Monday, November 15, 2010

Beware the chastened superpower (updated)

With the amazing shrinking fig leaf of the G20 leaving us all exposed to the great powers worst, there's some overdue angst in the media and officialdom about where the dollar is headed. From David Uren at The Australian:
With Australia standing out as almost the only open capital importing country with strong economic fundamentals, it should be expected that the Australian dollar will face more upward pressure.

The Reserve Bank has acknowledged this risk for the first time. Its latest economic review argues that the rise in the Australian dollar to parity was justified by both the strength of our export prices and the difference between Australian interest rates and those of the advanced countries. However, it says further appreciation may pose a danger.

"If developments in global financial markets resulted in a significant further appreciation that was unrelated to these factors, it would likely result in both growth and inflation being lower than in the central forecast."

Needless to say, this is behind the times. Manufacturing has been in recession for two quarters, education on a swan dive for a year, tourism in the dunny for longer still. The damage is already being done at current currency levels. As this blogger has argued before, you can conclude parity is justified if you have ongoing faith in global markets but why on earth would you?

But this line of reasoning is behind the times anyway. QEII is history, as is the world's reaction to it. It's what comes next that terrifies this blogger: the trade war.

The global press is full of stories about how the US has been whipped at the G20, Obama humiliated and attempts to address global imbalances shunted away.

Well, perhaps this blogger is wrong, but there's nothing more worrying than a humiliated Super Power. Having failed so miserably at the multilateral approach to solving it's deficit woes, a chastened Obama is surely going to head home to cook up some very nasty unilateral measures.

And these will have nothing to do with currencies. Expect tariffs.

Yes, that's where we are now, not at the point of some victory for China, but at the point of failure for the United States, who clearly understands that it needs to re-industrialise if it is to find some new source of demand to reemploy its desolate millions.

No prizes for guessing where US will aim up.

And that's where we come to another RBA report released Friday that makes positively terrifying reading. The Sources of Chinese Demand for Resource Commodities asks
"...Is China's demand for resources driven predominantly by domestic factors or by global demand for its exports? The answer to this question is important for many resource-exporting countries, such as Australia, Brazil, Canada and India. This paper provides evidence that China's (mainly manufacturing) exports have been a significant driver of its demand for resource commodities over recent decades. First, it employs input-output tables to demonstrate that, historically, manufacturing has been at least as important as construction as a driver of China's demand for resource-intensive metal products. Second, it shows that global trade in non-oil resource commodities can be described by the gravity model of trade. Using this model it is found that, controlling for domestic expenditure (including investment), exports are a sizeable and significant determinant of a country's resource imports, and that this has been true for China as well as for other countries.

The report also makes clear that construction is another huge part of Chinese resources demand. And as reader The Lorax points out this morning, 2009's huge surge in commodity demand accompanied a global manufacturing recession.

However, there are a couple of other factors to consider there. First, the burst was based upon temporary stimulus. Second, the surge was a part of the Chinese commodity inventory restocking cycle which was particularly potent in iron ore and coal following the running down on inventories associated with the huge pricing stoushes in 2008. Other base metal followed later as manufacturing recovered.

Of course, in the event that Chinese manufacturing is under attack from US tariffs, the same stimulus is likely, as has been argued by Michael Pettis consistently. But such an event is surely a blowoff not a sustainable growth policy.

Even in such a scenario, this blogger finds it hard to see the dollar going higher. If China is stimulating under pressure from a trade war, the risk trade is surely going to be under pressure as global market confidence takes a serious blow. The risk in the next post-GFC breakdown phase may not be a higher dollar but falling commodity prices.

This blogger isn't arguing that this will happen overnight, but with current geo-economic settings, it will happen.

Rob Burgess at BS is onto the same topic today and spins it a little differently in framing the RBA commodities research within an AWSJ op-ed written by Wayne Swan:
"…we need a new framework for cooperation to allow exchange rates to reflect economic fundamentals and support needed structural reforms. Currency issues were once left to the United States, Europe and Japan, but that will no longer work in the new world economy … the emerging economies need to allow their exchange rates to reflect the substantial growth they have achieved in their economies over the last decade and to respond more flexibly to underlying market forces."

Burgess then wonders what redress of the imbalances via currencies would do to "... the China-led minerals boom that has saved Australia's hide since the GFC" and uses the RBA commodity research to conclude:
While rattling the sabre with Uncle Sam on the world stage might make Swan feel pretty tall, there's a risk that a rising yuan could damage our biggest money spinners – coal and iron ore exports – impacting on GDP growth, employment and, of course, the boon in revenue the Gillard government expects from the mineral resources rent tax (MRRT).

There's some good research in this piece and its good to see other commentary is sharp enough to tackle the real risks. This column differs only in that when it looks out a little further, it sees the continued imbalances leading inevitably to trade war. Therefore it concludes Swan is doing the right thing in pressuring China to revalue - a less damaging outcome.


The Lorax said...

Macro Man's classic series of charts from June 2009 are worth revisiting in this context.

The "uptick" in Chinese resource imports at this time does not seem to correlate with an uptick in manufacturing exports. Just sayin'

The Lorax said...

How the world views Australia: Mighty Aussie Lets Stevens Stem Prices, Avoid Currency Controls

At a time when nations from Japan to Brazil are struggling to keep currency gains from damaging their economies, Reserve Bank of Australia Governor Glenn Stevens is welcoming a stronger exchange rate.

Glenn welcomes the Dutch Disease.