謝國忠：美元向好

2009-09-04 |謝國忠：美元向好


Dollar improving


Andy Xie/August 29, 2009


The dollar is likely to remain stable over the next twelve months. It could stage a cyclical bull market in 2011 as the Fed raises interest rate to 5% and the lower US asset prices attract foreign capital. The cyclical bull market may last two to three years. The longer term prospect for the dollar depends on the US's current healthcare reform. Its direction doesn't appear promising. The US Congress may pass part of the Obama agenda that increases spending and not the part that cuts cost. The long term scenario for the dollar remains bearish.



I have changed my view on the dollar in two aspects. First, at the beginning of the year I thought that the dollar would make a new low on surging US fiscal deficit. The previous low was in April 2008 when the dollar index ('DXY ') hit 71, 42% below its high in 2002. After Lehman Brothers went burst, the index rebounded by 20% quickly and peaked at 89 in early March, as risk appetite collapsed and the safe haven trade favored the dollar. When the risk appetite returned, it declined by 10% and has been range bound for three months. This has happened despite the overwhelming bearish sentiment towards the dollar, which triggered massive capital flow out of the dollar-based assets into commodities and emerging market stocks. What's supporting the dollar is the surging US household and corporate savings that have more than offset the increase in the US's fiscal deficit. As the US household savings continue to surge, the dollar is likely to remain stable.



According to the US Bureau of Economic Analysis ('BEA') the US personal savings rate rose above 5% in the second quarter of 2009 from 1% in the first quarter of 2008. The chances are that the savings rate could reach 8% by the end of 2009. It could rise further to 10% in 2010. The US federal deficit is likely above 10% of GDP in 2009. The household income is about 70% of GDP. The increase in the federal deficit is still greater than the increase in the US household savings. The gap is more than offset by the increase in the corporate savings. As the household sector saves more and spends less, the corporate sector needs to invest less. According to the US Census Bureau, the US's trade deficit in the first half of 2009 was $217 billion, down from $351 billion in 2009. The narrower deficit reflects smaller savings shortfall in the US. It results in less need for foreign capital and, hence, less pressure on the dollar.



Second, I am now expecting that a cyclical bull market for the dollar begins in 2011 and lasts for two to three years, advancing it one year from my previous view. The view is mostly based on my expectation that the Fed would raise interest rate to 5%. Most analysts don't expect the Fed to raise interest rate until the US's economy is strong again. On that logic the dollar couldn't recover as the weak US economy and low interest rate wouldn't attract capital. I think that inflationary pressure will force the Fed to raise interest rate despite a weak economy. The US economy will remain weak despite low interest rate for three reasons: (1) the US household sector must boost savings for many years to pay down debts, (2) supply-demand mismatch takes time to rebalance, and (3) the US financial institutions are still saddled with bad assets and couldn't boost lending for the foreseeable future. The US government has changed the mark-to-market rule for the US financial institutions so that they can carry toxic assets, possibly around $1 trillion and more than the total equity capital in the financial system, without worrying about consequences.



The US is handling its bad assets just like Japan did in the 1990s. Shouldn't the weak economy prevent inflation just like in Japan? The difference is that the commodity prices are sensitive to the US interest rate and globalization isn't helping to keep inflation down like before. Commodity prices are dollar denominated. If the Fed's policy rate is low, it boosts financial speculation in the market. Surging commodity prices bring up inflation expectation and can trigger a price-wage spiral. At some point the Fed would need to target oil price.



Globalization was a dis-inflationary force for the past two decades. It is the opposite today. Costs are rising faster in emerging economies than in the US. The dollar has adjusted sufficiently against other major currencies but remain overvalued against emerging market currencies. However, emerging economies are holding down their currencies to promote their exports, which is causing asset inflation that in turn inflates their costs. The emerging market currencies are appreciating through inflation, which boosts inflation in the US through its imports.



A major difference between Japan and the US is in their exchange rate behavior after their bubble burst: yen appreciated but the dollar collapsed. Japan trapped itself in deflation as a strong currency and weak economy sustained a deflationary equilibrium with low interest rate. The weak dollar over the past three years has stored up a lot of inflationary pressure. The higher US interest rate is to compensate for the currency depreciation before.



In addition to the interest rate, capital will flow from emerging economies to the US starting in 2011. The asset inflation in the emerging economies is sustained by momentum. As soon as the momentum stops, investors will realize that asset prices in the emerging economies are much higher than in the US even taking into account their higher growth potential. Capital flow will reverse then. It would be similar to what happened in 1996-97. A long period of weak dollar before drove capital into emerging economies and caused their asset markets to stay bubbly for a long time. Most speculators thought that the bubbly situation would last forever. The catastrophe came when the dollar went into a bull market. Virtually every emerging economy went into a crisis. I wouldn't be surprised that another bout of emerging market crisis may occur in 2012.



The cyclical bull market for the dollar may last for two to three years. It could bounce up by 20%. The dollar index may reach 100 during the period. It would be similar to the dollar's situation in the early 1980s. The Fed raised interest rate massively to tame inflation. Even though the US economy wasn't that strong and the fiscal deficit was large and increasing, the dollar rose substantially until the 1985 Plaza Accord. The coming dollar bull market may even be shorter.



