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American and Chinese style benign neglect…

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smart_1Nov. 13, 2009 - Erwan Mahe - One of the characteristics of deflationary spirals, when they come at the end of “unbalanced” economic growth cycles (unbalanced in terms of trade and payment balances), resides in the fact that natural devaluations are the only way for the hardest hit nations to dig themselves out of the hole.

The increased competitiveness of a nation’s currency resulting from such measures initially enables it to reboot its exports to the extent that it has competitive goods to sell, which explains the worries about the UK, which has often been caricaturised as more of a service centre (financial) than an industrial nation. But this currency depreciation also helps the country fight off potential deflation tendencies. It is from this perspective that Switzerland decided to sell down its national currency by now defending an exchange rate of CHF1.50 for 1 euro.

In the field of monetary arms, the Americans are clearly the all-time world champions, but that’s hardly news, as illustrated by a quick summary of the abandonment of the dollar’s convertibility in 1971.

The world had begun to accumulate dollar reserves as the US current account balance continuously worsened in the wake of the recession of 1958 and, later, with the explosion of government spending relating to the Vietnam War (Iraq-Afghanistan?). As such, its trading partners had become increasingly worried about what French officials described at the time as America’s “exorbitant privilege”. These worries sparked US Treasury Secretary John Connolly’s response in a speech before European bankers in 1973: “The dollar is our currency, but it’s your problem.”

It is interesting to note that the monetary shake-up had been anticipated much earlier, like when General De Gaulle criticised the Americans to indebting themselves free-of-charge, concluding that there existed no other real worldwide standard other than …gold.

He had instructed the Bank of France as early as 1958 to convert a maximum amount of its dollar reserves into gold, going so far as to send a French Navy ship in 1965 across the Atlantic to pick up a $150m gold shipment. This policy contradicted that of the Germans who promised the Americans that that would not convert their dollars into gold.

Here is video tape of his press conference: De Gaulle changes dollars for gold.

This is the sort of movement which explains the new rush for gold.

This movement is not due (as some simplistic explanations would have us believe) to demand by investors to protect themselves against inflationary risks (and some even say deflation!), but because they are convinced that the American consumer will never be able to change his free-spending ways and because the US current accounts unbalances will not be corrected, leading automatically to the dollar’s continuation depreciation.

I have displayed, below, a graph of the Dollar and the Sterling Index say you can see for yourself the response of US and British authorities to the crisis.Dollar and Sterling Indices since 2002

The Americans continue to use the same old methods with the British close behind ……


Just consider the following comments, which indicate that the depreciation of the dollar like the pound sterling is indeed purposeful, despite the ritual issuance by US officials of the mantra, “A strong dollar in the interest of the US”, which, despite everything, seems to satisfy Mr Trichet…Let’s start out with BoE chief King’s comments in his November “Inflation Report”:


The UK economy is facing a prolonged period of balance sheet adjustment. This process implies the need for the UK economy to rebalance away from private and public consumption towards higher net exports.

The fall in the exchange rate over the past two years will help to smooth that process.

There is likely to be sustained weakness of demand relative to that capacity path of CPI inflation under the same monetary policy assumptions. After rising sharply in the near term, inflation is likely to fall back to below the target, as the impact of the past depreciation of sterling fades, and as the margin of spare capacity pushes down on CPI inflation.

He could not be clearer!

The harshest representative of this approach is Plosser, the super hawk from the Philadelphia Fed (who fortunately cannot vote at the FOMC until 2011)!

As a general rule, Fed board members refuse to express themselves on the subject of the dollar, with this task usually left to the Treasury Secretary or the President:

“People talk about the fall of the dollar, but we have to remember that the dollar is not even where it was before the crisis started. It's still above that level.

If people believe that emerging markets and the world economy is going to grow faster than the U.S. in the months and quarters to come that might be a reason for the dollar to weaken that has nothing to do with inflation.

And so strong global growth and a weak U.S. economy or a weaker U.S. economy would mean in general that the dollar should depreciate”.

