The surprise has been that the world's largest economy has managed to attract so much foreign capital for so long. By the end of Q1 2007 the United States was importing foreign capital equivalent to 3.64 percent of its gross domestic product (GDP). To put this figure into context, even during the Breton-Woods agreement foreign capital inflow into the United States never surpassed 0.5 percent of GDP. In the late 1980s, when it seemed the United States economy was totally reliant on Japanese capital inflow, foreign capital flows barely surpassed 1.0 percent of GDP. Even the success in attracting foreign capital equivalent to 3.64 percent of GDP is not enough to stop the slide in the value of the US dollar (USD) and a slowdown in the economy in recent years.
So what happens now that private foreign capital is showing its reluctance to further increase its now huge commitment to the USD? Most people assume it means a collapse in the USD, US treasuries, US equities and the economy. However, such a conclusion ignores the highly probable response of public capital to private capitals satiation. It is highly likely that the emerging market central bankers will have to increase their actions to depress their own currencies, thus supporting the USD and the treasury market. The result of this action is not a credit crisis but an accelerated non-US economic growth and inflation. The impact on financial markets could not be more different than that expected by those awaiting a credit crisis.
Public vs private capital
The key question for global investors is: will the USD collapse if we continue to see smaller private capital inflows? If the answer is 'no' then we are likely to see less private credit available in the United States, which would be combined with a very weak USD with every probability of a weak US treasury market. That terrible combination of events would materially restrict the ability of the Federal Reserve to reduce interest rates and resuscitate an ailing US economy. In this environment we would face the biggest economic contraction in the United States since the early 1980s.But, of course, this is all dependent upon dwindling private capital inflows to the United States and not offsetting the flow of public capital into the United States. It is highly likely that such inflows do accelerate, which makes the outlook for the United States more positive. If we now see foreign central bankers increasing their USD buying then the USD will not collapse and the price of US treasury debt is likely to rise. In an era of a steady USD and a stable-to-strong treasury market, the Federal Reserve has ample scope to reduce short term interest rates to resuscitate the United States economy.
While private credit in the United States will remain more expensive and in shorter supply than it has been in recent times, the adjustment of the United States economy, should foreign central bank capital now flood in to the USD, would be much smaller than most predict. So what is the likelihood that foreign central bank inflows to the USD will accelerate and why are the consequences so positive for asset markets outside the USD?
The private wealth which flows into the USD has to be earned, inherited or stolen. It is driven by risk and return assessments, and it is difficult to predict. Of course the capital which flows into the USD from foreign central bankers is none of these things. It is printed and driven by politicians and bureaucrats who are pursuing their own goals of depressing the value of their own currency.
Reactive policies
The emerging market central bankers, the key buyers of the USD now for many years, have been pursuing a policy of depressing the value of their currencies for many decades and they are unlikely to abandon such policies now. No one ever described politicians and/or bureaucrats as proactive and they are likely to pursue policies until economic and then political problems force them to react.Even if a sudden, proactive burst spread through the emerging markets, politicians and bureaucrats the key question is in which jurisdiction would such a change result in a unilateral decision to abandon their currency policy. Any authorities who take such a step revalue against not just the USD but against most global currencies. The simple truth is that if one includes Japan, a country prone to massive currency intervention when market forces drive their currency higher, then around 60 percent of global ex US GDP is in the business of depressing the value of their currency relative to the United States.
Based on International Monetary Fund (IMF) statistics the United States is only 19 percent of global GDP (its lowest level since 1913) and more than half non-US GDP is now centring its monetary policy on the USD. The relative scale is such that foreign central bank inflows can accelerate and replace the dwindling flows of private capital to the United States. Those who expect a collapse in the USD, a surge in treasury yields and a deflationary future simply ignore this dynamic. If you accept the probability of rising foreign central bank flows into the United States, the US economic slowdown is less dramatic and it results in massive ex US liquidity creation, which is almost certainly inflationary.
Easier liquidity outside the US
Foreign central bankers are forced to buy USD and create local currency deposits due to their balance of payment surpluses and the general downward pressure on the USD. Thus the other side of supporting the USD is the creation of local currency deposits. The decline in private capital inflows to the United States thus exacerbates liquidity creation outside the United States. That is the first impact from the so-called 'credit crisis' which in fact suggests a move to significantly easier liquidity outside the United States.However this is only the first positive impact. Another key question which investors now have to answer is whether Ben Bernanke's famous savings glut disappeared this summer or whether it simply moved. Given the pace of the adjustment and the fact that major external surpluses elsewhere in the globe are not impacted by recent events in the United States, we must conclude that the savings glut has moved. Surges in the price of gold, the euro and emerging market foreign exchange reserves provide some evidence as to where the savings glut has shifted to. This type of capital targets countries that are already operating a balance of payment surplus and requires buying even greater sums of USD.
So to some extent the private savings glut which is moving on from the USD is simply recycled back into the USD but this time appearing as foreign central bank buying. The more this particular form of private capital flow redirection continues the more it results in emerging market central bankers creating increased liquidity. This will end only after a period of change in the political agenda for the emerging market currencies, following a period of rising inflation and surging asset prices.
So the United States is facing a credit crunch against a background of a weak to stable USD, a stable to strong treasury market and declining short term interest rates. In emerging markets we see rapidly rising narrow money growth which is increasingly likely to trigger strong commercial bank credit growth. This is a very inflationary situation which will become much more so if the European Central Bank (ECB) is finally forced to intervene to prevent the rise of the United States.
Events in the summer presage a shift in global growth prospects and an increased likelihood of higher inflation. A decline of US equity prices are likely in this environment and the rise of gold and emerging market equities will continue.
