Sunday, November 14, 2010

Andy Xie on G-20 in Seoul

The G-20 in Seoul was supposed to be a pressure cooker for China. Geithner coordinated a united front against China before the ministerial gathering by signaling that the euro and yen were high enough, emerging economies could restrict capital inflows and resource exporters would be exempt from the proposed 4 percent limit over GDP of the current account surplus ceilings. The coast was clear for everyone except China. The hope was for the G-20 to gang up on China at the Summit. Instead, it became a festival of global backlash against the Fed's QE 2. Some people are just too clever for their own good.

How are emerging economies curbing capital inflows?

A war of words is unfolding before the Summit and the battle lines have been clearly delineated. Germany is leading the charge against QE 2. China is more than willing to echo the sentiment. On the other side, the U.S. is leading the push for capping current account surpluses. It is backed by India's support for its QE 2. But an element of the absurd is at play here by targeting surpluses. Why isn't the onus on the largest deficit economies to rein in the deficits on their own?

The piling of sandbags against a deluge of hot money has begun. Taiwan is restoring restrictions on foreign holdings of local currency bonds. Korea is proposing a hefty tax on foreign holdings of its bonds. China is stepping up checks on sources of foreign capital inflows. Most of its foreign exchange reserves are not from trade surpluses, but from hot money. If the government is really serious, it could surely stop the inflows.

The fight against inflation is heating up too. Australia just raised interest rates again. China increased its deposit reserve ratio. The market is pricing in four rate hikes in the next 12 months. I think the rate hikes will continue. India's central bank just raised its interest rates too, in an effort to curb real estate loans.

When the U.S. is engaging in super loose monetary policy, emerging economies must curb capital inflows and increase interest rates to fight inflation and asset bubbles. It seems that the Fed's QE 2 has convinced everyone of this path. The measures may have come too late for some. Inflation in emerging economies may be already in double digit territory. It seems underreporting CPI has become fashionable, under the pretenses of prolonging an economic boom. The consequences could be severe.

Negative real interest rates and an increasingly large current account deficit are a lethal combination for emerging economies. History has shown repeatedly that it leads to crisis. Brazil and India are in that camp today. Brazil is running a surplus. But, it is too small to offset the Fed's impact on commodity prices. When commodity prices are so high, a country like Brazil should run a large surplus like Russia. India is running a huge deficit outright. Its real interest rate is severely negative by some measurement. Its boom continues because the Fed's policy encourages speculative capital to fund its deficit and support its currency value.

China and Russia have inflation too. But they have large current account surpluses and wouldn't have a liquidity crisis when the Fed is forced to abandon its policy. Brazil and India don't have the same cushion. Unless they tighten substantially in the coming year, they may feature big time in the looming 2012 crisis.

Can rich countries grow?

Germany is upset with the U.S.'s policy and for good reason. A decade ago, it was left for dead. Its economy was saddled with high cost commodity industries. As East Asian countries like China and Korea were charging into them, few thought Germany had a chance. The Germans didn't give up. They cut costs dramatically, even wines, to the Frenchmen's astonishment. In addition, they innovated and turned many commodity businesses into IPR-dependent ones. With low costs and pricing power, Germany is enjoying the fruits of an export boom. But, the Americans want to turn it into an exchange rate issue. It is facing many issues that Germany faced before. Instead of restructuring, it is looking for a quick way out through devaluation.

Even though Germany is very competitive, it's not growing rapidly like an emerging economy – and it shouldn't. High growth belongs to emerging economies. If rich economies try to grow fast, it will run huge deficits and lose wealth. The reason is globalization.

Information technology created the 21st century multinational corporation and made the current wave of globalization different from the previous ones. A multinational corporation is a company in name and substance. But it has the breadth of empire. It has transformed the world through investment and trade into one economy. Both demand and supply are global now. Cost arbitrage by multinational corporations have made it necessary for labor in developed economies not to compete against that in the developing economies. The wage difference is too big to be bridged in the foreseeable future. This force ensures that demand stimulus in developed economies will lead to widening trade deficit and limited impact on employment.

