That Seventies Show

There is a serious situation brewing that few people are talking about. This absolutely required a blog update.



One of the most dramatic features of the economic landscape during the 1970s was the disruption of the Oil Shock. Today, people are misled to believe that this was THE cause of inflation in that disastrous decade but that is a long way from the truth. In reality, it was more of a reaction to inflation. LBJ's creation of the modern welfare state combined with his escalation in Vietnam put the US on the path of permanent debt.



Accelerating inflation rapidly ensued for nearly a decade had already resulted in cumulative dollar inflation of over 50% before the Arab Oil Embargo and overnight tripling of prices. OPEC was using their market power and leverage to compensate for the falling value of the dollar and to get ahead of the galloping inflation our government and central bank had created. They noticed that they were being robbed via currency debasement and were in a position to do something about it because they controlled a large chunk of the oil export trade.



Unfortunately, we may be about to see history rhyme if not repeat in the near future. The effects could be extremely serious, with social consequences much greater than in 1974. And it could all be triggered by one medium-sized Southeast Asian nation that few people focus on when looking at economics. That nation is Thailand and the critical commodity that will be impacted is rice.



The likely result arises from the politics of inflation. Thailand's exports are priced in dollars and the severe erosion in value of the dollars earned has created pressure to increase income to revive living standards damaged by inflation. Because Thailand is the largest rice exporter by far in a tight market, they are in a position to demand higher prices - just as OPEC was in 1973-74. The current ruling party in Thailand is committed to increasing the income of farmers and is pursuing policies to control the rice supply and push up prices. From Bloomberg:

Yingluck has said the government will buy unmilled grain from farmers at 15,000 baht ($502) a ton at harvest in November, above current market rates of 9,900 baht. With Thailand the world’s biggest exporter, that may raise rice prices across a region that accounts for 87 percent of global consumption. The leader presented her economic policies to Cabinet yesterday and is scheduled to announce them publicly by Aug. 24.

...



Food makes up more than 30 percent of inflation indexes on average in Asia, according to Rabobank Groep NV. The weighting of rice in consumer-price indexes varies from 9.4 percent in the Philippines, 4.7 percent in Indonesia and 2.9 percent in Thailand, according to Bank of America.

Collateral Damage

The sad irony is that the people most affected by this will be innocent bystanders. The western central banks most responsible for currency debasement will hardly even notice. Few people in the West will be impacted at all. The people who will feel the pain will be Asian city dwellers. Middle and lower class urbanites will be especially hard hit. There will be a partial offsetting benefit in rising incomes for rice farmers but the disruption from shifting so much money from urban consumers is sure to trigger political unrest and likely a great deal of violence as well.



The numbers suggest a 50% increase in rice prices if the official Thai government pricing dictates to the world export market. This seems likely to us since they account for over a third of all rice exports nearly every year. With rice in short supply already, it is doubtful that importers will be able to refuse to buy at the higher price for very long. Because of rice consumption patterns, the effect will be overwhelmingly confined to Asia (85% of world consumption) and North Africa. As if those areas needed more economic pressure place upon them.



Once the Asian nations understand the full consequences of this move, the drive to move their economies away from the dollar should accelerate. With the dollar as the global reserve currency, the Fed is able to inflict widespread damage with its irresponsible policies. It appears the casualties in this round will be overwhelmingly Asian. That will increase the urgency to find alternatives to a dollar that is being sabotaged at the whim of Ben Bernanke.

Trade Grinds to a Halt

Over the last 6-9 months, we have seen many indicators of weakening demand and the impact on trade. For example, the collapse of the Baltic Dry Index - down more than 90%. This reflected lease rates for freighters and indirectly demand for bulk cargo capacity. The initial drops in shipping volume were modest but had a severe impact on commodity prices and shipping rates as the global economy swung from a sellers market to a buyers market. Now we are starting to see the full impact of credit withdrawal. Our thesis has long been that excessive and EZ credit (TM) were the root cause of massive false demand that radically distorted the consumer economies, those who manufactured and exported to them and the raw material suppliers to the manufacturers. The chain of causation has proven out and now we will see just how large that distortion was.

