Friday, October 8, 2010

Unpleasant scenarios

The blowoff in gold and oil must mean that we are rapidly approaching the zenith of this charming QE2 rally, which has morphed swiftly into outright currency war. Helicopter Ben is now completely boxed in by the stock market which has rightly interpreted his Jackson Hole pledge to print money "if" needed as a rock solid moral hazard upon which to go crazy. As one comment said on zerohedge this morning, this is now the biggest "sell the news event in history" and whatever Bernanke delivers, it won't be enough to satisfy the lunacy that has taken hold of markets.

Nonetheless, the underlying dynamics of this rally are the ones we are going to have to live with for the foreseeable future. And in that context, this blog is going to run through some scenarios for Australia as the currency war gathers pace.

The outstanding question is, of course, the imbalance between China and the US. So, what happens if China buckles and revalues the yuan 20% over two years in some informal Plaza Accord?

Micheal Pettis described the consequences clearly:
Most probably Beijing will do the same thing Tokyo did after the Plaza Accords and Beijing did after the renminbi began appreciating in 2005. It will lower real interest rates and force credit expansion.

This of course will have the effect of unwinding the impact of the renminbi appreciation. As some Chinese manufacturers (in the tradable goods sector) lose competitiveness because of the rising renminbi, others (in the capital intensive sector) will regain it because of even lower financing costs. Jobs lost in one sector will be balanced with jobs gained in the other.

But there will be a hidden cost to this strategy – perhaps a huge one. The revaluing renminbi will shift income from exporters to households, as it should, but cheaper financing costs will shift income from households (who provide most of the country’s net savings) to the large companies that have access to bank credit. So China won’t really rebalance, because this requires a real and permanent increase in the household share of GDP. Instead what will happen is that it will reduce Chinese overdependence on exports and increase China’s even greater overdependence on investment.

This will not benefit China. It will fuel even more real estate, manufacturing and infrastructure overcapacity without having rebalanced consumption. Expect, for example, even more ships, steel, and chemicals in a world that really does not want any more.

In this scenario Australia becomes Ken Courtis' light bulb plugged into the Chinese nuclear reactor. Chinese fixed investment and use of steel surges as the real estate bubble enters a blowoff phase.

As the $US falls, global equity markets at last have a seemingly sustainable narrative for US economic growth around export demand and the Dow powers ahead.

Commodities enter a combined demand and monetary boom that makes 2008 look like a dress rehearsal.

This may run for a couple of years and will look like an Australian Golden Age. But it ends in disaster as bad loans hobble Chinese banks when its bubble bursts and growth there slows permanently as it must grow through a balance-sheet recession. Even as tremendous new supply in commodities hits global markets.

If China goes this way, you might want to play the rise but you do not want to be caught at the end of it. This is the Goldman scenario on steroids and equals an Australian depression.

The second scenario is one in which China revalues the yuan at a sustainable pace, somewhere between five and 10 years. This becomes a story associated with the "Lewis Turning Point". As Alan Kohler put it some months ago:
It’s called the “Lewis turning point”, named after Jamaican-American economist Arthur Lewis, who was writing about Jamaica in the 1950s. Lewis describes what happens when a developing economy shifts from labour surplus to labour shortage, and wages start rising rapidly, especially for unskilled workers.

Ross Garnaut has argued that this point is upon China and if approached sensibly will result in decreases in the Chinese surplus:
As China enters deeply into the turning period...there will be large and continuing increases in real wages and in the wage share of income. The powerful tendency since the 1980s towards increased inequality in income distribution is likely to be reversed. The rise in the wage share of income is likely to be reflected in an increase in the consumption share of expenditure. There will be a reduction in the national savings rate.

It is possible that the investment rate will in fact rise. Whether or not this is the case, it is likely that China’s savings rate will fall more than its investment rate. This will reduce the external surplus in trade and current payments. It will therefore ease current international pressures over payments imbalances and exchange rates. It would be wise for China to ensure that total domestic demand expands enough to ensure that this is the case.

He goes on to argue also that "Rising real wages and the pressure of strong increases in demand for non-traded goods and services will be inflationary unless accompanied by a combination of firm monetary policy and an appreciating renminbi."

This blogger has seen Professor Garnaut argue at other events that this is the only scenario in which Chinese authorities will allow yuan appreciation.

This the most benign outcome for Australia in that we have only to deal with the slow decline of commodity prices as supply increases but remain supported by a weak $US. As well as the fallout from a high currency. Still not pretty but at least we have time to adjust through efforts to boost productivity.

But is Garnaut right that the Chinese can keep flipping the bird at the US and, increasingly, the EU? Not according to Robert Reich today:
Smoot-Hawley here we come.

Willis Hawley and Reed Smoot, you may recall, sponsored the Tariff Act of 1930 that raised tariffs to record levels on more than 20,000 imported goods. The duo said this would protect American jobs and revive the economy. It did the reverse, plunging the nation into an even deeper depression. Other nations retaliated. Global trade plummeted. Americans got poorer, as did millions of others around the world.

Why do I think we’re on the way back to Smoot-Hawley? Because with Republicans and blue-dog deficit hawks gaining ground after November 2, the chance of boosting the economy with an “infrastructure bank,” another big spending package, or even a big round of middle-class tax cuts is roughly nil. This means a lousy economy — possibly for years.

And that leaves trade as a sitting duck.

It is hard to fathom the fallout for Australia in the event of a China/US trade war. It is possible it could serve to bring the parties together in a G2 before too much damage was done. Even so in that event, if it results in driving China to the first scenario outlined in this post, Australia is still at medium term risk.

But wars of all sorts are much easier to start than finish. It's fair to say that the historical narratives surrounding 'trade wars' would weigh heavily on global markets and recovery. Volatility would reign as market and economic prospects waxed and waned with the cuts and thrusts of realpolitik.

Scolding air would also shoot up from the strategic chasm that Australia blithely straddles. Would the US pressure allies to join in tariffs against China?

One thing is certain. We need a G2, not a G20, where Kevin Rudd is nothing more than a fig leaf for diverging national interests.


The Lorax said...

Great post.

I think everyone agrees that the only way the world can rebalance sustainably is if China increases domestic consumption significantly, but that is a multi-decade process.

You're tight with the Garnauts. What's John's view on whether China can start growing consumption faster than investment or exports?

P.S. carbonsink and The Lorax are the same person. I just forget who am sometimes.
P.P.S. This blog deserves more readers!

Bear Feller said...

I agree. This is the best post yet. We're in for some fun.

Anonymous said...

Excellent Post David. Andie Xie has put forward the Japan post Plaza agreement as a scenario also, but not as it pertains to Australia.
I simply cant beleive that the authorities here are not talking about what would happen to us when we have a serious decline in the terms of trade. Well done for making the case.

P.S I am forwarding this site to eveyrone I know more readers are on the way.