The problem with this Beggar thy Neighbour approach, which has led to a slew of complaints lodged with the WTO, is that G-20 countries had promised to avoid engaging in this sort of behaviour so as to avoid a 1930s-style depressive spiral. As such, it is beginning to wear thin with its trading partners.

What is more ironic is that the United States is the country that complains the most about China’s currency manipulations. The market is swirling with rumours and theories about Obama’s visit to China from 15 to 18 November.

Some think they saw in page 45 (in reality, page 46!) of the PBOC report published the day-before-yesterday the announcement of the beginning of the yuan’s convertibility, which led to a hike in forward contracts against the US dollar.


“Policy makers will improve the setting of the Yuan’s rate in a “proactive, controlled and gradual manner and based on international capital flows and movements in major currencies”.

However, these hopes were quickly quashed because, as we have relentlessly pointed out, the Middle Kingdom has no other choice but to rely on its current deflation exporter to the world model. As such, they will wait for much concrete evidence of a pick-up in global demand (thus, from the US) before considering an orderly revaluation of their currency, as between July 2005 and July 2008.

Moreover, it can hardly lecture the US about its budget deficits, because it needs the US consumer.

So the calls to cool it last night should come as no surprise:

“China's exports are more important than U.S. deficits," the (anonymous) official said.

"The Chinese government will not ask for any specific U.S. announcement about an exit strategy but will simply mention it."

"China's economic recovery is currently stabilizing gradually, and (the government) won't immediately allow the Yuan to appreciate."

And let us not forget:

PBOC Governor Zhou Xiaochuan was reported to have said last week that the Yuan is not facing large pressure to appreciate.

“China is unlikely to see significant inflationary pressure next year due to overcapacity in the market”, Fan Jianping, chief economist of the State Information Center.

The icing on the cake came from China’s number one, Wen Jiabao, who must be the only Chinese official to express an opinion on inflationary anticipations, which isn’t as surprising as all that, given the lack of the PBoC’s independence:

"The government will balance the relationship (between) boosting economic growth, adjusting the economy's structure and managing inflation expectations”.

"Will keep appropriately loose" monetary policy and expansionary fiscal policy

But the major problem at this time, which is raising fears of a Trafalgar hit like Nixon’s in 1971 (and which is one of the reasons implied interest rate volatility is trading so cheaply these days), is that today’s concomitant decline of the dollar and the yuan against all other currencies in the world (aside from the £ and the Irish currency) is beginning to seriously annoy other countries who are taking the full deflationist blast with the ensuing deterioration of their own trading terms.

Some of these countries are not just sitting idly by: Brazil has imposed a tax on incoming capital and Taiwan has prohibited non-residents from investing in the country’s bank certificate – all with the aims of preventing their currencies from appreciating.

Apart from seeking correct matters through regulatory measures, central banks find themselves having to intervene on currency markets to buy up dollars and slow the appreciation of their own currencies, like in Russia, South Korea, Thailand and the Philippines

Japan seems to be taking all that rather stoically for the time being, given the Finance Minister’s position, but the news published this morning on the price front are anything but brilliant:

Japan's corporate goods price index fell 6.7% from a year earlier in October, marking the 10th consecutive y/y drop.

Weak final demand was partly behind the continued CGPI drop and the data showed that firms have not been able to pass higher material prices on to final goods prices,

In Europe, we are absorbing these hits while gritting our teeth, under the impulsion of Germany which remains as proud as ever of its euro-deutschemark and still convinced that, regardless of the euro exchange rate, their Porsches, machine tools and Zeiss optic instruments will continue to sell abroad.

We only had this little comment from ECB official Bonello today, who repeated that:

The European Central Bank was monitoring currency movement because they affect the evolution of prices (!)

That’s a good first step, but, in the meantime, Ireland has published its October CPI, which is more catastrophic than expected, -6.6% on an annual basis (-2.8% harmonised with the EU)…

Erwan Mahé - Asst allocation and option strategy

22, rue des Capucines - 75002 Paris

TEL : + 33 1 53 05 57 20



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