Domestic Strife
Our back of the envelope calculation is that first-order effects in the US will be 10% of GDP, with further ripple effects from there. Our assumptions are fairly simple. Net additions to household debt ranged between $800 billion to $1.2 trillion from 2002 to 2007. That number fell to $77 billion in Q2 and negative $117 billion in Q3. All data come from the Fed Z.1 Flow of Funds release. We merely assume that net consumer credit will go to zero, whereas it could go severely negative as defaults and debt repayment have already caused outstanding credit to fall. We further assume that household savings will rebound from approximately zero to halfway back to the historic 10% range. The cumulative impact would be to reduce personal consumption by $1.3-1.6 trillion or between 9% and 12% of GDP.

Granted not all of this will hit US production. Much of the damage will occur in the export economies as we stop buying from them. We have repeatedly argued as much. Outsourcing which destroyed jobs in the US and made the target nations prosperous is now going in reverse and this should provide a partial circuit-breaker to the US economy which MAY prevent a consumption-employment-income-consumption death spiral like the 1930s. On the other hand, business spending is also falling and that swing is far more difficult to estimate. For modeling purposes, the hit to US output from lower capital spending should be roughly equal in size to the reduced demand for imports so US GDP probably declines 9-12% - straddling the 10% line of the textbook definition of depression.

Unless people dig themselves even deeper into a debt hole, households will not take on further debt - either out of prudence or inability. It would have been extraordinarily difficult to stop this a year and virtually impossible now. Once the (misplaced) confidence evaporated, the conclusion became inevitable.


Globo Stop
I'd like to thank Karl Denninger of Ticker Forum for his inimitable description of the current crisis. The PG version of which runs:

We're screwed, but they're screwed worse.

We are indeed seeing just how bad the rest of the world has it right now. The NY Times did an excellent piece over the weekend that described the rapid decline of world trade. Here's the money quote:

Over all, the total reported exports from those 43 countries peaked in July, at $1.03 trillion. By November, the figure was down 26 percent, to $766 billion. Since the figures are seasonally adjusted, the monthly figures should be comparable.

This is not just a problem for Asia but a global one. German exports fell 21%. Over a quarter of all world trade went away in only FOUR MONTHS. I think this is a pretty good example of just how much credit distorted the US and world economy. At some point, credit goes from a useful organ to a cancer. We have often spoken of the Universal Debt bubble and the breathtaking size and scope of it. It was "fun" while it lasted but the bill for the UDB is about to come due. The check is on its way to the table and we're going to spend a lot of time arguing over who gets to pay for it. George Washington spoke of government but it applies to credit as well and the distinction between the government and the banks grows ever smaller:

... a troublesome servant and a fearful master. Never for a moment should it be left to irresponsible action.

Submerging Market Update

note: This post was begun some time ago and the date-time stamp reflects the initial draft. The bulk of the data has been added since then.


China: The Collapse Begins
Chinese exports are collapsing and industrial activity with it. Recent reports suggest that they are experiencing mass factory shutdowns with owners and manager absconding. According to the BBC, migrant workers from rural areas are returning to their homes in the countryside en masse. Those watching the media would think that an shocking collapse came out of nowhere in the last few weeks. Readers of Financial Jenga have known that this was not just possible but virtually inevitable for many months.

China could spend some of their dollars but they need to keep at least $1 trillion so the Yuan doesn't completely crash and burn. The interesting problem is the currency mismatch and "sterilization" issues. China's money supply growth is going to fall quickly as there will be fewer incoming dollars against which to issue new Yuan. Yes they will also be exporting fewer dollars to pay for raw materials but that doesn't matter to the unemployed citizens.

The mismatch issue is more critical. Everybody likes to talk about China's currency reserves. The problem is they've already been used up. Yes, they still have the dollars at the central bank but they've already issued Yuan against them as part of their "sterilization" operations. I.e. they cannot use the reserves to "stimulate" the domestic economy. They can SPEND them abroad, which will enable China to consume but will add production elsewhere, doing nothing for the production side of the Chinese economy. The mismatch problem is that they need more Yuan but what they have are Dollars. Much of the existing base of Yuan supply only exists because of the Dollar reserves. If they spend down the reserves, they either have to reduce their domestic money supply or simply print more money to make up the difference.