Europe and Japan have accepted this reality and have gone into the wealth preservation mode: focusing on pricing power, not volume in exports, targeting low growth rates and cushioning displaced workers with benefits. The U.S. is in so much trouble because it wants to grow out of its problems. When labor costs ten times that in developing countries and, adding to this is the fact that the other side has ten times as many people, this sort of thinking seems irrational. Yes, technology and quality can improve exports. But, this will barely affect trade volume. When the U.S.'s best product idea – the iPhone – doesn't lead to a rise in production at home, one should be wary of optimistic sound bites.

The U.S. government wants to change the global reality by rearranging the exchange rates. If this idea works, one must lift the standard of living in countries like China and India instantaneously to that in developed economies or lower the U.S.'s living standard to that of China and India's. Neither is possible. The political atmosphere in the U.S.'s requires solutions that generate instantaneous effects. The world can't offer that. As long as the U.S. continues to search for the impossible, the world will be a dangerous place.

Where are the real fault lines?

Rising incomes and widening wealth gaps are a global phenomenon. The top 1 percent of the U.S.'s population takes one fourth of the national income and 40 percent of the wealth. China's household income is below 40 percent of GDP, probably the lowest in the world.

The process of globalization should lead to increasing gaps in wealth. It is demonstrated in the strong balance sheets and good earnings of the top global companies, even as major economies struggle with low growth rates and high unemployment rates. But, globalization is not the only reason, and may not be the most important one in explaining highly concentrated wealth.

Financial bubbles, created by loose monetary policy from people like Alan Greenspan, are the most important factor for the rising inequality. The bubbles mislead low income people to borrow and spend on fictitious paper wealth. Their debt becomes the profits for a few. When the bubble bursts, the lower income groups spend less and cut the labor demand for themselves. Lower income demand usually produces lower income employment.

China's low consumption is due to excessive government power, not from low exchange rates. The force that pushes the economy forward is the government's desire and plans for big investment. It then raises money through taxes, property sales or state monopolies overcharging. Under such a system, consumption can't possibly play a leading role. Focusing on the exchange rate won't solve anything and may make the situation worse.

How will the U.S. treasury market fare?

The U.S. is obsessed with manipulating demand, through lowering or increasing debt cost, to manage its economy. It doesn't recognize that supply side management is the key in an era of multinational corporation-led globalization, because the latter doesn't provide instant gratification. Under political pressure to bring down unemployment rates quickly, it will continue to muck around with the money supply and the dollar's value in search of a quick fix. It will stop only when it can't do so anymore. Only a collapse of the treasury market can play that role.

The U.S. government is running a budget deficit close to 10 percent of GDP. The U.S. runs a current account deficit of nearly 5 percent of GDP. The dollar is so weak that inflation is likely to run above average. But, the treasury yields are close to historical lows. Investors justify their holdings by assuming that they can sell to the Fed at higher prices. This perceived Bernanke "put option" is similar to the Greenspan "put option." Investors bought crazy financial instruments, because they counted on Greenspan to bail them out in a crisis. But these maneuvers only work on the market's faith. But the Fed cannot buy all the treasuries out there. It will cause hyperinflation.

The trigger for the crisis will be something that panics treasury holders. It could be the worry over another maxi-dollar devaluation or inflation. Most American policy thinkers don't believe that inflation will come. Otherwise, they would have to pull back the dollar printing presses. But, when one looks at food and oil prices, it seems it's only a matter of time before inflation hits the U.S. via emerging economies and commodities.

Brace yourself for turbulence ahead. Unfortunately, it will likely end with another crisis. Hopefully, the world will be better off after 2012.

(Ref. Group Study Questions, for 20, Nov 12, 2010)