Massive shifts in investment capital throughout the world were both a cause and effect of exchange rate volatility in 1997. Dramatic changes in the perceptions of investors regarding the economic fundamentals and financial stability of most Asian countries led to the large scale movement of capital out of Asia and into the US, resulting in a collapse in the value of many Asian currencies when measured against the US Dollar. This process is self reinforcing as capital is attracted to invest in the currency which is demonstrating relative strength. The US Dollar also benefited greatly in 1997 from uncertainty created by the impending monetary unification of Europe. This net capital outflow from Europe to the US began in 1995, with the trend accelerating as EMU became more likely. In fact, Martin Armstrong has argued that capital fleeing EMU for the relative stability offered by the US was a primary cause of the collapse of Asia in 1997. He asserts that money flowing into the US due to EMU caused the Asian currencies which were pegged to the US Dollar to become vastly over-valued, supporting artificially low interest rates, large foreign debts and speculative booms. When these unrealistic currency valuations were inevitably exploited, asset values crashed exposing the huge debts which had fueled the economic booms.
Before taking a look at what we can expect in 1998 for the major currencies, I would like to examine how trade and investment capital flows affect currency exchange rates using US/Japan as an example. At the current exchange rate of around 130 Yen to the Dollar, Japan has a large trade surplus with the US. What this means is that Japanese goods are more attractive to US consumers than US goods are to Japanese consumers when 1 Dollar is valued at 130 Yen. The difference between the goods sold by Japan and the goods received by Japan (the trade surplus) is made up using Dollars. Japan is generally considered to have a favourable balance of trade with the US, although Milton Friedman argues that the opposite is actually true because the US is getting useful goods in exchange for pieces of green paper. Assuming that trade accounted for the majority of international capital flows, then Japan would continue to accumulate pieces of green paper (Dollars) in exchange for its useful goods. After a short while they would stop being prepared to exchange 130 Yen for 1 Dollar and would begin to offer less and less Yen for each Dollar. The price of the Dollar in terms of Yen would go down, reducing the price of US goods in Japan and increasing the price of Japanese goods in the US. The Dollar/Yen exchange rate would eventually settle at the point where exports and imports were roughly in balance. This is a simplistic view, but the argument is essentially valid.
Contrary to the above, what we are actually seeing at the moment is that the currency of the country with the large trade surplus continues to get weaker and weaker in terms of the currency of the country with the large trade deficit. This is because international capital flows are now dominated by investment, not trade (Princeton Economics reports that trade now accounts for less than 10% of total capital flow, compared to 90% prior to 1971). However, the same rules still apply, that is, the Yen will continue to weaken against the Dollar until total capital flows are roughly balanced.
The Japanese Yen
The Dollars gained by Japan through its trade surplus with the US are being invested in the US, creating an ideal situation for the country with the so-called balance of trade problem. Not only are useful goods obtained in exchange for pieces of green paper, but those pieces of paper are then used to support the US debt and equity markets. Following are some of the reasons why large quantities of investment capital are exiting Japan :
- The deficiency of assets against liabilities which exists within the Japanese financial system (refer to my previous article entitled "Japanese Monetary Problems")
- An institutionalised lack of transparency in the banking system. No one is really sure of the true picture regarding the non-performing loans and net capital positions of Japanese banks, creating great uncertainty. Uncertainty repels investment.
- Tight government control over banking and finance, including government directed lending.
- Beginning in 1995, capital fleeing the European debt markets due to uncertainty surrounding EMU made its way to the US, reversing a down trend in the US Dollar. A strengthening US Dollar made the "Yen carry trade" very profitable. In other words, if the Dollar/Yen rate is stable or rising it is profitable to borrow yen at the record low interest rates in Japan and invest this money at the much higher rates offered in the US debt markets.
- A negative outlook for Japanese economic growth due, primarily, to a failure to address the apparent insolvency of many large Japanese companies and financial institutions.
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The European Currencies
EMU is now accepted as being a reality, with discussion revolving around who the initial participants will be and whether the Euro will be a strong or a weak currency. The current timetable is for the initial participants to be selected in May 1998 (at which point their existing currencies will be officially linked at fixed rates) and for the gold policy of the European Central Bank (ECB) to be decided some time before this.
The major problem facing EMU, and one which I believe is insurmountable, is that monetary union is not feasible without fiscal union, and fiscal union is not possible without political union. I seriously doubt that Europe will be brought together under one government, so what we will end up with is a group of politically diverse countries with a German/French controlled ECB trying to impose consistent monetary policy.
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Although some unknowns will be clarified during the next 6 months, it is difficult to see how the Euro could ever be stronger than its weakest link. In any case, much uncertainty still remains. It will not be feasible for large investments to be made in the long term debt of governments and corporations of the EMU countries when the rates for conversion to the Euro, the gold backing of the Euro, and the process for managing the quantity of Euros across a politically diverse bunch of countries, are all unknown. It is therefore likely that the currencies of the EMU countries will weaken further in 1998 against the US Dollar, with volatility increasing as we approach the first major milestone in May 1998.
The strongest European currencies of late have been the ones which are not embroiled in EMU - the British Pound and the Swiss Franc. The British are currently non-committal regarding EMU, but it is likely they will eventually join for political reasons. The strength of the British pound is therefore probably temporary. The Swiss Franc, on the other hand, may continue to be a good hedge against EMU uncertainty and instability.
