Andy Xie, our renowned Chinese economist, wrote an article in CaixinOnline on the consequences of a strong dollar (when the US dollar experiences a bull market). Andy emphasizes the importance for the emerging countries, including China, to shift the priority from growth to financial stability.
The Consequences of a Strong Dollar
By Andy Xie
Since the end of the Bretton Woods system in 1971, the U.S. dollar has experienced a bull market twice. The first one in the 1980s was due to Paul Volker’s high interest rate policy to cure chronic inflation. The second began in the mid-1990s as the IT revolution sucked investment into the United States. The coming dollar bull is due less to the United States’ strengths than the weaknesses in other major economies.
[..] Paper money not anchored to gold is a recent phenomenon. During its 40-year experiment, paper currencies have depreciated greatly against gold. When we say a currency is in bear or bull market, this is relative to other currencies. Paper currencies as a whole have been depreciating in value due to inflation. This is why gold is up 45 times against the dollar since the gold standard was abandoned four decades ago. While gold fluctuates in price and enters bear or bull markets alternately, its value will appreciate against paper currencies in the long run because, without a firm anchor, central banks inevitably expand money supplies to fix short-term problems and worry about inflation later.
The dollar bull market ahead is one of those episodes that will see the dollar outperform other major currencies. In the long run, the dollar will still underperform, and paper currencies in general depreciate in value.
The Weak Euro
The euro crisis has been raging for three years. The focus is on debt sustainability in southern European economies. The solution so far is (1) transfer of money from the north to the south and (2) fiscal retrenchment in the south. It is not working because the measures don’t deal with the competitiveness gap between the two. […]
The only solution to the euro crisis is more inflation in northern Europe to balance the competitiveness problem of the south. The rising property price in Germany is the beginning of this process. The underlying force is the European Central Bank’s monetary expansion. When it is recognized that the solution to the euro crisis is inflation, not deflation, the euro will decline to address the competitive consequences for the whole euro zone. The chances are that the euro will be a weak currency during this process, possibly for five years.
The Yen’s Bear Market
The Japanese yen is in its own bear market independent of the dollar situation. The yen has been a strong currency for the past four decades.
[…] The strong yen has pushed Japan into deflation for the past two decades. Japan’s nominal GDP has been declining, while its national debt has skyrocketed due to fiscal stimulus to offset the impact of deflation on demand. The two trends will trigger an explosion sooner or later. Weakening the yen is the only way out, which would decrease the need for fiscal stimulus and boost fiscal revenue. The Japanese government is weakening the yen now for that reason.
[…] The yen has been a strong and safe haven currency. The dollar has been weak but also a safe haven currency. There is plenty of liquidity still parked in the yen. As the dollar becomes a strong currency and the yen a weak one, the reversal in liquidity flow would strengthen the dollar’s appreciating trend.
Crises in Emerging Markets
The first dollar bull market in the 1980s triggered the Latin American debt crisis, the second the Asian Financial Crisis. Neither was a coincidence. […]When the dollar turns strong, the debt burden becomes unsustainable. Hence, no lenders want to roll over the loans anymore. A liquidity crisis ensues. This is what occurred in Latin America in the 1980s and Southeast Asia in the 1990s.
The Vulnerable BRIC
In the dollar bear market of the past decade, the BRIC countries have been the darlings of international speculative capital, like Southeast Asia fifteen years ago. Even though they have little in common, just a phrase has launched numerous funds in their name. Whenever there is a hot concept like BRIC, there is a bubble. There has never been an exception.
The BRIC countries exhibit all the symptoms of binging on cheap credit: high levels of indebtedness, inflation and strong currencies.
[…] High inflation and a strong currency have propelled demand for foreign capital. […] Foreign capital inflow supports their currencies, increasing their money supplies and inflation.
In recent months the BRIC countries no longer receive strong inflows anymore. Their currencies have been under downward pressure. The BRIC economies now are similar to Southeast Asian economies in 1996. Wrong policy moves could aggravate the situation and trigger a full-blown financial crisis.
Loosening or Tightening?
India just cut interest rates. Its latest inflation rate is 7.2 percent. Though it is at a three-year low, the level is still high. The moderating inflation gives the central bank the excuse to cut interest rates. Its goal is to stimulate growth. However, declining interest rates could speed up capital outflow. The resulting currency depreciation could worsen inflation again.
The real angle to the rate cut is the confidence game. Foreign capital, especially the footloose kind, plays the bubble game. It needs growth to embolden its risk appetite. The rate cut may increase capital inflow in the short term. The wrong policy in a conventional sense could work in a bubble environment.
The confidence game works when speculators want to play. It requires the global environment to be supportive. The most important supporting factor is the weak dollar. […]
The confidence game doesn’t work when the dollar is strong. The BRIC economies need to shift their priority from growth at any cost to financial stability. The biggest mistake that Southeast Asian economies made fifteen years ago was their reluctance to sacrifice growth despite the inflation challenge. The right policy for the BRIC countries would be tightening now, ahead of the curve. Unfortunately, all policy-makers are oriented to the short-term oriented nowadays. Some emerging market turbulence is quite likely within the next 24 months.