The Hu Jintao Dollar?

A long-time investor in the Tocqueville Funds recently questioned my reference to the “weak” dollar in our last report to shareholders. As far as semantics are concerned, our friend is entirely right. I have long argued against judging balances of payments or currency behavior in terms of virtue (or lack thereof) on the part of the countries concerned. The United States is not alone responsible for its large current account deficit, which was broadly welcome when the world was flirting with recession and deflation. Similarly, it is not alone responsible for the behavior of its currency. So, I accept the criticism that, by calling the dollar “weak”, I slipped into journalistic laxism.

A Dollar Neither Cheap Nor Expensive

From a fundamental point of view, it is not at all clear that the dollar is either significantly overvalued or undervalued at current levels. Our shareholder friend should know:  he is chairman of a Big Board company that manufactures industrial products and competes head-on with cheap imports from Asia and elsewhere. In spite of this, his company has not only held its own in the U.S. market, but it now exports to 70 countries. In his letter, he states that “actually, on a market-based basis … the dollar is probably valued just about right or closer than it has been in several years”.

This evaluation corroborates those of other industrialists. In fact, even when the Euro was worth 90 cents, there was quite a stir on Wall Street but we heard surprisingly few complaints from US manufacturers. Now that the Euro is worth $1.24, we hear equally few complaints from European manufacturers. It is probably fair to say that, in the last few years, industrial managers have learned to cope with a broad parity range between the two currencies. As for the Yen, Japanese companies have repeatedly stated that they can live with its 20%-plus appreciation against the dollar since early 2002 -- even a greater one, in fact, as long as the rise happens progressively.

It should be remembered, as well, that oil and other major raw materials are priced in US dollars: to a not-negligible extent, the impact of rising commodities on European and Japanese manufacturing costs are being cushioned when the local currencies rise. As a result, the loss of competitiveness they could suffer from their currencies’ appreciation is less than meets the eye.

Most observers agree that, if there is a currency that is undervalued and deserves to be revalued, it probably is the Chinese Renminbi. But even this view can be debated, since China’s overall current account is essentially in balance. Its large trade surplus with the United States is offset by deficits with neighboring Asian countries, which sell it parts and components, as well as with global suppliers of industrial materials. In fact, to a significant extent, Chinese exports to the United States have merely replaced exports that used to come from other Asian countries, such as Taiwan, Singapore, Korea and even Japan, which, in turn, have been boosting their exports to China.

The rise of the Chinese economy has been so fast and, initially, so focused on exports that it naturally created a large bi-lateral trade imbalance with the United States, a country with a large and generally open market that, in addition, was enjoying an unprecedented boom in consumer spending. But, with China’s new focus on developing its potentially huge domestic consumer market, it is not far-fetched to envision an extended period of Chinese trade deficits in coming years.

So, it could be argued that the main cause of the growing US current account deficit is less a mis-alignment of currencies than an insufficient rate of economic growth by traditional importers of US goods, such as Europe and Japan, on the one hand, and the under-developed Chinese consumer market on the other hand.  Of course, the early lead of US multinational companies in moving production to China did not help. The imbalances caused by the recent re-organization of world trade flows will eventually self-correct.

Unfortunately, nowadays, trade balances probably have a much-diminished effect on currencies.

Under the influence of globalization, freer global financial markets, and speedier communications, financial flows between countries have grown exponentially in the last couple of decades, to the point where they now dwarf the value of trade between countries. In fact, a number of economists have begun to suggest, as I have suspected and mentioned for a number of years, that capital flows now determine trade flows rather than the opposite -- as had traditionally been the case, and as we were taught.

The Coming US Slowdown

In the last few years, as the world was flirting with recession and deflationary spirals, Alan Greenspan performed the role that he had initially assigned himself during the 1987 stock market crash: that of the world’s lender of last resort. He did this by pumping large amounts of liquidity into the US economy, which soon translated, for the United States, into a role as the world’s consumer of last resort.

The liquidity provided by the Federal Reserve, and the resulting very low interest rates, unleashed a strong recovery in the price of financial assets (stocks and bonds) and an unprecedented boom (some say a bubble) in real estate values. Real estate wealth, in particular, can fuel consumer spending by facilitating borrowing by homeowners on the value of their homes. This is one of the reasons why consumers, today, are heavily indebted.

Optimists point to the fact that the ratio of mortgage debt to housing values is not outrageous by historical standards and that the debt service burden of homeowners, overall, has not increased along with debt levels. However, this feat was made possible by declining interest rates and the lengthening of mortgage maturities, as consumers refinanced their appreciated homes and withdrew some money for spending in the process. But, as former presidential chief economic adviser Herbert Stein said (or something to that effect): “What can’t last forever won’t”.

