well, i'm probably early but i just sold my gold fund (only had it a couple days!) at 11am. ===============================================================
What? O ye of little faith.....
As a result of the recent PPPPPT (Practicing Potentially Premature Pwofit Taking) ruling, you are hereby sentenced to read the following essay in it's entirety before reporting back to Swing Trader Central for re-admission.
International Perspective, by Marshall Auerback
China And The US: The Great Unravelling Begins?
May 18, 2004
The late economist Herb Stein used to say that when a trend was unsustainable, it usually would come to an end. It’s worthwhile considering this rare nugget of economic wisdom in the context of the US/China relationship. We could well be on the threshold of a very important growth inflexion point in both economies, the implications of which have clearly alarmed the markets over the past several weeks. So with apologies to Graham Greene, it behoves us to ask: is it truly the end of the affair between these two economic behemoths?
The economic intertwining of the US and China has grown apace over the last 15 years and has begun to resemble less a romance, more the beginnings of a death embrace. Today, China uses its peg to recycle massive dollars back into Treasuries to the US, which enables it to continually expand its capital expenditure to overproduce goods that America doesn't need and can only buy on credit provided by its Chinese benefactors. It has become an increasingly important, albeit fundamentally unhealthy dynamic, underpinning the global economy. The process has become akin to a tavern owner readily extending credit to an alcoholic in order assure his continued consumption of its leading spirits, wines and beer, and rapidly building up production as the customer’s insatiable appetite for drink is further encouraged by ready access to a generous bar tab.
Describing the process in this manner explains the logic behind Herb Stein’s remarks. Until recently, both the providers and the users of the global capital flows have been happy with the world of exploding US foreign liabilities: the US because it gave the country an apparently cost free means of perpetuating endless credit bubbles, and China because it gave further impetus to a social revolution, rapidly turning up living standards throughout the countryside and cities, against the political backdrop of an authoritarian regime deeply paranoid about any incipient signs of social instability.
But now the chickens are coming home to roost: the numbers coming out of China suggest that its monetary authorities face an uphill task to cool a rapidly overheating economy. Consumer prices last month rose at the fastest annual rate in over seven years. Retail sales rose 13 per cent over the same period and imports surged by 43 per cent. What happens in China matters not just because the country is a huge creditor to the US, but is also gradually replacing the latter as a global locomotive. The commodities markets in particular have read the signs out of China ominously and reacted accordingly.
Thus far, Beijing has tried through a combination of moral suasion, administrative fiat and (more recently) interest rate hikes to rein in speculation and stage a soft landing in advance of the Olympic Games in 2008. The jury is still out on whether this can be achieved, and it is also unclear whether market turmoil will, as appears to be the case in Washington, stay China’s hand and thereby allow even greater excesses in this economic relationship with the US to be perpetuated. Beijing’s dithering on significant interest rate hikes thus far is at least partly driven by a growing appreciation of the fragile nature of its state banking system, which the authorities are desperate to privatise. Arguably, China’s decision to address their current boom excesses exclusively through domestic adjustments, such as in the credit area, rather than through the expedient of a revaluation of the renminbi, could diminish import growth, shift the focus to export-driven growth and thereby perpetuate growing political and economic tensions with the US, particularly problematic during a Presidential election year in which the easy resort to protectionism becomes too tempting to resist.
On the other hand, were China to embrace the panacea of cutting the link to the US dollar, it is possible that the cure could be worse than the disease. At a time when the authorities are already moving to choke off domestic demand, anything that would suppress export gains in an economy already struggling to engineer a soft landing (and with a widely acknowledged bank loan problem) would be very dangerous for Beijing and have unhealthy knock-on effects for Washington. If the Chinese were to sever their links with the US dollar, this would likely constitute an enormous vote of no-confidence in the dollar as a major reserve currency on the part of the world’s largest savings bloc.
True, there are already signs that the reign of King Dollar is drawing to a close. East Asia is including moves toward closer co-operation on bond markets, currencies, and the management of foreign exchange reserves, according to leading Asian bankers and monetary officials who met this past weekend in Seoul. The meeting was a follow-up to a process commenced back in 2002, the so-called Chiang Mai Initiative, which called for a pooling of foreign reserves, and the continuing development of local-currency bond markets. New steps introduced this past weekend included calls for more regional free trade agreements, followed by interim measures to stabilise Asian currencies against each other and, finally, monetary union.
