The Devil and the Dollar

The dollar fell 2% against the yen last week and is at a 19-month low against the euro and appears set to go lower. Several Asian currencies, even including the Philippine peso, are at their best levels since the Asian financial crisis of 1997-1998.

Is this a blip? Or the start of a massive decline of the dollar against Asian currencies generally – to match or even exceed the dollar’s fall against the euro from a peak of 85 to the dollar to 1.31 today?

If so, what should investors be doing?

Doomsday for the dollar may in fact not have arrived. But arrive it will as time runs out on the pact that the US made with the devil – enjoy yourself as much as you can, have your every wish granted for, the punishment will be in the future. As 16th century playwright Marlowe put it:

FAUSTUS. Ah, Faustus,

Now hast thou but one bare hour to live,

And then thou must be damn'd perpetually!

Stand still, you ever-moving spheres of heaven,

That time may cease, and midnight never come;

Fair Nature's eye, rise, rise again, and make

Perpetual day; or let this hour be but

A year, a month, a week, a natural day,

That Faustus may repent and save his soul!

O lente, lente currite, noctis equi!

The stars move still, time runs, the clock will strike,

The devil will come, and Faustus must be damn'd.

O, I'll leap up to my God!--Who pulls me down?--

See, see, where Christ's blood streams in the firmament!

One drop would save my soul, half a drop: ah, my Christ!--

Ah, rend not my heart for naming of my Christ!

Yet will I call on him: O, spare me, Lucifer!--

Where is it now? 'tis gone: and see, where God

Stretcheth out his arm, and bends his ireful brows!

Mountains and hills, come, come, and fall on me,

And hide me from the heavy wrath of God!

No, no!

Then will I headlong run into the earth:

Earth, gape! O, no, it will not harbour me!

You stars that reign'd at my nativity,

Whose influence hath allotted death and hell,

Now draw up Faustus, like a foggy mist.

Into the entrails of yon labouring cloud[s],

That, when you vomit forth into the air,

My limbs may issue from your smoky mouths,

So that my soul may but ascend to heaven!

[The clock strikes the half-hour.]

Ah, half the hour is past! 'twill all be past anon

O God,

If thou wilt not have mercy on my soul,

Yet for Christ's sake, whose blood hath ransom'd me,

Impose some end to my incessant pain;

Let Faustus live in hell a thousand years,

A hundred thousand, and at last be sav'd!

O, no end is limited to damned souls!

Why wert thou not a creature wanting soul?

Or why is this immortal that thou hast?

Ah, Pythagoras' metempsychosis, were that true,

This soul should fly from me, and I be chang'd

Unto some brutish beast! all beasts are happy,

For, when they die,

Their souls are soon dissolv'd in elements;

But mine must live still to be plagu'd in hell.

Curs'd be the parents that engender'd me!

No, Faustus, curse thyself, curse Lucifer

That hath depriv'd thee of the joys of heaven.

[The clock strikes twelve.]

O, it strikes, it strikes! Now, body, turn to air,

Or Lucifer will bear thee quick to hell!

[Thunder and lightning.]

O soul, be chang'd into little water-drops,

And fall into the ocean, ne'er be found!’

From The Tragical History of Dr Faustus, Christopher Marlowe, 1593

“Ah, Faustus, now hast thou but one bare hour to live and then thou must be damned perpetually.

Stand still you ever moving spheres of heaven that time may cease and midnight never come”.

Midnight is at hand for the $800 billion a year US current account deficit which has been financing not just the US consumption binge and the Iraq war but the global asset price bubble which is affecting, to varying degrees, assets around the world and of every variety.

So what does this mean for an Asia which has been the silent partner in the Faustian bargain, acquiring most of those excess US dollars in return for the ability to sell unlimited amounts of sneakers, toys and laptops to Americans?

Just how big a currency hit awaits much of Asia is illustrated by two facts which are currently escaping the same attention as the dollar’s decline. The euro is at an all-time high of 150 to the yen, having risen from 110 in three years. This is based almost entirely on interest rates differentials, in particular the multi-billion dollar “carry trade” by which financial institutions borrow in yen at very low interest rates and invest in high-yielding currencies.

The carry trade is actually a crap shoot, a gamble on whether profits on interest differentials outweigh the losses eventually to be sustained when high-yielding currencies collapse under the weight of their foreign debts, as much of Asia did in 1997/98. It is no coincidence that the country with highest yielding of openly traded currencies, New Zealand, also has the highest current account deficit, an alarming 9% of GDP. Next on the list is the US itself with a deficit of 6.5% of GDP and Australia at 5.5%. Taiwan, also with very low interest rates, a large current account surplus and a fierce devotion to a weak currency, is also a contributor to the carry trade.

The euro is also, it is seldom noticed, at an all time high against the yuan whose snail-pace appreciation has had no significant impact either on its trading strength or restraining its domestic credit bubble.

