Pessimism on the World Financial Situation

The present global financial situation is a reminder of the story of the German who in 1939 wanted to get as far away as possible from likely war in the west -- and went to Guadalcanal in the Solomon Islands, which would later become the scene of some of World War II’s bitterest fighting.

Supposedly much of Asia is now relatively safe with few real estate bubbles (China and Hong Kong excepted), fairly low public debt and more foreign exchange reserves than they know what to do with. The likes of Taiwan, Indonesia, Thailand and Malaysia are not full of excitement but they look healthy enough. And China continues to forge ahead despite inflation at 6 percent or so and rising doubts about the health of its financial institutions.

All in all it looks healthy compared with Europe with its wobbly euro and nearly-collapsing peripheral states with their outsize debts, or the US where the external deficit remains chronic, politics a dangerous standoff and unemployment at unacceptable levels.

However, take a closer look and Asia may not be so great after all. China’s latest export data shows year-on-year growth of 25 percent. But how much of this is due to currency factors? China expresses its trade accounts in dollars, not a slowly appreciating yuan. Yet most of its exports to Europe are in euros and some to other destinations in recently strong currencies such as the yen and Australian dollar. Allow for that and the numbers are less healthy – and that is before both the latest economic slowdowns in Europe and the US, and before the impact of rapidly rising wage costs on some industries where lower cost suppliers are now available.

Not that China is in much danger of seeing its trade surplus vanish, even if exports to the west stagnate or even fall. If current global gloom prevails, the next result must surely be a further decline in commodity prices, which have been so long boosted by a mix of Chinese demand, slow growth in supply and speculation financed by cheap money. All those have started to come to an end – though the process could be drawn out.

That should benefit Chinese consumption and bring down inflation but is just the news that the commodity exporters of Southeast Asia, Australia and the Gulf do not want. They are not going to be rushing to boost local demand if export prices turn sour. They have found it hard enough to grow fast even when external conditions have been very positive because domestic issues – politics in Malaysia and Thailand, skills shortages almost everywhere, stand in the way.

Meanwhile China’s problems are internal, not external, wedded as the government is reducing inflation while trying to achieve a growth rate which is unsustainable given zero manpower growth and past overinvestment in unproductive assets. The existence of a growing number of first-class Chinese companies, mostly from the private or semi-private sectors, cannot hide a macro picture in some ways reminiscent of Thailand in 1996. The big difference of course is that China is a creditor, not debtor. That precludes crisis but not a combination of inflation and sharp slowdown. It will shy away from strong efforts against inflation because the higher interest rates need would expose the over-borrowed situation of so many state enterprises, and put upward pressure on the Yuan to the distress of influential exporters.

So how does that leave buoyant Asia compared with sclerotic Europe and the US, both now suffering in different ways from the second deluge fall-out from the financial excesses which ended dramatically in 2008?

In theory both currencies should continue to weaken but do not bank on that. For sure, the euro is a mess that may collapse but Europe’s problems are mainly political – the unwillingness of the rich core to bail out the peripherals whom they injudiciously invited into their club. A Eurozone shorn of Greece, Portugal and even Spain would actually look quite strong. As for the US, its trade deficit is likely to decline due to weakening commodity prices and feeble consumer demand. It will not disappear but lack of viable alternatives and the continued efforts of China and others to remain close to the dollar will ensure that it will not fall so far as to actually force trade back into balance.

The idea that the yuan is an alternative is an illusion. Beijing will continue to allow gradual increase in its use in trade but access will remain controlled and the exchange rate managed carefully. There is an obvious contradiction between the internationalization of the yuan and China’s need to limit capital inflow and keep the yuan from rising too steeply. China likes to see itself as savior of the world economy but is not big enough for that and anyway its insistence on sustaining huge trade surpluses is more of a drag on global growth than a stimulus.

There are other currencies which look strong enough to be worth holding through most sets of circumstance in the coming months. But two of them, the Thai baht and Singapore dollar, have already risen to the point where there is some local discomfort. They may well see their trade performance slip as demand in the west stagnates and commodity prices ease. Korea and Taiwan appear destined to continue to enjoy large trade surpluses even as global demand weakens but access to their closely managed currencies remains difficult as they seek to keep competitiveness against Japan and China.

Growth prospects in other regions of the world, including India and South America, are also weakening as they face the twin problems of rising inflation and weakening external balances. Brazil’s currency is looking seriously overvalued, like the similarly iron-ore driven Australian dollar. India with its low external dependence seems a more likely prospect for slowed but still creditable growth. But portfolio investors may have a hard time finding companies with good growth prospects which are attractively valued.

But gloom about the world in general is no reason for a flight into gold, now six times its price of a decade ago. For sure a final spike to more than US$2,000 an ounce is more likely than not. But gold is now mere speculation, the opposite of safety. Take it with you if you have to go to Somalia or get Ghadaffi assets out of Libya but don’t buy it and leave in a bank vault. Gold mines take a long time to develop but with the marginal cost of production now around US$800 an ounce it is only a matter of time before new supply rises – at any rate, long before the world reverts to the gold standard. Indeed, though China and others have been increasing their gold reserves, they have no reason to want it to play a larger role in the global system because most central bank gold is owned by the US and Europe.