Clearly, Asian monetary union is not going to occur overnight and the dollar will still play an important role within the region as a reserve currency. But at least China, in contrast to the US, has a cushion of huge foreign exchange reserves and domestic savings with which to cope with growing American financial fragility: $440 billion in foreign reserves and a further $1.350bn in retail bank savings. When national savings rates are high, as they clearly are in China, this provides for a huge degree of policy flexibility. China may only have blunt weapons with which to handle overheating – the economic equivalent of pushing a walking stick into the spokes of a bicycle’s front wheel. But its huge domestic savings gives the country a powerful means of re-stimulating a sluggish economy. Not so in the US, which looks increasingly trapped in an economic cul-de-sac of its own making.
With the current account deficit now approaching $600 billion, the US needs to attract around a net $2.7 billion of overseas capital every working day. As James Grant noted in last Sunday’s New York Times:
“By any and all measures, America is more heavily indebted than ever before. In 1958, when the funds rate was last at 1 percent, the economy's overall indebtedness was about half of today's. Back then, overall debt (excluding the borrowings of banks and the federal government) represented 84 percent of gross domestic product. Nowadays, it stands at 163 percent of GDP.”
This horrendous debt position has been accommodated domestically by the Fed and internationally by America’s East Asian satellites and China. China has effectively acted as the marginal bid in the Treasury market and, by extension, fixed the mortgage rate at currently low levels, thereby fuelling a housing boom. The effect of this on American consumption has not been difficult to perceive: Americans have been using their homes as ATM machines, refinancing their mortgages in order to fund their spending. But even in the sluggish economy of 2000-2002, housing prices have soared.
Because of these rising prices, people have felt that despite all the ups and downs in stocks and salaries, that their overall situation was okay. Homes are the biggest asset most families own, and their value has been rising nicely. For that reason, Americans have felt more comfortable buying big-ticket items, from SUVs to new computers to Disney World vacations. Much of that spending has gone right onto the VISA card. But that debt has been kept somewhat manageable by another factor in housing prices: mortgage refinancing, where China’s importance cannot be overstated.
Adding to this picture of household sector profligacy fuelled by a housing bubble has been extraordinary fiscal laxity: the Bush administration’s recently announced 2004 budget forecasts a $485 billion deficit, but this figure excludes the deficits of agencies that are guaranteed, backed or sponsored by the U.S. government (such as Fannie Mae or Freddie Mac), a bailout of which could render the final number substantially higher, even before adding in the cost of the Iraq war and any other new outlays required to sustain the new American imperium (After the most recent request for a further $25bn to finance the cost of the war in Iraq, the total could easily top $150 billion through the next fiscal year — as much as three times what the White House had originally estimated.)
By virtue of accommodating, nurturing instead of confronting these mounting external imbalances in its economy, America has now become subject to the same kinds of pressures as the emerging markets did in 1997/98. To paraphrase, Tennessee Williams, it is highly dependent on the kindness of strangers.
Today, by pursuing a more unilateralist foreign policy, the United States will have to absorb all of the costs without help from traditional allies. Its actions over the past 10 years (even before the Iraq war) have almost seemed calculated to lose the country as many friends as possible. The real risk is that the US now runs the risk of third world style debt trap dynamics on its own.
It is worthwhile pondering the risks facing the US economy today by re-examining the emerging markets’ crisis of 1997/98, whose parallel with today’s American economy grows more strikingly ominous. After 1995 the rise of the U.S. dollar and the depreciation of the Japanese yen and the Chinese Yuan led to a loss of export competitiveness in Asian economies whose currencies were effectively pegged to the U.S. dollar. The capital inflows exacerbated the real appreciation of the Asian currencies. The appreciation raised input prices relative to output prices, squeezing profits and hurting export growth. The Japanese recession reduced export profits. As a consequence of these external “shocks,” Thailand and Malaysia developed large and out-of-character current account deficits.