The recent past, which about to break down, is thus a combination of

• Low US interest rates and the Fed determination to use the dollar’s reserve-currency position to keep the economy expanding whatever the cost in foreign debt accumulation

• Japan’s stubborn belief that monetary pump-priming and minimal interest rates are necessary to spur the domestic economy and enable a cheap yen to drive exports and corporate profits

• China’s obsession with currency stability against the dollar, a misguided policy made more obdurate by US lecturing. This has persuaded the central bank to keep interest rates low despite the lending boom.

• Varying degrees of determination in the rest of Asia to keep currencies close to movements of yen and yuan against the dollar. The artificial nature of this is indicated by the appreciation of the Asian currencies – won, baht and Singapore dollar – which are both open and offer positive real interest rates against most other Asian units.

The combination of Asian and oil exporter surpluses that is the counterpart of the US deficit has, together with domestic low interest policies, created the credit bubble behind the boom in asset prices and of leveraged and private equity buyouts of listed companies. Debt is cheap compared to equity almost everywhere. Most stock markets are still relatively cheaply valued compared with bond markets. Of course there are exceptions – the whole Indian market and Chinese banks being rather obvious cases.

So what is about to happen?

• The US consumer is beginning to tire, particularly as the house price decline looks set to continue. But inflation in the US is probably more deeply entrenched than the Fed admits. The Fed will be between a rock and a hard place, reluctant to lower rates ever as the economy weakens. However, ultimately it will opt for inflation over unemployment. It will even encourage it by fostering a weak dollar.

• A much weaker dollar will be the focus of the coming (mid-December) visit to Beijing of Treasury Secretary Henry Paulson and Fed chairman Bernanke to lean on China for much faster appreciation. (By the way, where is the central bank independence demanded by the IMF?)

• When the carry trade ends it will end with a bang not a whimper. It could be quite bang given the size of it – it has been estimated that international banks’ net cross-border liabilities in yen total the equivalent of $450 billion, and could be further enhanced by un-hedged derivatives contracts.

Asia must bear the brunt of the next big currency change. The euro has already experienced most of its rise against the dollar. It is now in relative equilibrium with near balance on the Eurozone current account and a relatively tight monetary policy.

But should an Asia long used to being in a near-dollar zone really mind a 30 to 40 percent rise against the dollar? The answer for individual investors is surely not – so long as they have not been following the trend of their central banks and buying dollar assets rather than local ones. At the same time, a major currency shift will be destabilizing in the short term and will undoubtedly lead to a drying up of the easy money conditions created by weak Asian currencies and low Japanese and Chinese interest rates.

The coming transition will hurt exporters in particular. The US could well go into a real and prolonged recession. China will be hurt both by that and its own investment cycle as the excesses of the investment boom just coming to an end will take time to work themselves out. The recoveries in ageing Europe and Japan may falter.

But there is probably little reason to panic about Asian markets, the above exceptions apart. Such is the competitiveness of East Asia as a block that its global market share should continue to rise. The scope for domestic demand stimulus and demographics except in Japan remain favorable, even for Taiwan and China for the next five years.

Strong currency prospects for foreign investors in Asia as well as continuing relatively low interest rates will underpin most stock markets. The big hit to asset values in Asia is going to be taken not by local investors but by their central banks which have been accumulating excess amounts of soon-to-be devalued dollars.

So what should an investor’s strategy be?

Avoid the dollar (and the HK dollar, but not HK assets, until it ends its peg) like the plague. Ditto the carry-trade beneficiaries, the Australian and New Zealand currencies. Take a neutral view of the euro which has come a long way in a short time. In Asia prefer the laggards, the yen, yuan, NT dollar and ringgit to the won, baht and Singapore dollar. Avoid the rupee, rupiah and peso, all driven by interest rates. In the case of India, growth itself, let alone the currency, looks vulnerable to a contraction in international liquidity.

Stock markets will take a hit almost everywhere but there is no need to panic because most valuations in Asia are supported by earnings. More important may be to avoid owning any dodgy debt or investing in opaque hedge funds or private equity funds using cash influxes, and debt, to buy up supposedly cheap assets. It is better to buy companies which have sold assets to the private equity crowd, and those with Asian assets but dollar debts. Avoid Dubai real estate.

Is this all too gloomy? Maybe. The great global liquidity expansion may contract only slowly, in which case surplus money will be moving into Asian assets for quite a while yet. Fear of the dollar will cause Asian investors to retrench to local markets. (The central banks would wish they could do the same but they can’t get out of the dollar without accelerating its demise).

But given how much money most Asian investors have made – or should have made since the crisis, keeping plenty of cash in Asian currencies now looks a sound strategy with low risk and the chance of picking up dollar assets on the cheap a year or three from now.