This is a great article that explains why a significant drop in the U.S. dollar as more and more dollars get printed doesn't mean a collapse is imminent for the global economy. Globalalization has changed the dynamics of the world.
"In the past five years, the world economy has grown the fastest since World War II. We believe the trend is only going to continue, if not accelerate due to the free-flow of excess capital and uneven distribution of global wealth."
"The GDP per head in China is some 1/30th that of the U.S." It's not going to stay that way forever.
By John Lee, CFA
January 31, 2007
From Closed to Open:
Before 1990, economies were relatively localized. Global trade was thin and technologies such as “email” and “the internet” barely existed. Phone, letters, and faxes were the means of communication. Companies predominately produced and marketed goods locally. Internationalization was unheard of besides a few large brands such as Coca Cola.
Source: WTO, Statistics Database
As you can see from the chart above, it took nearly ten years for world trade to double from 1990 to 2000. From 2001 to 2007 the same feat took only 6 years.
From the perspective of money movement, in the 1980s and early 1990s international equity investing was mostly reserved for the large institutions. Mutual funds were not popular until the mid 1990s.
Things have changed today. Now one can buy or sell a piece of an international market from anywhere in the world through ETFs and mutual funds. What is more you can do it all in the comfort of your own home, online, with commissions that are only fractions of what they once were.
As I shall demonstrate in this paper, an open global economy with an increasingly integrated workforce and expanding consumer markets has diversified the risk of a systemic fiat currency crisis and the collapse of the dollar. I will elaborate the claim with observations on money supply, currencies, foreign reserves, and economic growth. I will then conclude with my views on the current investment climate and my investment outlook moving forward.
Tying the Dollar’s Fate to Globalization?
In closed economies when money supply grows 15% a year and budget and trade deficits exceed 6% of GDP, a currency crisis often ensues. Examples abound from Turkey, Brazil, to several Asian countries involved in the mid 90s crisis. I can hear the question: so why hasn’t there been one in the U.S.?
The answer can be found in the following chart.
Figure: Foreign Exchange Reserve Asset Holdings (USD Billions)
Source: IMF, World Economic Outlook
Recall that the eventual collapse of a Ponzi scheme is not necessarily caused by the size of the scam, but the inability to recruit new participants.
Instead of circulating in the U.S. economy and causing price increases, excess U.S. dollars have gone to Asia in exchange for Asian goods. Asian central banks in turn have soaked up the dollars, printed local currencies from thin air, and pumped the liquidity into their local markets.
In a way, the U.S. is exporting inflation in return for real goods. You would be amazed at how far the dollars bills have traveled, from the high mountains in Mongolia to small streets in Bangladesh. No doubt, a money supply growth of $12 trillion would have caused hyperinflation in a closed U.S. economy with 300million people. But in an open international economy that same $12 trillion is spread out among 5 billion people. In addition tens of trillions of U.S. MBS (mortgage backed securities), US corporate bonds, and US treasury bonds are now owned by institutions and retirement funds worldwide. Indeed globalization is postponing dollar’s fate of demise.
The Collapse of “Export Oriented Economies” During a Global Recession Debunked
If a person saves more than he spends, that person becomes wealthier. By the same logic, if a country exports more than it imports, she becomes richer. I grin every time well known analysts call for China’s slowdown and collapse, should U.S. consumers spend 5% less on Asian goods.
An “export oriented economy” implies that the economy depends on exports to survive. I don’t think that there is any empirical evidence to back up such a dependency. While an economy might have a positive trade surplus, its well-being is not necessarily tied to the need to constantly export more than it imports. In other words, when an economy is enjoying a trade surplus, it is in savings mode; and when it is in deficit, it is in spending mode. The mode can certainly switch back and forth. An economy in savings mode (i.e. an export-oriented economy) is only saving up pent up demand, which will come out of the woodworks at a later date.
I want to give you a concrete example.
China has been in savings mode for the last six years and has accumulated more than $1 trillion dollars in reserves. Does the Chinese economy really depend on exporting more goods in return for ever-depreciating paper bills? Hypothetically, if US consumers spent $100 billion less on Chinese goods, China could just print $100 billion in local currencies and hand them out to the hungry and needy to pick up the slack. The effect of such charity is the same as exporting goods to U.S., except of course that
- China wouldn’t receive the $100 billion from the U.S., which is irrelevant with the $1 trillion war chest she already has
- The goods stay in China and improve the quality of life in China rather than in the U.S.
In a wacky way, reduced U.S. consumer demand actually is a blessing in disguise. Local Asian economies are rapidly becoming self sufficient, witnessed by the strongest Chinese GDP growth in a decade at 10%+ despite lackluster U.S. growth. The double digit consumer spending growth in China has continued annually since 2001 (vs anemic sub 5% in the U.S.)
What Do The Following Trends Have In Common?...
Weakening dollar, Surging Commodity Prices, Rising Trade Deficit, Staggering Accumulation of Global Foreign Reserves, and Rapid Global Economic Growth.
Answer: these trends all occurred at about the same time in 2002. While most U.S. readers recognize and acknowledge most of the above trends, few realize that the only time that the world economy has grown as fast as it has over the last five years was right after World War II.
It always has been difficult, if not impossible, to determine cause and effect in markets. For example, arguing the cause and effect between a strong stock market and a robust economy is no different from the perennial chicken and egg debate. Even economic statisticians have reported no clear historic relationship between the stock market and the economy as measured by GDP growth.