The obvious question is: “What happens when interest rates rise again?” At that time, home values are likely to decline (as they do when borrowing costs increase) while the level of consumer mortgage debt won’t. In addition, the burden of servicing that debt will rise again, along with interest rates. In fact, even if prices do not fall and interest rates do not rise (e.g. if both hold steady), the refinancing of home mortgages at lower rates will dry up, eliminating an important source of spendable money for consumers. The wealth effect of rising home equity will have vanished.

Thus, with interest rates no longer declining and home prices no longer rising, consumer spending will start growing more slowly than consumer incomes, in contrast to what has happened for several years. What will then replace housing and consumer expenditures as growth engines of the U.S. economy?

Together, consumer spending and residential investment account for almost 76% of the US Gross Domestic Product, up from 71% ten years ago. Most of the increase in these two components has been offset by a deterioration of net exports, which have gone from a deficit of a little over 1% of GDP to one of 5% currently. Other major components of GDP have grown more or less apace with the total.

Total government expenditures (including states and localities) account for almost 20% of GDP. They are unlikely to decline, of course, because of the spending on war and homeland security. But the current public scrutiny of our budget deficits will preclude government spending from adding much to the economy’s growth as well.

While the composition of business capital expenditures has changed significantly in the past ten years, as purchases of equipment accelerated but investment in structures lagged, total capital spending has remained constant at slightly over 10% of GDP. With consumer spending and housing likely to slow down as a result of financial constraints, capital expenditures could only grow faster than GDP as a result of a much-improved foreign trade picture. Thus, the burden of sustaining the rate of growth of the US economy will fall largely on Net Exports, a small sector that accounts for a negative (-5%) of GDP.

Net Exports can improve in two ways: reduced imports or increased exports. I believe that both will materialize, but probably not enough to prevent a significant slowdown of the US economy’s growth trend.

America’s imports, which are very sensitive to household spending, will naturally slow along with consumer demand. As for exports, they should improve if the economies of Japan and Europe continue their budding recoveries. So far, these economies have bounced mostly on the strength of their export sectors, but each is giving signs of developing some domestic momentum. There are also some signs of recovery in selected Latin American countries, such as Brazil. Finally, in spite of the recent slowdown engineered by China’s authorities to prevent localized bubbles, the development of consumer markets in Asia – including China’s – seems set to continue apace and probably to accelerate – albeit from a relatively small base.

Altogether, therefore, US Net Exports are likely to improve slowly but steadily in coming years – as long as economic expansions or recoveries in the rest of the world are not stalled by an outright recession in the United States.

The Chinese RMB: Beware What You Wish For

As I mentioned earlier, capital flows have become so important, in recent years, that they now can have a major impact even on large, developed economies such as that of the United States.

Private capital flows include Foreign Direct Investment (FDI), which represents corporate investment in plants, equipment or whole companies abroad, and portfolio investment, which represents cross-border trading in stocks and bonds by financial institutions and private investors.

In the late 1990s, both categories of private investors became over-enthused by America’s technology revolution and the accompanying stock market bubble. Portfolio investors carried stock valuations to unsustainable levels, which led to the subsequent, severe bear market. Industrial investors, particularly in sectors such as telecommunications, also poured excessive capital into new facilities and infrastructure -- some of which remain idle to this day. Given the excesses committed during that period, it is unlikely that private inflows of foreign capital into the United States will reach back to the euphoric levels of the late 1990s any time soon.

More importantly, private investors accept the business or market risk of investing in foreign stocks or industrial facilities on the hope of making a superior return on their investment: they are less likely to aggressively pursue this prospect in a slowing economy. To give an order of magnitude, foreign direct investment into the United States has collapsed from about $80 billion annually to a rate of less than $5 billion between 2001 and now. Foreign portfolio purchases of US stocks have also declined markedly.

As for private investors in bonds, they, too, will probably remain shy as well, as long as there is a risk of US interest rates rising faster than those on their local markets and, additionally, they perceive the risk of a further decline of the US dollar.

Already, as foreign direct investment and portfolio investment into the United States have abated, the burden of recycling the outflow of dollars resulting from the America’s large trade deficits has increasingly fallen onto the shoulders of foreign central banks. Typically, they do this by buying US Treasury securities. US government securities held in custody at the Federal Reserve for the accounts of foreign government have increased by roughly $450 billion since early 2003 and now stand at almost $1.3 trillion – including 20% of all Treasury bonds outstanding. There has not been such a rapid and massive accumulation of dollars by foreign central banks since the late 1970s. That episode was a prelude to the severe, global recession of 1980-1982 – artificially, but briefly interrupted by a capital-spending spurt associated with the second oil shock of 1979.

Presumably, some of the securities held at the Fed on behalf of foreign governments belong to OPEC oil producers cashing in on high oil prices, but the figures for some of these countries are somewhat fuzzy. What is certain is that the two most aggressive purchasers of US government paper in the last three years have been Japan (trying to prevent an excessive or too rapid appreciation of the Yen) and China (attempting to maintain the official parity between the RMB and the dollar, partly through exchange controls but also through currency intervention). Europe, by the way, has not been intervening on the currency markets to any significant extent.