The Hong Kong Dollar
Everything in Hong Kong revolves around the property market, which in turn is driven by interest rates. In recent years HK has enjoyed negative real interest rates courtesy of a high inflation / moderate nominal interest rate environment made possible by the Hong Kong Dollar being pegged to the US Dollar. It has been very profitable to borrow large sums of money to invest in property, despite low rental yields, because capital gains have been quick and substantial. When the HK Dollar came under attack in the last 5 months of 1997, interest rates were immediately raised to defend the peg. This caused an instantaneous increase in the costs of servicing the large debts which had supported the extreme valuations, causing forced sales and a reduction in demand. The rest is history, with stock and property markets down 40% and 20% from their peaks.
Further large falls in property prices seem inevitable with interest rates continuing to be maintained at high levels to ward off speculative attacks on the currency. The bottom line is that the HK Dollar is linked to the US Dollar at an unrealistically high rate (around 7.8 HK Dollars to 1 US Dollar). With de-valuations throughout the region, HK has now become very noncompetitive for tourism. Also, higher mortgage rates are causing HK people to restrict their spending, which has a ripple through effect on the entire economy.
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When the HK Dollar is either de-pegged or re-pegged, interest rates will be able to fall and an economic recovery could commence. It should be noted that with the exception of high debt levels, Hong Kong does not have any of the problems which are plaguing other Asian countries. Despite now belonging to China, Hong Kong has the freest market in the world. It also has the lowest tax rates and huge foreign exchange reserves. Following some more turmoil during the first half of 1998 and barring interference from the Chinese government, HK is well positioned to continue its incredible success story.
The US Dollar
The US Dollar should continue to gain strength in 1998 for the reasons outlined above. The major risk with the Dollar is political, that is, that a concerted effort will be made by the US government to weaken the Dollar. Due to the preoccupation of politicians with the 10% of international capital flows which constitute trade, political pressure will continue to mount as the US trade deficit balloons to previously unheard of levels. The US will try to pressurise Japan into taking steps to strengthen the Yen, but this will be futile since the Yen must get weaker in order to balance total capital flows. The only alternatives for the US, in the eyes of the politicians, will be to pursue monetary policies which de-base the Dollar and/or increase barriers to imports.
The US stock market exceeded almost all expectations in 1997. The deflationists foresaw economic contraction and debt defaults while the inflationists foresaw higher interest rates, with both groups expecting consequential problems for the stock market. Even the most ardent bulls did not anticipate a third year in a row of 20% + gains. The explanation for this incredible performance can be grasped if we use an objective measure of inflation. If the supply of money increases at a greater rate than the supply of tangible assets, then higher prices will inevitably result. A reasonably good approximation for the true inflation rate is therefore :
(Total Money Supply Growth Rate) - (Economic Growth Rate)
If we assume that the total supply of US Dollars is increasing at the rate of 10% per year (which it has for the last 6 months) and a GDP growth rate of 3%, then the true inflation rate is around 7%. In other words, the US currently has negative real interest rates. This conclusion is exactly opposite to the commonly held beliefs, but is substantiated by the performance of the financial markets. The negative real interest rates have been and continue to be sustained by the large in-flow of foreign capital.
Following on from the above argument, further increases in the supply of US Dollars would reduce the already negative real interest rates thus adding even more fuel to the stock market bubble. A final blow-off top followed by a stock market crash of 1987 proportions would then be in the cards. This is the challenge facing US monetary authorities as they simultaneously try to dampen speculation and temper the strength of their currency.
Gold
The biggest negatives for gold going into 1998 are the strength of the US Dollar, a potential US budget surplus, and a final wave of selling by European CBs. *The positives are the wildly fluctuating exchange rates of the major fiat currencies, the large increases in money supply which we are seeing throughout the world, and the fact that European CB selling should subside once the gold policy of the ECB is proclaimed.* It is therefore likely that new lows for gold will occur during the first half of 1998, when the negatives will have maximum effect, followed by the commencement of a genuine bull market in the second half when the effects of increasing money supply start becoming more obvious. This is also in line with Princeton's 8.6 year investment cycle, for which the next major turning point occurs in July 98.
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Fiat Currencies
In order to maintain its usefulness as a medium of exchange each fiat currency relies on confidence in the ability of the monetary agents to ensure that :
a) the assets of the monetary system are sufficient to cover the liabilities of the monetary system, and
b) the value of each currency unit in circulation will not be significantly diminished by the creation of new currency units
Since the floating exchange rate system was born in 1971, currencies have been on a wild ride. A system which is based primarily on confidence, which sets no objective limits on the creation of money and which, by its nature, encourages the rapid movement of investment capital throughout the world in search of exchange rate gains (or simply exchange rate stability), contains the seeds of its own destruction.
The mind boggling volatility in currency exchange rates which occurred in 1997 looks set to continue in 1998. We can only wonder how long the world can live with a monetary system whose failures are becoming larger and more frequent, with each new crisis wiping out the hard earned wealth of millions of people.
The reader is invited to respond to Milhouse's wisdom via email: sas@hk.gin.net
Milhouse
5 January 1998
Also by Milhouse:
Japanese Monetary Problems
Gold Versus The Dollar
European Monetary Union
US Money Supply and the Demand For Gold
US / Japan Trade - Reality Versus Perception
Is Gold Still a Store of Value ?
Central Banks and Their Gold
The Intrinsic Value of Gold
Gold & Disintegration of U.S. Economic Influence
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