People like to point to China's dollar reserves but they've already had as much stimulative impact on China's economy as they ever will. Note that the Yuan is NOT a convertible currency. There is no large pool of Yuan outside of China that could be exchanged for dollars and spent in the domestic economy. Nor can they be lent out with the understanding that the loan be spent on Chinese goods (vendor financing). They have already done that indirectly by purchasing Treasury and Agency debt. Those looking for such an impact don't understand the structure of China's financial system.


Latin Cognates
Despite a vicious snapback, the trend is quite clearly down. Likely driven in part by the Fed's dollar swaps, these markets found support last week but it looks like a dead cat bounce. During that week a rally in their sovereign bonds of 200 basis points +/- 10 bp, left Mexico and Brazil debt trading 8.55% and 7.58% respectively. What this tell us is that the threat of immediate default has been averted by Fed imprudence but no one is willing to lend at anything less than a huge multiple of the 100 bp spreads we saw only a year and a half ago.

Latin economies are heavily dependent on natural resource extration. Thus they have had and continue to have a symbiotic relationship with the resource-eating black hole known as China. With consumption slowing worldwide and the initial feedback effects on the exporting countries, we are starting to see resource demand falling but the excess capacity created is collapsing commodity prices. The storm of demand destruction is roaring up the supply chain and spawning tornados that tear through individual sectors. The latest example comes from Brazil, where giant mining conglomerate Vale do Rio Doce is desperately cutting spending. The big news is the cancellation of 12 giant ore carriers - which would have been built in new Chinese shipyards. At the same time, they are cutting ore production as demand falls.

An intersting question is how much demand for their own ore Vale just destroyed by cancelling the ship order. This is a vicious circle as the feedback loop in the symbiotic relationship turns negative. Rising expectations and optimism feed off themselves - until they don't anymore. Then ugliness always ensues. In this case the fall will be long and ugly - like that of Icarus, who flew too close to the sun. We have dubbed it the Universal Debt bubble as virtually every country and every industry was caught up in it. Countries like Brazil and China were some of the biggest beneficiaries of the UDB, yet those who advocated the Decoupling Theory essentially argued that the biggest beneficiaries of a trend would be hurt little if at all when it ended. The silliness of THAT position is now manifest for all to see.

Containment Breach
We've heard many times how the crisis would be "contained" to a specific industry or geographic region. The authorities making these countless claims were either lying, incompetent or both. We see now that it is and was global and across the board - thus UDB is very accurate. While we expect exporters and raw materials producers to suffer worse than most, the damage goes on elsewhere. German factory orders fell 8%. US durable goods spending fell 14.1% in the 3Q GDP report. Japanese auto sales have hit levels not seen since the 1970s, while US sales are Back to the Future of the 1980s. This is global and ugly friends. Please protect yourselves.

Some Key Questions

The most important question facing us today, both in the US and around the world is just how much of our supposed wealth is real and how much was part of the illusion generated by bubble-mania and the UDB. Most of the actions of various governments and CBs seem aimed at preventing us from answering this question accurately. In The Limits of Optimism we outlined the various elements of the capital structure and it should be immediately apparent why the stock market is the chosen instrument for conjuring chimeras. By coercing a larger and larger percentage of accumulated capital into stocks, Wall Street ensured a large pool of buyers to continue pushing prices higher in complete defiance of fundamentals. By allowing so much of our wealth accumulation to be attached to something so insubstantial, we have collectively ensured the destruction of much of that wealth. Something that falls as soon as anyone wants to sell isn't much of an investment.

Now we see some of the real world impacts of aggressively tying ourselves to the stock market. Once again, the secondary feedback effects may be greater than the primary impact. According to the WSJ:

At the end of 2007, companies in the S&P 500 had a combined pension-plan surplus of about $60 billion, The market selloff in the nine months to late September turned that into a combined deficit of about $75 billion...