As manufacturing came under pressure, more and more investment went into the property market and the stock market. In Thailand, Malaysia, and Indonesia, asset bubbles began to blow out and the fringe of bad industrial investments also expanded. The rising inflow of foreign capital—mainly bank loans and portfolio capital rather than foreign direct investment—went disproportionately into unproductive activities with a high component of speculation. The continued fast growth rates (that supported the perception of an unchanging “miracle” in Southeast Asia) concealed a rise in the ratio of “bubble” to “real” growth, much as we see in the US today.
Right up to the eve of July 1997 the continued fast growth of the “miracle” economies of East Asia looked to be one of the certainties of our age. None of the four main crisis-afflicted countries (South Korea, Thailand, Malaysia, Indonesia) had had a year of significantly less than 5 percent real gdp growth for over a decade by 1996—Korea not since 1980, Thailand not since 1972. The crash was even more devastating to people’s living standards and sense of security than the Latin America crash of the 1980s. Some estimates suggest that around 50 million of the combined over 300 million people of Indonesia, Korea, and Thailand fell below the nationally defined poverty line between mid-1997 and mid-1998. Many millions more who were confident of middle-class status felt robbed of lifetime savings and security. Public expenditures of all kinds were cut, creating “social deficits” that matched the economic and financial ones. Nature was pillaged as people fell back on forests, land, and sea to survive. Indonesia’s real gdp shrank 17 percent in the first three quarters of 1998, Thailand’s 11 percent, Malaysia’s 9 percent, and Korea’s between 7 and 8 percent. It took nearly two years to reach the bottom.
The miracles led to the biggest financial bailouts in history. The imf mounted refinancing to the tune of US$110 billion, almost three times Mexico’s US$40 billion package of 1994–95 (the biggest in the imf’s history to that date). Yet the investor pullout continued through 1997 and 1998, the panic feeding upon itself. The fact that the collapse continued in the face of the largest bailouts in history suggests that something was awry with the imf’s bailout strategy, a matter of concern to countries elsewhere that might find themselves needing imf emergency funding in future.
The contractionary wave hit many other middle-income and low-income countries beyond Asia, particularly through falls in the price and quantity of commodity exports like grains, cocoa, tea, minerals, and oil. Russia’s renewed financial crisis and default in August 1998 triggered more contractionary shockwaves. Even countries that had diligently followed free market policy prescriptions (such as Mexico) were hurt as investors sold domestic currency for U.S. dollars in fear that any “emerging market” could be the next Russia or Indonesia. Brazil and some other Latin American countries in 1998 came perilously close to repeating the East Asian disaster.
This is what potentially lies in store for the US in 2004/2005. Obviously, Mr Greenspan will do all in his power to prevent this eventuality, but against a backdrop of Chinese tightening, a Korean central bank which is now exhorting its citizens to pay down debt and save more (despite a 20% national savings rate), and a natural tendency of East Asian toward continued neo-mercantilism (understandably brought about as a consequence of the events of 1997/98), the range of options available to the Fed are miniscule.
And protectionism is not much of a solution either, given that this would further highlight America’s limited range of policy options available. When foreign investors see a nation resorting to protectionism, they often interpret this as a sign of weakness, and accordingly seek out higher risk premiums, which the US can ill afford at this juncture. Protectionism also means in effect “biting the hand that feeds the US economy”, because to the extent that protectionism succeeds in reducing the imbalances in US trade, also reduces the increase in dollar savings held in the hands of foreigners. Assuming no change in their portfolio preferences away from US assets (a not entirely realistic assumption, as there may well be some form of retaliation which reduces the proclivity to hold dollars), there is in fact less foreign savings available then for them to disperse additional external financing requirements at the margin.
The greater the debt, the more deflation-prone the economy. A further complicating variable in the case of America is when too much of this debt is held by foreigners, many of whom are not well pre-disposed to the US today. That enhances the risk of capital flight, higher interest rates – in effect, reinforcing the deflationary vulnerabilities at the core of the US problem. Capital flight becomes an even bigger problem if there is nothing in the way of an external growth offset, which is clearly a problem in the event that China begins to slow dramatically, given the latter’s important secondary role as global locomotive. The great unraveling might therefore be rapidly coming upon us.
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