Monday, August 10, 2009

Global Rebalancing Is Happening.

From as long as I can remember, the global economy worked something like this:

1- China produces goods on the cheap
2- US Buys these goods
3- China recycles US Money back into US Securities

This was the biggest reason for the low interest rate environment that led to the housing boom over the last 10 years. China's willingness to recycle USD profits back into the US via Treasury purchases.

tradersutra.blogspot.com/2009/08/chinese-market-tickticktick.html

tradersutra.blogspot.com/2009/08/more-on-usd-and-china-decoupling.html

Other resources based economies like Brazil, Australia, and Canada also thrived on this model by providing the raw materials to China. China in turn, kept their currency artificially deflated, so they can take further necessary steps to keep this going. This was the great global imbalance.

As the US trade and current account deficits rose, many economists began to question the sustainability of this relationship and whether it could be changed without causing a major economic dislocation. As it turns out, economists were right that the relationship was unsustainable, but rather than the rebalancing causing a major economic disruption, it is the economic disruption that is driving the rebalancing.

Back to the housing bubble, China's insatiable appetite for US Treasuries kept long term rates low so that the risk of holding longer duration securities was minimized. From this more complex agency/mortgage securities had to be created to keep up with housing demand. If you remember, both Bernanke and Greenspan before him blamed the global savings glut for the rise of China's Treasury purchases. But in actuality, its was Greenspan and Bernanke's over printing of USD that led other developing countries to keep buying anything with a US price tag.

Bottom line:

If US monetary and fiscal policy had encouraged savings rather than consumption, we wouldn’t now be talking about rebalancing the global economy.

tradersutra.blogspot.com/2009/08/more-on-trends-and-effect-on.html

If the US had balanced its budget, the flows would have at least gone to productive assets or trade rather than financing wasteful government spending.

So how does this end? What is the aftermath of this great rebalancing?

Well, since the Chinese and other developing countries hold all of the cards, they will determine to what extent any rebalancing takes place. Also the Chinese Central Bank will have to determine the their own demand for US Treasuries. What will China do with the roughly $2T of USD Reserves? We need China to keep buying Treasuries, but something has to give. China cant keep their currency so undervalued.

So whats the plan?

There has to be a smooth unwinding of the China/USD relationship. US households need to save more and spend less, but China consumer spending also needs to continue.

Once US Savings rises, we don't need much cheap China goods, this will lead to China overcapacity, idle factories, less employment, lower China GDP Growth. This would put a serious dent in China's plans. On the surface this is not good for global economies, but the ridiculous USD/China relationship has to change.

The Chinese have already spotted the above scenarios and are actively negotiating bilateral agreements with a number of developing countries to conduct trade in currencies other than the dollar. So far, they have opened negotiations with a wide range of countries, including Argentina, Brazil, Malaysia, South Korea, Indonesia and Hong Kong. This effort is intended to reduce the need by the Chinese and other economies to hold dollars for the sole purpose of conducting trade outside the US. This is one of the reasons I believe that the USD is still going south and Crude Oil will continue north, killing the US Consumer, which leads to less consumer spending in the US. Its going to be a hard landing.

tradersutra.blogspot.com/2009/08/cftc-told-you-so-moment.html

tradersutra.blogspot.com/2009/08/crude-jokes-indeed.html

tradersutra.blogspot.com/2009/07/crude-oil-speculation.html

Also of note, China has been stockpiling huge amounts of natural resources like copper and crude. This strategy will focus more on emerging economies rich in natural resources. I think on the margins, China would rather invest in the US, but as you know from the Dubai Ports and Unocal deals, our politicians prefer pandering to xenophobes over encouraging investment.

Furthermore, more and more US Treasury purchases is happening in the short end of the curve. As an example, in May of this year, Brazil bought $12 billion in T Bills but sold $9 billion in long term notes and bonds.

The US economy has suffered since the turn of the century from a lack of real investment. Foreign inflows, rather than being invested according to market forces, were diverted by Fed policy into non productive assets such as housing, automobiles and other consumption goods.

Government spending, always inefficient but especially so when the spending is used to finance wars, consumed a larger percentage of GDP than necessary. Rather than reduce the distortions of the Fed and government spending, we are in the process of doubling down on a bet that has proven disastrous. The choice is simple,either we make the necessary changes or the market will force them on us. So far we are continuing the double down bet.

Unless we change our policies, the demand for US Treasuries and the US dollar will continue to wane as China and the other emerging economies pursue their publicly stated goals

We will be left with the choice of funding our deficits through private US savings and much higher taxes.

This path leads to a further reduction in the willingness of foreigners to fund our spending, higher interest rates and higher rates of inflation. A lower dollar will eventually lead to recovery through a reduction in imports and an expansion of exports but that path leads through a minefield of inflation that will destroy US wealth and make it more difficult to expand the private investment that our economy needs to compete in the new emerging economic order.

Obama is correct when he states that we need to change our economy so we don’t experience the booms and busts that have characterized the US economy of the last two decades. But listen less to what he is saying and watch what he does more attentively. Its totally the opposite. Any type of transformative change is going to be painful, but why should only taxpayers only feel the pain? Every thing is being done so that Wall Street doesn't feel any dislocation.

The sooner we make the difficult choices that re-transforms America to its once great self the better. It looks like the common citizen in the streets is ready for this. Our elected officials are not. So far this administration, like the last one, is pursuing policies that just make the transition more difficult, lengthy and painful.

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