Of course that was before October even started and we all know that things didn't go so well during that month either. Double digit declines were the rule for the month - pretty much across the board. The pension obligation and attempt to meet it by speculating in the stock market are yet another example of companies tying their fortunes directly to stock market whims rather than fundamental performance. It worked well for a while - allowing them to report higher profits than justified by actual results as speculative profits allowed them to pay less into the pension funds than a sensible and stable plan would have required. The reverse is now occurring and it's going to be nasty. This is yet ANOTHER headwind for corporate profits as they are forced to pay cash in to make up for speculative losses.

The lesson that should be learned here is "don't gamble with retirement money" but I fear few will choose to learn it until all other avenues have been exhausted. People can usually be counted on to do the right thing after all else fails.


Confirmed Reservations
Occasionally, I will encounter a supercilious restaurant host who will haughtily ask if we have reservations. When the right mood strikes the answer will sometimes be "yes, but we're planning on eating here anyway." In much the same vein, our prior reservations about the export economies and China in particular have been confirmed with a vengeance recently. Reuters reports that China's PMI hit 44.6 in October - indicating clear and serious contraction in factory output. This now makes three of the last four months down. In addition, recent BBC reports suggest that half of the toy factories in China have shut down since the start of the year.

Keep in mind that we expect a crash and burn in China's economy even if exports stagnate, much less roll over. Government action can partially ameliorate this but only to a small extent. We laid out the full case four months ago in China Syndrome. All of the elements preliminary requirements have now been met for this scenario to play out. The US is desperately trying to prevent a meltdown across the submerging markets with swap lines to exchange valuable dollars for garbage currencies like the Mexican Peso and the Brazilian Real. The temporary availability of dollars in those imploding economies has relieved the pressure from capital flight for the moment and perhaps even caused a small short squeeze for those who were looking for reality to catch up to those nations' financial system. But the banking systems overseas cannot sustain their credit expansion in the face of falling external demand and especially the collapse of primary commodity prices on which their economies rely heavily.

UDB meltdown

We have often spoken of the UDB (Universal Debt Bubble) and how it had permeated nearly every asset class and geography. It's existence is the reason that we have often chided believers in economic "decoupling" as fantasists. We wrote about the structural weaknesses of the Asian economies in China Syndrome and Silent Scream. The trend has been quite clear lately as India teeters on the edge of recession and Japan's trade surplus collapses. Today we receive additional confirmation (as if any were needed).

The last bastion of the "decoupling" fantasy is China. Yes OPEC and Russia can remain strong as long as oil prices stay high but that scenario rests on the further assumption of nearly unlimited demand growth out of Asia (especially China). Chinese growth had continued to be high even as it trended down for 5 consecutive quarters. Now we see a report that the industrial sector is SHRINKING outright over there. Bloomberg reports that Chinese PMI fell to 48.4 in July (anything below 50 indicates contraction). Naturally, there will be apologists who will blame the entire decline on the Olympics and the shutdown of industry in the Beijing area. I present for their edification import orders:

The output index fell to 47.4 in July from 54.2 in June, while the index of new orders dropped to 46.2 from 52.6. The index of export orders declined to 46.7 from 50.2.

Clearly, there is no correlation between demand for exports and the Olympics. While that is likely and aggravating factor, it's a long way from the heart of the problem. Exports are the be-all and end-all for China's economy and they are going down in no uncertain terms. This should be no surprise as the end demand in their trade partners is clearly weakening. This is horrible news for China, as their entire economy is a pyramid leveraged to exports. What we wrote in China Syndrome less than a month ago has particular resonance given this report:

Essentially, everything will be fine as long as everyone there believes the economy will continue to expand at a breakneck pace and invests accordingly. This is virtually the definition of a pyramid scheme.
...

The most likely trigger for a fall in China's capex is weakening exports. They don't even have to stagnate to trigger real problems, much less fall. When the current investment pattern is predicated on rapid and continuous growth, material decline in the growth rate should be sufficient to kick off lower capital spending. An event the magnitude of 1980 would cause a direct hit of 12% of GDP in China in addition to any multiplier effects and that is hardly unthinkable. Keep in mind that exports themselves account for 33% of Chinese GDP so any outright decline there would be a real problem for them - likely triggering a minimum 20% fall of GDP. Frankly it will be difficult for them to avoid it given the economic and political climate in their trading partners.

