from http://www.prudentbear.com/internationalperspective.asp
"Catastrophist" warning: "the final shock to an already sick system" is interpreted to "merely" mean the end of USD hegemony, not the "end of the capitalist system". ----------------------------- International Perspective, by Marshall Auerback
John Snow Lights the Fuse September 30, 2003
“Be careful what you wish for” is an aphorism on which US Treasury Secretary John Snow might care to reflect in light of the foreign exchange market’s latest trashing of the dollar. Consider last weekend’s G7 communiqué from Dubai: "We reaffirm that exchange rates should reflect economic fundamentals. We continue to monitor exchange markets closely and cooperate as appropriate. In this context, we emphasize that more flexibility in exchange rates is desirable for major countries or economic areas to promote smooth and widespread adjustments in the international financial system, based on market mechanisms."
The statement may well help to placate US domestic manufacturers (what’s left of them), who have been complaining loudly about competition from China, but such rhetoric from the G7 does not come without a cost.
Despite subsequent British denials that the statement reflected a change in policy, the G7 ministers have with this language attacked not only the Chinese currency peg but also the Japanese strategy of flooding the market with yen to forestall its appreciation. That policy has been critical to jacking up the Nikkei and generating a more accommodative global set of financial conditions because Bank of Japan Governor Fukui, in marked contrast to his predecessor, has left such sales of the yen unsterilised.
That is, until just a week ago, when the Yen cracked the important 115 to the dollar barrier, a sign, posits PIMCO’s CIO, Bill Gross, that the Asian appetite for dollars and U.S. Treasuries might be sated, and that the long enamored and widely held “Yen carry trade” might be on its last legs.
If true, it means a very important source of financing for the US external imbalances may be drying up, which is something the US can ill afford at this juncture. In the words of Paul Donovan, an international economist at UBS, “The precarious funding situation means the US administration needs to be delicate with any rhetoric on the currency or it risks accelerating what should ideally be a gradual fall in the dollar. If Asian support for the dollar or the Treasury market is no longer forthcoming, they would have a serious economic problem.” A serious economic problem which would have ramifications in Asia as well, notably Japan and China.
Japan entered a period of strong growth in 1996 after large fiscal stimulus, only to choke off recovery with tax increases. An ill-timed rate increase by the Bank of Japan ended a 1999 recovery. Now, Japan’s prospects for a sustained recovery still depend on two factors: continued strength of external demand growth led by China and Asia and by the United States in the industrial world outside Asia, and continued efforts by the Bank of Japan to move from just containing Japan’s deflation to eradicating it so that domestic demand can grow steadily.
Since April, when its new governor, Toshihiko Fukui, took charge, the Bank of Japan has increased the liquidity it supplies to the Japanese economy. As money flows into Japan intensified, especially during the second quarter of 2003, the Bank of Japan increased its purchases of dollars in order to prevent the yen from appreciating. During the period from January through July 2003, Japanese dollar buying totaled about $75 billion--a record level, according to A.E.I. economist, John Makin. The previous highest intervention level was $65 billion during all of 1999.
Until the G7 meeting in Dubai, the increased foreign exchange intervention by the Bank of Japan was left largely unsterilized. That is, when the Bank of Japan is purchasing dollars in the foreign exchange market, the yen proceeds of those dollar sales by Japan’s private sector were being left in the system with the result that the monetary base expanded more rapidly. This unsterilized intervention by the Bank of Japan can probably be credited with slowing Japan’s deflation rate during the second quarter. However, if the recent strengthening of the yen represents yet another about-face in Japan’s hitherto accommodative monetary posture, then this has ominous implications for global growth.
The BOJ’s policy about-face comes amidst signs of a renewed economic weakness in Japan. The tertiary index, which primarily represents activity in domestic sectors, collapsed in July and there has been little sign of a rebound in August. In addition, the all-industry index fell 1.4 per cent in July versus expectations of a drop of 0.4 per cent. Until recently, Japan’s export sector has been the one beacon of conspicuous economic strength and that is now placed under threat as a consequence of the yen’s sudden appreciation of the dollar.
The resultant sell-off in the global equity markets, therefore, should be telling the ministers that they lit the fuse on a very big powder keg last weekend. Assuming the Chinese continue to resist revaluation or flotation, and the Japanese authorities are blocked from stopping appreciation of the yen, then this may well lead to a combined Japanese recovery fizzle and possibly an uncontrollable financial bubble in China.
This ill-conceived strategy of the US Treasury Secretary therefore works at direct cross-purposes with the nascent Japanese reinflation effort, which is merely one element of its foolishness. Signaling problems ahead, the Nikkei has already plunged some 7% from its recent highs even though a continuation of the Japanese asset inflation (as manifested by a rising stock market) is probably the linchpin of a sustained global economic acceleration (or, at the very least, a potential growth offset to the US or China). If this rally is aborted, then the capital flows will shift elsewhere and it's a good bet a lot of it will shift into China, as the goods-producing sector becomes hypercompetitive with the G7 and speculation on an eventual revaluation versus the dollar will intensify.
As for unintended consequences, the Chinese authorities may respond eventually with even tighter credit policies than those already introduced to slow down its real estate market and capital expenditure excesses, to minimize the risk of extreme debt growth and bubble-style overinvestment. If the Chinese continue on their current course of action, then there will be a risk of at least a short-term downdraft in growth in East Asia, even as Japan and Europe will be struggling to a greater degree. Were a financial accident in the US to arrive at the same moment -- always a possibility -- then one could easily envisage a synchronized global growth stall. This is not what the doctor ordered in a world characterized by overcapacity and virtually no pricing leverage.