Currency is like any commodity whose price depends on supply and demand. Its internal value is interest rate and external value exchange rate. For the past two millennia the currency in use is either gold or silver. The size of an economy determines currency demand. Before industrialization economic growth was imperceptible in human time. Hence, the demand for currency was fixed. If gold supply is stable, it is a perfect situation for price stability. When European colonial powers brought back massive amounts of gold and silver after the discovery of Americas , it led to inflation.



In the era of industrialization the rapid economic growth led to money demand rising faster than supply. Deflation became the norm during industrialization. The appreciation of money increased incentives for money hoarding, which could cause a deflationary spiral. Central bank was invented to increase money supply . The usual currency system was pegging paper money to gold, the so called gold standard. Its advantage is that the total currency supply could be much larger than the actual gold reserve through the multiplier effect of the credit system.



Paper currency has a tendency to depreciate, as its cost of increasing supply is relatively small. A popular economic theory is 'money illusion'. It assumes that people cannot link immediately inflation to money supply increase. Hence, they are willing to work for the same amount of money for the same amount of work when money supply increases at first, ie, tricking people into working for less. This assumption is the key to the effectiveness of Keynesian stimulus. The gold standard limits money creation as the central bank must hold enough gold for its printed money. It could manipulate total money supply by changing interest rate to influence the multiplier effect in the credit system. Without the gold standard money holders can only depend on a central bank's goodwill for preserving the value of money.



The track record of central banks on preserving the value of money is quite poor. Since the gold standard was abandoned in 1971, the dollar has depreciated from $36 to 945/ounce of gold. In terms of gold price the dollar has depreciated by 96% . The Chinese Yuan was pegged to the dollar below 2 before its depreciation began in the 1980s. It is now 6.8. In terms of gold Chinese currency has depreciated by 99%. Such massive debasing of paper currency is unprecedented in human history.



Central banks, as they are subject to political powers that need money to fix short term problems, are not kind to money holders. They are the only business that is bent on harming its customers. That is why central bank governors are either very old, with beard, or scholarly-looking, because they need to project the image of gravity to fool people into holding a depreciating asset. I don't mean central bankers are evil. They are subject to their political masters and must please them, even though independence is the mantra for central banking. When push comes to shove, don't trust your central bank.



The long-term prospect for the dollar remains bearish. The key is fiscal balance. If a government runs large and chronicle deficit, its central bank is likely to accommodate. Otherwise, the resulting high interest rate would kill the economy. From that perspective the dollar's future remains shaky.



The US government is likely to incur fiscal deficit above 10% of GDP in 2009 and 2010. This is not the scary part. When the US economy recovers, the fiscal revenue would too and the deficit would decline. The biggest problem for the US fiscal balance is its healthcare expenditure. The US's healthcare cost is likely to be 16.5% of GDP in 2009, doubled in two decades and twice as high as the median among OECD economies. Its share in GDP is rising by 0.5 percentage point per annum. Nearly half of the healthcare cost is born by the Federal and local governments. Unless the trend is reversed, the Federal Reserve will be forced into printing money to fund the fiscal deficit.



The Obama Administration puts healthcare reform its number one priority. If the reform is successful, the US economy and the dollar will have a good future. The Obama Agenda mainly has two components: (1) spending $1 trillion over the next decade to expand medical insurance to 15% of the population without it today, and (2) providing a public option for purchasing medical insurance. The second part is running into fierce resistance now. As one sixth of the economy is healthcare, one can imagine how many are against the reform that would harm their interest. As far as I can tell, when the US Congress convenes in autumn, it would pass a bill on the first part and ignore the second. While providing medical insurance to those without it is a laudable social objective , it worsens the fiscal situation.



The root cause of the US healthcare problem is its incentive system: patients demand expensive services as they don't need to pay for it, hospitals, doctors and drug suppliers overcharge price-insensitive patients, and insurance companies keep raising premium to cover escalating costs . McKinsey Global Institute documented in its recent report ('Accounting for the Cost of Healthcare in the United States', January 2007) that one third of the US healthcare expenditure was due to high input costs -doctors, nurses, etc. are paid more than in other countries-and inefficiencies. In a system with cost socialized and benefit individualized, overpricing and inefficiencies are inevitable.



The demographic trend will make the healthcare cost more daunting in future. The healthcare cost rises exponentially with age. As the US's baby boomers retire, the healthcare cost would rise even faster. The US fiscal balance is heading for a catastrophe. It is possible that the US could experience hyperinflation at some point.



The value of a currency is relative to other currencies. The US's situation is not unique. Aging is a dominant economic factor in Europe and Japan. Their currencies have been relatively strong due to their high household savings that are sufficient to fund their large fiscal deficits . However, the future may not be so. Japan's fiscal debt is already 200% of GDP. European countries' are around 100%. As long as these deficits can be funded by domestic savings, they can keep increasing fiscal debt and hide the burden by keeping interest rate low. The low interest rate must be supported by strong currency. But the strong currency will weaken their economies in the long run. Hence, they will have lower income and savings in future. At some point in the next decade Europe and Japan may need to print money to fund their deficits, which would lead to weak currencies.



Aging is such a dominant force negative for currency value. Hyperinflation may spread around the world. While the long term prospect for the dollar is poor, it isn't good for other currencies either. We must be vigilant in terms of holding money. However , don't rush out to change paper money for other assets now. Stocks and properties are grossly overvalued in many countries, especially in China. Money is still cheap relative to such overvalue assets. But, don't forget to switch money into stocks and properties when the bubbles burst.