China is simply following the same pattern that we have already seen in India. In China's case, the slowing of demand may have been masked by the massive construction projects and inventory building prior to the Olympics. In many ways, this event is similar to the Y2K phenomenon that marked the top of the tech bubble. It is a date-certain occurrence which inspired massive spending and investment as well as hoarding and stockpiling (for different reasons). That date also marks the absolute cutoff of all related investment and spending as well as a potential inventory draw down. In this instance, the cycle is exacerbated by the reduction or cessation of industrial activity in and around Beijing. So instead of a gradual reduction in industrial production growth like India, China looks to be set for a sudden end to growth.

We see problems globally, not just in the US and Asia. Deflating housing bubbles in Spain, the UK, Italy and Australia. Retail sales falling across the developed world, with their supplier nations beginning to follow suit. This is no ordinary credit crisis. It is the beginning of the end for the largest and most extensive credit bubble in all of human history - the Universal Debt Bubble. No nation, no asset class will escape the effect of the bubble bursting. Preserve your wealth, reduce risk and get ready to buy assets on the cheap on the other side of this mess.

China Syndrome

Today we turn our attention to China - certainly the most celebrated economy in the world today and possibly the most celebrated ever. Yet China's contemporary economy may be the most unbalanced in the history of the planet.


The Problem
Though it is hard to find reliable numbers, most sources agree that capital investment in China accounts for over 40% of GDP. Frankly, this is a terrifying and unprecedented number. For reference, Japan during their boom years was typically around 30% of GDP and never exceeded 35% for long. During the Roaring Twenties, fixed investment in the US economy averaged less than 20%. Looked at a bit differently, about 42% of China's economy is based on ------ the expansion of the economy. This creates tremendous momentum but also huge potential for disaster. Essentially, everything will be fine as long as everyone there believes the economy will continue to expand at a breakneck pace and invests accordingly. This is virtually the definition of a pyramid scheme. Does anybody see anything wrong with this picture? Does this perhaps sound familiar? It should since the psychology is the same as every bubble in history.

So what could go wrong and how would it likely play out? I'm going to use post-war US recessions since that is an example most readers can relate to and gauge the seriousness. In reality, the US economy is relatively stable and mature so I would expect volatility to be much higher in China, not to mention the bubble nature of current investment levels. During its post-war recessions, US capital spending declined between 10% and 30% - with the extreme value being achieved in the 1980-82 period. This is simply the impact of over-investment during the preceding boom and the sudden realization of that fact and the resulting over-capacity during the recession.

The most likely trigger for a fall in China's capex is weakening exports. They don't even have to stagnate to trigger real problems, much less fall. When the current investment pattern is predicated on rapid and continuous growth, material decline in the growth rate should be sufficient to kick off lower capital spending. An event the magnitude of 1980 would cause a direct hit of 12% of GDP in China in addition to any multiplier effects and that is hardly unthinkable. Keep in mind that exports themselves account for 33% of Chinese GDP so any outright decline there would be a real problem for them - likely triggering a minimum 20% fall of GDP. Frankly it will be difficult for them to avoid it given the economic and political climate in their trading partners.

This would be just the result of inflated current investment combined with a typical cyclical decline in demand overseas. We don't need a replay of the Great Depression for China's economy to suffer horribly. From 1929 to 1932, capital investment in the US economy fell by over 90%. Given the much higher weighting of such spending in China today, the result of such an event would be literally unthinkable.


Dichotomy
You might ask why China's currency is doing so well if their economy is so vulnerable? And that would be a fair question, though we would point out that the Shanghai exchange is down over 50% in less than a year, so some markets are reflecting probable severe damage to the economy. But the answer to the currency issue is the one that we often give - perception lags reality.

It's usually a pretty good bet that the locals will know their market better than those who are far away. This is just common sense. In China, only local buyers can participate on domestic stock exchanges and they have obviously gotten a lot more cautious since the Fall. However, the currency market is subject to outside forces despite the nation's currency controls. Essentially, the locals have started to sell China while the foreigners are still buying. We have long believed that there is a hot money problem in China since their currency reserves have been growing a lot faster than their trade surplus would suggest. In addition, the reported surplus itself looks pretty squirrelly.

