Since the announcement of the UK gold sales on 7th May and the completion of the first sale on 6th July, the Pound has fallen steadily and is now trading near 3-year lows against the US Dollar. However, those who believe that the recent plunge in the Pound's exchange rate will dissuade other governments from selling their own gold reserves are sadly mistaken. Whether or not the sale of gold contributed to the drop in the Pound, it is clear that currency devaluation is a primary goal of the British Government (and many other governments). Indirect evidence of this goal has been provided by three reductions in official UK interest rates so far during 1999 and the Bank of England's admission last month that it was seeking increased inflation. Any remaining doubts were removed during the June 16th debate on the gold sales in the House of Commons when Sir Peter Tapsell, who was arguing against the sale of gold reserves, made the following statement: "A more sensible policy than selling gold would be to build up our reserves by buying dollars and other currencies with our Sterling. That would help to lower the exchange rate of Sterling, which is a desirable objective at present, and increase our reserves of foreign currencies, which the sale of gold will not achieve." The UK government is not alone in its desire for a cheaper currency and the fall in the Pound in the aftermath of the gold sale announcement will certainly not discourage other governments from off-loading their reserves.

As stated by Peter Tapsell, a more sensible policy would be to buy Dollars and other currencies (using newly created Pounds). This is a policy clearly favoured by the Japanese with the Bank of Japan (BOJ) having bought between 10 and 20 billion US Dollars during the past month in an attempt to lower the exchange value of the Yen.

The fact that continued intervention by the BOJ has led to only a minor up-move in Dollar/Yen is somewhat puzzling considering the strength of the US economy relative to that of Japan and the on-going problems facing the Japanese banking system. Possible explanations for the limited impact (to date) of the intervention are:

• liquidation by hedge funds that are long Dollars and short Yen
  
  
• repatriation of investment capital from the US due to expectations that US asset valuations have reached a peak
  
  
• excess US Dollars in foreign hands due to the huge US trade deficit
  
  

Each of the above could explain the failure of the Yen to weaken significantly in the face of the BOJ's concerted efforts at devaluation. However, there is one more possibility - maybe, just maybe, Japan's economic recovery is real. When Japan's 1st quarter GDP growth was reported as being a very robust 1.9% (7.9% annualised), analysts fell over themselves to explain away the improvement. A common refrain was that most of the growth was due to government spending. This may be so, but huge government stimulus packages have, in the past, failed to spark any signs of recovery. It is certainly true that Japan still has some enormous problems to address, such as the non-performing loans within its banking system (somewhere between 1 and 2 trillion dollars worth) and a federal government debt that is forecast to reach 110% of GDP this financial year. There are, however, some positive signals coming out of Japan, including:

• strengthening energy demand
  
  
• year over year changes in capacity utilisation and industrial production are still negative, but have been trending upwards since mid 1998
  
  
• declining corporate tax rates (from 50% in 1997 to 41% in 1999)
  
  
• corporate re-structuring and greater focus on shareholder returns
  
  
• increased labour productivity in the manufacturing sector
  
  

Perhaps the most positive sign of all that this Japanese recovery may be the real thing is the performance of Japan's stock market. The Nikkei is in a strong up-trend and is now trading at its highest levels in almost 2 years. Stock markets tend to hit their peaks and troughs well in advance of the real economy. The initial stage of a bull market usually occurs when the economic outlook appears to be at its bleakest and therefore tends to be greeted with complete disbelief by the majority of investors and the financial press. Some time later (usually 6 – 12 months) the signs of recovery become more obvious to the majority, but by that time the share market has invariably rallied strongly from its bear market lows.

The jury is still out regarding the Japanese recovery, but the stock market is likely to give us the verdict before the year is out. After such a strong move up the Nikkei should undergo a correction of some magnitude during the next few months (probably in parallel with a correction in the US market). If the up-trend extending back to 5th October 1998 holds during such a correction (the important level is currently about 14,000 on the Nikkei), this would be a very bullish development for both the stock market and the economy.

Afraid to let anything get in the way of their still fragile and patchy recovery, the Japanese monetary authorities are likely to continue their attempts to weaken the Yen. As well as making Japanese exports more competitive, buying Dollars with newly created Yen also increases the Japanese money supply. Because the Yen is not a particularly useful currency outside Japan, this new money will end up back in the Japanese economy thus furthering another objective – increased price inflation. If you are a private individual or company and your liabilities exceed your assets by a wide margin, then your only course of action is to declare bankruptcy. If, however, the entire banking system has liabilities that greatly exceed its assets then declaring bankruptcy is not an option. In this case the government will likely step in and attempt to eliminate the deficit by either removing some of the banks' liabilities or pursuing policies that increase the value of their assets. Since bailing out the banks would most likely be akin to political suicide in Japan, the asset inflation path has been chosen.

Japan can continue devaluing the Yen as long as the US is prepared to accept a $20B per month trade deficit and maintain its strong Dollar policy. The strong Dollar policy promoted by Bob Rubin has encouraged massive foreign investment in the US that has, in turn, helped support US debt and equity markets. The willingness of foreigners to invest in the US and a Federal Reserve prepared to supply seemingly unlimited liquidity have also allowed Americans to import more than they export and spend more than they earn. As long as the US is widely viewed as the best available investment location then the demand for US Dollars will remain strong, the US Dollar will remain strong, the US economy can sustain its strong growth, the US can keep on enjoying the benefits of low priced imports, and the rest of the world can continue to throw its products at this giant, voracious consumer. There are, however, two problems ahead.

Firstly, signs of economic recovery are appearing throughout the world. Although such a recovery (assuming it does manage to persist) is extremely good news, it will almost certainly lead to capital repatriation from the US. On a relative valuation basis the US equity markets are now exceptionally expensive and, at these levels, would only be attractive to foreign investors in the absence of any viable alternatives. If repatriation does begin to occur in earnest then the US Dollar will come under pressure, prompting the central banks of Japan and Europe to intensify their currency devaluation efforts.

Secondly, the US trade deficit is probably going to become a major political issue, particularly as jobs are lost in industries that suffer due to low priced imports. Pressure will mount to either implement protectionist trade policies, a course of action that would set off a trade war and plunge the entire world into recession, or devalue the Dollar.

The current finely balanced position contains the seeds of its own destruction. Either the Dollar weakens due to capital repatriation, or due to an excess of supply over demand created by the escalating trade deficit, or due to intervention by politicians seeking an election issue. A falling US Dollar will set off further rounds of competing devaluations as the exporters of the world struggle to maintain a competitive advantage. As this process gathers pace it will only be possible to maintain One's purchasing power through the ownership of physical assets that increase in value as the fiat currencies of the world are debased.

Milhouse
Hong Kong
9 July 1999

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