China has been extending credit to the US so that it could keep expanding its capital expenditure to overproduce goods that the world doesn't need (as well as providing jobs for its dispossessed migrant workers coming into the cities). And Japan's massive intervention against the yen was creating the stimulus required to start the process of positive recursive growth dynamics in that country. Now this entire process, as inherently unstable as it was, is in danger of being reversed. The US is already tapped out and the latest downdraft in the dollar and the markets might prove to be the final shock to an already sick system.
It is worthwhile noting that this latest shock to the global economic system comes amidst persistent weakness in US employment statistics. Initial claims are still averaging above 400,000 per week, (though the latest weekly figure was probably pushed down because of hurricane Isabel). Now help-wanted advertising has slipped again, and is just bumping along at a level more than 50% below the peak of the past few years. In this context, a steep stock-market drop could trigger an abrupt pullback in consumption outlay growth.
Essentially, the Bush team is trying to grab growth away from Asia for their re-election drive, as apparently they do not trust that the domestic economic acceleration so clearly underway will hold up through next summer. They may succeed in bullying the Japanese into playing this game, but, as the recent global stock market setbacks indicate, at great risk of economic and financial dislocations that could send a tsunami or two back toward American shores.
In spite of the sharp recent fall of the greenback, the US Treasury Secretary almost incomprehensibly suggested that the recent G7 communiqué does not represent a change in the US "strong dollar policy." This bizarre affirmation came in spite of the fact that Mr. Snow has spent the past month running around the globe, lecturing the Chinese on the need to revalue their currency up, whilst concomitantly pressing the Japanese to desist in their policy of selling yen. Meanwhile, as might have been expected the Chinese are officially lashing out against critics of their currency policy, and warning others not to pursue protectionist measures. And foreign creditors finally seem to be taking note, in effect creating the conditions for a huge credit dislocation by selling dollars, which may ultimately have the cost of driving up long term rates (as a risk offset to a decline in the value of their dollar holdings were the greenback’s gradual fall to turn into a rout).
This has been an extremely clumsy maladroit approach on the part of the US economic team. It echoes the period preceding the 1987 crash, during which then Treasury Secretary James Baker in effected repudiated the Louvre Accord and renewed a policy of dollar devaluation as a consequence of his repeated frustration with Germany’s reluctance to embrace a more growth-centric model to alleviate growing American external imbalances. Against this backdrop of deteriorating global economic coordination, investors initially ignored the omens: stocks became more overvalued than at any time since 1929. Economic growth slowed in 1986 but picked up in 1987 and, like today, investors were becoming enamored with the notion of a global economic recovery. When that economic improvement came, the bond market crashed. The U.S. had a declining dollar and a persistently wide current account deficit, which contributed to the bond market crash and, later, the stock market crash.
Almost all of the conditions of 1987 now exist. However, in 1987 the Fed raised short-term rates, which it definitely will not do now (as Fed Governor Bernanke repeatedly reassures us). In 1987, the stock market initially ignored the crash of the bond market and kept on rallying. In retrospect, it is now understood that portfolio insurance contributed to this levitation in the U.S. stock market. In so doing it created systemic risk. When the stock market trend turned negative, portfolio insurance turned a market decline into a crash. Perhaps this role today will be played by new forms of portfolio insurance, such as capital protected portfolio insurance (CPPI), a new product which has been growing rapidly.
It remains far from clear whether China or Japan will change their approaches. Chinese officials have said they will not change their currency policy anytime soon, and Japanese officials have already warned that the markets "overreacted" when they drove the value of the yen on Monday to its highest level in three years.
But, like 1987, the damage may already be done. The technical pattern for the US stock market is extremely bearish. Most extraordinary has been the explosive growth in NASDAQ margin debt to a new all-time high of $25.9bn by the end of July (growing $7bn in a mere 3 months from May alone). This shocking rise in margin debt comes in spite of the fact that the underlying market cap or collateral has recovered but a fraction of its 2000 to 2002 decline. The buildup in margin debt has taken a mere 6 months and is likely to show an even further increase when the August figures are released. By contrast, it took almost 3 years for NASDAQ margin debt to grow from a $5bn to $21.9bn at the peak of the market in 2000.
From a valuation perspective, if one uses trailing reported earnings, the U.S. market’s P/E ratio is higher than it has ever been except for the period of the recent Bubble and the stock market peak in 1987. If one uses national accounts estimates of corporate profits, the U.S. market’s P/E ratio is much higher than it was in 1987. The ratio of the U.S. stock market capitalization to GDP tells the same story.
As regards relative global valuation, the U.S. is the outlier among global stock markets. Its cash dividend yield is less than half its historic average. The cash dividend yields in Europe are much closer to the U.S. historic average. Japan has a lower cash dividend yield, but it has a huge corporate financial surplus.
Often after a bubble bursts, there is a rally which is its echo. This is what we might have been experiencing over the past several months. When echoes of prior bubbles burst, they often burst violently. During bubbles investors truly believe. During the echoes of bubbles, they no longer really believe. They know their risks. Therefore, they are weak hands and they are hair trigger. It is often one event which creates the cascading effect of rapid panicked selling. John Snow’s ill-conceived berating of China and Japan, foolishly reflected now (apparently) as official G7 policy, may have lit the final fuse. The after effects which we have long feared may finally be upon us.
-- /**********************************************************************/ Brad Mayer