The hot money problem has recently been recognized by the government and some of the financial press. Here's an example from the Financial Times:

Given that the inflows far outstrip trade and direct foreign investment, China appears to be receiving vast amounts of speculative "hot money".

The FT article goes on to cite an estimate of $150-$170 billion of hot money flowing into China in the first 5 months of 2008. This money is coming in despite the collapsing stock market and despite the fact that the Yuan is losing domestic purchasing power at a rapid pace - far faster than the currencies the money is coming out of certainly. This is the virtual definition of speculative money flow. The FT continues:

China has two big attractions for foreign investors - interest rates are higher than in the US and the currency is expected to appreciate.

Of course real interest rates in China are hugely negative - 400 basis points or more due to high and rising CPI. This is a far worse situation than in the US or Eurozone. And why is the currency expected to appreciate? Why because everyone THINKS so. Kind of reminds of the tongue-in-cheek description of a celebrity as "some who's famous for being well-known." What it boils down to is herd-animal behavior. The herd is going over there, they must know something. Let's follow them, the grass must be better over there. Mooooooo.

One final clip from the Financial Times:

But government officials also believe that illegal transfers are taking place - through foreign companies declaring that funds are for direct investment and then putting the money in the bank and exporters exaggerating the value of overseas revenues in order to bring in extra funds. (As an aside, economists point out that if fraudulent export receipts really are widely used to bring in hot money, China's politically troublesome trade surplus would actually be much lower than thought.)

Prior to 2005, China's trade surplus never exceeded $50 billion on an annual basis. It hit $100 billion that year and roughly $250 billion in 2007. The dollar peg was dropped in mid-2005 and the surplus began to grow explosively at the same time, soaring through the period of the stock bubble. The monthly surplus peaked in October 2007, the same month as the stock markets did worldwide - including China's. Since the suspected route of the hot money is fraudulent trade or investment deals, we cannot know with certainty but the timing of the flows is highly suspicious.


Suspicions
Here at Financial Jenga, we are automatically suspicious of consensus, orthodoxy or any widely-held belief unless there is strong evidence to support it. The meme of unstoppable growth in China does not meet that test. While that country has many strengths, they appear to already be discounted and then some. The massive imbalances create vulnerabilities and the economy appears to be just as much a bubble as anything in the West - perhaps more so. In this case, the bubble is in factory investment, not housing but tremendous over-supply is already present, with more being created. The Wall Street Journal recently published a front-page article about factories closing down as overseas demand falls and China's manufacturers become uncompetitive due to rising costs. We've already discussed the implications of that scenario. We have long believed that China today is very comparable to Japan 20 years ago and we see nothing to make us change that hypothesis.

Silent Scream

(editor's note - This blog entry was completed and posted on July 4. The entry date is showing as July 1, as the software uses the date on which the first draft was saved.)


Marc Faber was on Bloomberg TV today and he mentioned that the higher reported consumer inflation rates in Asia were a function of lower per capita GDP and a higher proportion of income spent on food and fuel - which are nearly the only prices that are rising aggressively. Common sense right? But of course that really made me start thinking - always a dangerous prospect.


Asia, Inc.

So Asia's consumer "basket" looks a lot different than that of the average American or Western European. But there are other differences as well. Many Asian nations are resource-poor, major importers of either food, raw materials or both and they depend upon exports of manufactured goods to pay for those imports. Now, let's look at the situation from a slightly different perspective. The industrial sectors of Asian economies look much like any diversified manufacturing enterprise.

Similar to our notional enterprise, these nations' factory sectors buy raw materials and energy. They employ people, paying wages in the process and sell a finished product to a customer. Substitute "import" for buy and "export" for sell and it's actually a pretty good analogy. A few differences, instead of profits, these entities collectively produce a surplus for the nation and they are also responsible for feeding and housing their workforce like an old-fashioned company town to the extent that the workforce doesn't grow its own food.So how do current conditions affect our metaphorical manufacturer? Inputs costs are rising fairly fast overall, with oil being a spectacular example though most increases are far more sedate and a fair number of industrial inputs are falling in price. Just as important, labor costs are rising. This is an obvious corollary to rising living standards and wage costs have been rising by double digits across much of Asia for years. At the same time, demand for many of their products has been weakening as their key markets (US, Europe, Japan) drop into a coordinated recession. So raising prices significantly isn't a solution as they would quickly suffer loss of market share. These factory economies are backed into a corner as surely as domestic manufacturers, with rising costs and falling demand. The Asian suppliers have the additional burden of rising labors costs on top of that. They can choose either lower revenues, lower profit margins (surplus) or some of both.