Recently, pressure on China to revalue the Renminbi has been mounting -- particularly from the election-bound United States. So far, the Chinese have steadfastly resisted – partly to show that no one tells them what to do, and partly because they felt they weren’t ready. But things have been changing. In particular, the focus of growth policies is shifting from exports alone to include domestic consumption. A cheap Renminbi made investment in China attractive for foreign investors, who have been eager to seize the opportunity. A strong Renminbi would increase the purchasing power of Chinese consumers and rein in any resulting inflationary pressures. Some concerns linger about the weak state of the banking system and how it would cope with a freer foreign exchange environment but, soon, it will be in China’s interest to revalue or float its currency. In addition, I have to assume that a good deal of China’s foreign debt (both public and private) is denominated in dollars. Revalue the Renminbi and the country’s debt burden is instantly lessened.

Unfortunately, the immediate, direct impact of such a revaluation on China’s bilateral trade with the United States is likely to prove disappointing. First of all, as many observers have pointed out, China has a large supply of cheap labor to help keep costs in check. Second, many products assembled in China have a significant content of parts and raw materials denominated in dollars and Japanese yen, which would soften the impact of a revaluation on manufacturing costs. But, more importantly, many Chinese-made products no longer compete with American-made ones. A few months ago, I asked the CEO of a leading Chinese manufacturer of consumer electric products what a 30% revaluation of the RMB against the dollar would do to his business. His answer was: “It might reduce demand for our products because of the impact of higher prices on purchasing power. But in terms of market share… we don’t have competitors in the United States any more.”

Thus, most of the trade impact of a Renminbi revaluation will likely be indirect. Some manufacturing of cheap products might be moved to Vietnam, Sri Lanka or Indonesia, which will be able to afford more imports – some but not most of which might come from the United States. And, to the extent that higher dollar prices for Chinese exports to the United States reduce American consumers’ purchasing power, imports from China might decline, at least temporarily. In the end, however, the true boon for the US trade balance will only come from the development of comfortable Chinese and Asian middle classes, which is under way but progressive.

A much bigger impact on America and the dollar should come from a shift in capital flows. It is not only Japan and China that have been accumulating, with increasing reluctance, dollar-denominated reserves. It really has been the majority of Asian exporters.

First of all, if China revalues the Renminbi, it will have less need to intervene to support the dollar by intervening in the foreign exchange market. If it decides to adopt a new peg against a basket of currencies, it might even be tempted to diversify its international reserves away from the dollar and toward the Japanese Yen and the Euro. The flow of capital toward the United States would be reduced significantly and, with it, the demand for US Treasury bonds.

Japan’s corporations were happy to take advantage of the undervalued Renminbi when they were – belatedly but very aggressively – setting new manufacturing facilities in China, over the last few years. Now, they are eager to see China’s consumer market develop as fast as possible, to capitalize on their already highly-recognize brand names – especially in consumer electronics. A revalued Renminbi that increases the purchasing power of the Chinese consumer would help.

The Chinese, Korean and Japanese economies already are increasingly integrated. A stronger Renminbi will naturally relieve the pressure on these countries’ governments to intervene in order to keep their currencies from appreciating against the dollar.

Somehow, Europe seems to be left outside of this loop, and it might be hurt more by a decline of the dollar against the Euro than it would be helped by a revaluation of the Renminbi. We will watch future developments closely.

The United States will almost surely be faced with increasingly reluctant official buyers of US Treasury bonds to finance its declining but still large current account deficits. No severe crisis need ensue and the problem can solve itself over a longer time horizon. In the meantime, there are only two ways to make investment in US government paper more attractive: to increase its returns by raising interest rates and to make US investments cheaper by letting the dollar drift down.

In the last few years, China has come to determine the price of oil, copper, steel, aluminum and various other materials. Now, the very future of the US dollar may lie in its hands as well.

François Sicart

^© Tocqueville Asset Management L.P.

October 11, 2004

The information contained herein has been obtained from sources believed to be reliable and to the best of our knowledge is complete. The validity and completeness however cannot be guaranteed by Tocqueville Asset Management.  Nothing herein constitutes investment or any other advice and should not be relied upon as such.  This document has been prepared solely for information purposes and does not constitute an offer or an invitation to buy or sell securities.  Any reference to past performance is not necessarily a guide to the future.  Tocqueville Asset Management L.P., their affiliates and their officers, directors, employees, advisors or members of their families as well as the clients for whom they manage portfolios; 1) May have positions in securities or options of issuers mentioned herein and may make purchases or sales of the securities or options while this publication is in circulation; 2) May hold directorships in corporations discussed in this publication.  The opinions expressed in this document are those of Tocqueville Asset Management as of the date of the writing and are subject to change.