FYI | May 04 2007
By Greg Peel
Everything just seems to be going swimmingly at the moment, which is often a cause for concern.
The world is seeing restrained liquidity growth in the US, which is helping cool down the US economy, which had shown signs of overheating. Liquidity growth outside the US is fuelling a global boom the likes of which we’ve never seen before. Around the world, only two economies are in recession (Lebanon and Zimbabwe). Equity markets are setting record highs, and have bounced back healthily from the risk scare earlier in the year. So what might happen now that could upset the applecart?
There are a couple of obvious ones, such as a complete breakdown of trade relations between the US and China, a marked acceleration in tensions between the US and Iran over nuclear weapons, terrorism (imagine what would have happened if the Saudis had not foiled terrorist plans to fly planes into Saudi oil refineries), or something right out the box like an earthquake in Japan, or even San Francisco. But apart from such external shocks, what could happen to upset the currently benign investment scenario?
This is the question being put to the respected investment consultants at GaveKal. On a medium to long term basis, GaveKal has maintained a very bullish stance, particularly in equities.
At the moment, this is the scenario:
Central banks, mostly in Asia and the Middle East, are controlling the levels of their currencies against the US dollar.
This encourages the private sector in those countries to borrow US dollars in order to buy assets locally, leading to a big increase in monetary aggregates (Singapore M3 is up 23% and Hong Kong 17% for example), which in turn fuels a surge in economic growth and asset prices.
Asian and Middle Eastern central banks end up with the excess US dollars created, which is mostly deployed into fixed income instruments around the world. This “forced buying” of bonds helps to keep real interest rates low, which encourages risk-taking, which increases asset prices around the world.
The only real spanner in the works that GaveKal can foresee, outside of the aforementioned shocks, is rising inflation.
GaveKal reminds us of a famous quote from renowned economist Milton Friedman: “A central bank can control its exchange rate, its interest rate, and its money supply/inflation, but it can’t control all three at the same time”. So far, Asian policymakers have been content to control their currencies and their interest rates while letting money supply grow markedly. This is okay, as long as there are no signs of inflation. If inflation signs emerge, will the policymakers remain relaxed about money supply growth?
It has been GaveKal’s view that inflation is not a sustained threat for Asia. In simple terms, the global economic theme of the past ten years has been the marriage of expensive machines (built in Japan, Europe and North America) with cheap labour (mostly in China). This is evident in the movement of manufacturing industry from mature economies to emerging economies, which have in turn exported goods at ever cheaper prices.
The next ten years, suggests GaveKal, will feature the marriage of very cheap labour (in Indonesia, Vietnam etc) with very cheap machines (built in China, Korea etc). Already China is a net exporter of machinery and equipment, which suggests the cost of manufactured goods must continue to fall. The Chinese boom is allowing the rest of the third world to industrialise quickly.
Another important development, GaveKal notes, is the unprecedented Asian infrastructure spending boom. Believe it or not, the incredible pace of road construction in China means that pretty soon 90% of China’s massive population will live within one hour of a motorway. This means the cost of distribution of goods in China will plummet, leading to lower domestic prices.
As GaveKal points out, the boom in road construction in the US in the 1950s is what allowed companies from Wal-Mart to McDonalds to distribute goods at cheaper and cheaper prices. So why would Asia be any different?
Putting all of the above together, one would happily believe there could be absolutely no risk of Asian inflation for a long time yet.
But there is a risk, and that risk lies in food prices.
In mature economies, rises in the price of food do not have too much of an impact. We spend about 10% of our weekly budgets on food. But the poorer people of the developing world spend more like 30% of their weekly budgets on food. While we might put off buying a new house because prices are high, Asians can hardly put off buying food.
The irony is that the world’s greatest fear of inflation has, in the last few years, stemmed from oil prices. Being the world’s largest consumer and importer, the US is particularly vulnerable to high oil prices. To that end the Bush Administration has thrown all its weight behind the development of ethanol, and legislated to increase the ethanol content of fuels. The result is that crops once used for food are now given over to ethanol production. This leads to a rise in global food prices, and suddenly a new inflation fear is created.
Australia attempted to get rid of the cane beetle problem by introducing cane toads. Now it has a cane toad problem.
GaveKal notes that the student riots in Tiananmen Square were as much a revolt against high inflation and rapidly rising food prices in China as a cry for democracy. And we all know how the Chinese government responded. If rising food prices spark inflation in China once more, how will the government respond this time?
As a matter of fact, this is exactly the problem that has been facing China’s little brother, India. Since 2004, Indian inflation has doubled from 3% to 6%, and the government has responded by raising rates to 7.75%.
India has not been undergoing the same infrastructure explosion as China. Thus inflation has resulted from bottlenecks in the Indian economic growth story. To date, raising interest rates has done little to solve the inflation problem. India is now taking another tack.
Only last week, the world expected India to raise rates at its regular meeting, but it didn’t. It appears the government is content to let the currency rise to absorb some of the inflationary impact (which is mostly due to high energy and food prices). The Indian rupee has now shot to a level above the beginning of the 1997 Asian currency crisis. The Indian stock market has undergone a substantial rally.
If this policy were to be followed across the rest of Asia, what would happen?
GaveKal suggests it could create a “triple whammy” for Western economies. Asian central banks would slow the export of capital into Western bond markets, and global rates would begin to drift higher. Asian exchange rates would move sharply higher, affecting higher prices for imports around the world. As Asian exchange rates move higher, Asia’s private savers would begin to repatriate capital, thus amplifying the relevant movements in exchange and interest rates. Money aggregates in the US and Europe would collapse. Equity markets would collapse.
GaveKal is quick to acknowledge that this scenario involves a lot of “ifs”. But then the consultants were asked to come up with a scenario that would derail the current global steam train. It may be that different responses will flow from Asia altogether.
But GaveKal is not presently worried about asset valuations, or excess liquidity, or a private equity bubble. They do not fear an economic meltdown, or a violent end to the yen carry trade. What they do fear is just what effect changes in Asian monetary policy might have on global real rates.
To that end the consultants suggest monitoring Asian inflation in general, and food prices in particular. They note that no one has paid much attention to the situation in India – yet.