that these countries are likely to diversify into.
Talking about the potential for turbulence in the monetary system, I would like to mention a point raised last week by Alan Greenspan, Chairman of the Federal Reserve, during what may be his last testimony to Congress before he retires. He was asked by Congressman Ron Paul why doesn't the U.S. return to a gold standard when fiat money (paper money not backed by gold) created the problems of the 1970s in a scheme to induce inflation and defraud people of their hard earned money. Greenspan didn't dispute Ron Paul's assessment of the 1970s, but said a 'scheme' would imply a conscious effort, yet the effects of the 1970s policies were "inadvertent." Greenspan said that in the early 1980s, a return to the gold standard, as he suggested at the time, may have been a prudent option, but that former Chairman Paul Volcker's policies were also effective. Nowadays, however, there is no need to return to a gold standard because central banks have learned from their mistakes and are acting as if there were a gold standard. Greenspan must have forgotten George Bernard Shaw's quote:
You have to choose between trusting to the natural stability of gold and the natural stability of the honesty and intelligence of the members of the government. And, with due respect to these gentlemen, I advise you, as long as the capitalist system lasts, to vote for gold. -- George Bernard Shaw
Greenspan appears to be a victim of the same lack of modesty as all central bankers throughout history have been. Every generation of central bankers seems to believe that they have not only learned from the mistakes of the past, but also imply that no new mistakes will be made. During World War I, the German Reichsbank's central bankers -- all educated men --, believed financing a war is 'exogenous' and non-inflationary to the economy; hyper-inflation a few years down the road proved them wrong. Nowadays, former Fed Governor and possible Greenspan successor, Ben Bernanke, has not ruled out throwing money out of helicopters to stimulate the U.S. economy; and Greenspan's policies have contributed to the greatest financial imbalances in world financial history. And these are U.S. central bankers. What about Asian central bankers that were burned just a few years ago by a major currency crisis?
China has put in place an important step to facilitate the unwinding of the global imbalances. Be aware, though, that dollar diversification is going to pose its own set of challenges. The U.S. economy has been driven by extracting cash out of ever more expensive assets; as demand for U.S. assets decrease, creditors may demand higher interest rates for their dollar holdings. The reduced demand for U.S. assets does not bode well for the frothy U.S. housing market. Greenspan has already forecast that the U.S. savings rate will increase - not because we are turning the U.S. into a nation of savers, but because equity extraction from homes will diminish (home equity extraction negatively influences the savings rate). While these adjustments are necessary and long overdue, we do not see that events will unfold without a fight. In Asia, we do not believe the intra-Asian consumption will be make up all of the reduced U.S. consumption; and in the U.S., policy makers over the past 20 years have been confirmed in their opinion that a supply side stimulus is the cure to all economic problems. In that fight, we have our doubts that central banks will, as Greenspan puts it with self confidence, act as if we had a gold standard.
For the long-term investor, the Merk Hard Currency Fund seeks protection against a decline in the U.S. dollar relative to other currencies. Just as our central bankers, we hope that the dismantling of the global imbalances will be orderly. However, it may be prudent to build your investment portfolio not on hope, but by taking advantage of diversification opportunities that seek to protect against a protracted decline of the U.S. dollar.