Now let's look at factors that introduce some added complexity to the model. Instead of cutting wages, nations also have the option to devalue their currency. This effectively reduces labor costs though not other inputs if they are imported. Lower "profits" can take the form of actual margin compression at the individual companies or smaller surpluses in the trade account. The factory sectors of Asia have an additional burden of the industrial surplus having to subsidize food imports - which of course are rising in price fairly quickly also.

What we see then are economies that likely will have to accept either smaller surpluses, lower corporate profits, lower wages, weaker currencies or some combination of the above.


Theory meets fact
Normally, high inflation rates tend to be associated with weakness against other currencies. Rapid declines in domestic purchasing power usually are accompanied by lower international purchasing power - again common sense. This is doubly true if the high-inflation economy does not raise interest rates to restrain demand. CPI equivalents have been high and rising across Asia for some time now, yet the currencies - like most others have been gaining vs. the dollar. To make matters worse, real interest rates in those countries are negative as well and have been for some time. Consumer prices are going up faster in most Asian economies than even the worst-case numbers here in the US - for instance John Williams at Shadow Government Statistics.

It has been odd to see such currencies rising against the dollar but there are several factors that have contributed. First was the differential in growth rates. Second was the perception of deep trouble in the US financial system combined with the impression of unstoppable rise for Asia. Third was the systemic imbalance of trade. Well, now we see that the extenuating factors are all at least beginning to falter. Growth rates are falling across Asia and we believe this is only the beginning of a very deep retrenchment there. The perception has shifted and the false impression that Asia would be immune to the problems of the US has been broken. The terms of trade are also starting to shift as fewer goods are sold to the US and other export markets. US trade deficit remains relatively flat with less of a gap with Asia being offset by higher oil prices.

In light of these factors, we are seeing high CPI and deeply negative real interest rates catching up with many Asian nations. Significant, and in some cases quite large currency reversals have taken place. One of the worst is India, where double-digit CPI, twin structural deficits and a severe slowdown are the story. With CPI pushing 12% and policy rates between 6.0% and 8.5% it's no wonder the Rupee recently reversed - down over 10% vs the dollar this year. Similar situations are brewing in Korea, the Philippines, Thailand, Malaysia and China, not to mention Vietnam. With the exception of still-hyped China, these currencies have lost 5-14% against the dollar from their recent highs. It's taken a while but normal economic relationships seem to be asserting themselves.

As we mentioned above, these economies are in the midst of a squeeze that will push down revenues and profits as well as the currency. Despite significant drops in many regional exchanges, fundamental deterioration can drive this process much further. The potential for a currency kicker on the downside simply makes these markets even more attractive as shorts. Loss of confidence could inspire capital flight, which would devastate both the local stock markets and the currencies. Again, with the exception of China, these nations probably won't have to worry about their currencies being too strong for much longer.

The stock markets and currencies of Asia's industrializing nations are screaming but few people seem to be listening. They were key beneficiaries of the UDB and it's demise will hurt them in direct as well as indirect ways. But that is a subject for another post.


Tea Leaves
So, why does the dollar index still look so weak? The index really isn't a good indicator of the strength of the dollar against the world since it is a trade-weighted index. Note that the Euro accounts for 57.6% of the weight, with both the Pound and the Yen also in double digits. The policies of the Fed have done nothing to help the dollar but at this point, the weakness is just as much a tribute to the ambitions of the EU and Germany's near-pathological fear of inflation as they are the result of incompetence at the Fed (though there is plenty of that). I have almost nothing good to say about the Federal Reserve but they only deserve half of the credit for the decline of the dollar index.