Try and imagine you live in a country where you can borrow at 6-7% per annum for a return of about 15% – obviously not guaranteed but pretty good odds. Would you do it? Of course you would. Now, imagine that country is China. Hold your horses, you may argue. The cost of borrowing is higher than 6-7% in China. More like 10-12% for the average entrepreneur. Well, don’t bet on it. As the world increasingly becomes one big open market place, and the Chinese authorities stubbornly maintain their view that the best recipe for China is a Yuan which closely follows the US dollar – albeit with a couple of percentage points of annual revaluation thrown in for good measure – borrowing in US dollars to invest in China carries little or no perceived currency risk.
The dollar peg: what are the implications for emerging markets?
In a recent article in the FT fm2, some interesting observations were made in terms of the implications of large emerging economies such as China deciding to shadow the US dollar. In fact, the dynamics are not terribly different from those of the EU, where several countries have enjoyed an unprecedented boom in recent years as a result of the “one size fits all” monetary policy forced upon us after the introduction of the euro.
Had countries such as Denmark, Ireland and Spain been able to determine their own independent monetary policy, interest rates would most likely be higher in those countries today. However, these countries, and more, have benefited from the fact that ECB’s policy has largely been dictated by the sicklings of Europe, i.e. Germany, France and Italy.
When credit is cheap relative to expected returns, it encourages increased borrowing. It is as simple as that. There are obviously other measures available, should your government be keen to slow down the economy, but with monetary policy outsourced to the eggheads in Frankfurt, membership of the euro club has effectively stripped its members of the most effective tool available.
Now, let’s go back to the Chinese example. Access to cheap capital has a number of implications – positive as well as negative. One of the most obvious ones is asset inflation, in recent years manifesting itself through higher property prices and buoyant equity markets all over the world. It should also be noted that China is not the only country linking its currency to the US dollar, although some tie ups are more formally established than others. The currency peg approach has been fashionable in Asia for years and is now spreading to other parts of the world.
The dollar peg: effect on current account deficits
This also helps to explain why so few emerging economies are running current account deficits –contrary to economic theory which suggests otherwise. Normally, when a country runs a large surplus, currency appreciation will, over time, reduce the level of competitiveness and thereby reduce the surplus. However, when the currency is artificially held down, as is the case with China and certain other countries, no such mechanism is in place to address the imbalance. Another, and potentially positive, side effect from the Dollar Club phenomenon is the effect an American slowdown may have on the other members of the club. It is an almost universally accepted view today that a meaningful US slowdown will have negative implications for growth in other parts of the world, as many emerging economies are export driven.
However, this argument fails to address the rebalance of economic growth which may happen as a result of lower US dollar borrowing costs. Let’s assume for a second that the US economy were to go into recession at some point in 2007 (for the record, we do not expect this to happen). The Fed would almost certainly lower the Fed funds rate in order to stimulate domestic demand. Meanwhile, as a result of even cheaper credit amongst the other Dollar Club members, growth in these countries could in fact accelerate. So far so good.
Why currencies should be allowed to float freely
More worryingly, the long term implications for inflation are not encouraging. Eventually, excessive levels of liquidity will not only feed into asset inflation but will also put upward pressure on consumer price inflation. How long it will take before this problem becomes apparent is difficult to say. What we can say, though, is that when the problem is there for everyone to see, it will be a difficult one to handle for the local monetary authorities, as they will find that they have lost the ability to effectively control monetary policy, just as it has been the case in Europe.
How markets will react to that situation is anyone’s guess. One thing is sure, though. The only lasting solution is to allow all currencies to float freely. Only then will the imbalances we are currently experiencing be addressed once and forever. However, as long as the Chinese (and others) show a complete disrespect for fair play, the chances of that happening are probably quite remote.
By Niels C. Jensen, chief executive partner at Absolute Return Partners LLP. To contact Niels, email: njensen@arpllp.com