Regardless of cause and effect, in my view it was no coincidence that the above mentioned trends started at about the same time in 2002. Let me expand:
Prices today are set in dollars. So what affects commodity prices?
- The demand and supply of the good (such as oil)
- The demand and supply of the dollar.
Most people understand the first but rarely think about the second point.
Thirteen times more money has been printed since oil reached $40 in 1980. Commodity prices, measured in dollars, naturally go up as more dollars get printed and as the dollar weakens against other currencies.
Figure: CRB Commodities Index 2001-Present
Figure: U.S. Dollar Index 2001-Present
The price jump comes to center stage when money reaches the hands of the masses instead of concentrating in a few hands.
The distribution of money to the masses has much to do with the trade deficit. The trade deficit enabled Asian and Russian central banks to accumulate an unprecedented amount of dollars. These banks in concert with the government use the dollar to import copper and oil; and subsidize those commodities for domestic consumption, bidding up prices well past historic levels.
So you see that it is only partially correct to attribute high oil prices to peak oil theory and Chinese demand. Oil production has been ever climbing to date; the 1 billion+ Chinese (who have been on earth since 1980’s) with no dollars are not the same as the 1 billion+ Chinese with $1 trillion dollars to spend. In short, it is not the demand and supply of oil that has changed, but rather the demand and supply of the dollar.
Those Wishing For Another Asian Currency Crisis Will Have To Wait
Foreign Exchange Reserves of Countries with the Largest Holdings (2001-2005)
In 2006, the Fed stopped publishing M3 (a common measure of money supply), citing expense as the reason for its removal. M3 has grown thirteen-fold since 1980, going from 800 billion to over 10 trillion today. This averages out to over 10% a year. The rise was particularly alarming in the last five years with annual growth exceeding 15%.
By the end of 2005, four of the top five countries with the largest holdings of foreign reserves were Asian (Japan, China, Taiwan, Korea) and the country with the fifth largest reserves was Russia, a large exporter of oil. Over the past decade, exports from Asian countries have soared and their foreign reserves, largely denominated in US dollars, have skyrocketed.
The key cause of the Asian monetary crisis of the late 90s was excessive corporate and government borrowing. The debts were issued by international banks in U.S. dollars and at some point the borrowing countries were not able to pay up due to a lack of dollars in their central banks. Such instability caused international capital to flee the countries. Local currencies were converted to dollars, which further exacerbated the downward spiral of local currencies and economies. Such phenomena were seen over and over again throughout the 90s in Mexico, Russia, Latin America and Asia.
The picture decidedly changed in 2001 when the dollar index peaked and the U.S. trade deficit started soaring. The U.S. trade deficit allowed various countries like China, India, Japan, and Russia to start accumulating dollars. Lacking dollars was no longer a concern.
Today, if capital flight were to happen in South Korea, once plagued by a monetary crisis:
- Where will the capital flee to, given South Korea now has over $200 billion in foreign reserves?
- With foreign reserves nearing 50% of her GDP, the Korean government has enough reserves to support its currency and keep the equity market from failing.
In fact, the numbers are really quite stunning; Taiwan has enough foreign reserves to give every single citizen (child or adult) USD $8,000, which is nearing the average annual salary of a new college graduate.
Excess dollars has removed much of the fear associated with Asian currencies and thus stabilized investment and made long term investment planning possible. The Asian growth this time is permanent and less speculative.
The GDP per head in China is some 1/30th that of the U.S. Those who believe that .Asian equities have topped are missing the picture. The disequilibrium in GDP will be quickly bridged with the ease of investment capital flows, and with the technology and infrastructure that can raise the productivity of the workforces of developing countries on par with the rest of the world readily available. Asian equity markets will continue to outperform Western equity markets in the long run.
Eg: Thai Stock Exchange, The Long Term Chart Looks Bullish
The collapse of the dollar index since 2001, aided by the chronic U.S. trade deficit, drove capital away from dollar and dollar centric investment themes (Nasdaq, U.S bonds). It is no surprise that commodity prices rose at the same time of the peak of the dollar, and that Asian foreign reserves started build up thanks to a burgeoning U.S. trade deficit. When one billon Chinese and Indians are armed with over one trillion dollars to shop, commodity prices naturally go up.
The U.S. continues to print dollars with reckless abandon. The bulk of those dollars are exported to the banking systems of developing countries. Excess dollars parked at foreign central banks enhance the stability and attractiveness of investing in emerging markets and have eliminated the possibility of capital flight. This has facilitated the long term growth of developing nations and the global economy.
There is no doubt that globalization has extended the life of the fiat currency system by bringing in more participants that believe in making and saving fiat money. Labor, money, and goods now freely travel across borders. Technology and infrastructure will help to quickly bridge the gap in productivity and GDP per head between the East and the West.
In the past five years, the world economy has grown the fastest since World War II. We believe the trend is only going to continue, if not accelerate due to the free-flow of excess capital and uneven distribution of global wealth. Long term equity bears should reassess their bearish position.
We like gold because of its international status as money. Gold has survived the test of time like no other form of money has. While we are bullish on gold strictly because it is undervalued relative to current copper and oil prices, we are not married to it, as we anticipate the pendulum will swing the other way as gold eventually becomes overvalued relative to equities, real estate, and other commodities. By then it will be time to make a switch. As Warren Buffet puts it succinctly, the rule of successful investing is “Buy Low, Sell High”.
Gold Relative To Oil Since 1991
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