Wednesday, November 23, 2005


Alan Kohler sees a shift in the dynamics surrounding the gargantuan record-breaking US trade deficit. The thing that tipped off the change was the uncharacteristic rise in the price of gold coincident with the continuing rise in the strength of the US dollar. Historically, they tend to be inversely related.

He re
ckons petrodollars are being turned into gold. Up until recently, the story behind the ballooning trade deficit has been the "vendor financing" effect, where the Asian countries used US$ earned from selling cheap goods and labour by converting them into US treasury bonds, thus keeping long term US rates low nothwithstanding the best efforts of the Fed to raise them (see The rising Fed rates managed to strengthen the US dollar even if it had no appreciable effect (in any) on longer term rates. Kohler tips us to a change whereby that mutually beneficial financing effect is phasing out, being replaced by a more ominous petrodollar effect. This is how he tells the story:
"So what's the problem? It's that the US dollar is overvalued and the country's competitiveness has eroded to the point where the cash rate arbitrage will be pitifully inadequate to hold the currency. This has occurred because Asian central banks, led by China, have been buying US bonds at ridiculously low interest rates in order to keep their own currencies and improve their own competitive position.

US consumers and businesses have been buying their goods from - and outsourcing their services to - cheap currency countries, which has stopped what would have otherwise been a natural depreciation of the dollar. As a result, the US current account deficit is now pushing $US800 billion ($1086 billion), $US300 billion higher than when, as research house Bridgewater Associates puts it, "private sector capital gave up on the dollar in 2002". It is also the biggest financing task the world has ever known.

Meanwhile, Asian current account surpluses are declining and those of oil-exporting countries are rising. According to the ANZ Bank's Saul Eslake, current account surpluses of the Middle East have quadrupled in two years to more than $US200 billion. Russia's surplus is up to $US120 billion and even Latin America is running a surplus now because of oil from Venezuela. In fact, Australia is about the only commodity exporting nation still running a deficit (because we are bigger consumers).

Total trade surpluses of commodity exporting nations are about $US400 billion. Asian surpluses, meanwhile, have declined from $US370 billion a year to $US300 billion, so the most important financiers of America's consumption addiction are no longer the Asian countries supplying the finished goods and services acting out of self interest - what Eslake calls the greatest vendor financing scheme in history. Commodity exporters, especially oil, are taking over, and they have an entirely different set of motivations.

"Unlike the oil shocks of the past, which gave rise to the concept of the petrodollar - a recycling of windfall [sic] oil revenues into dollar-denominated assets - the current windfall [ditto] accrues to a Middle East that is much better prepared for inward re-investment.

"Take a look at year-to-date returns in the stockmarkets of the region's major oil producers - Saudi Arabia (+96 per cent), UAE (+179 per cent in Dubai and +85 per cent in Abu Dhabi), Kuwait (+84 per cent), Qatar (+77 per cent), and Bahrain (+32 per cent). Also take a look at the urban construction boom - Dubai is starting to look Singaporean in scale."

And they are investing in the other asset that is no one else's liability - gold. Certainly the Arabs are less inclined to finance American consumers than the Chinese and are more worried, as investors, about the sustainability of the US current account deficit.

American financial assets [bonds and equities] will have to be repriced eventually, either directly or through a depreciation of the currency, or both.

And while there is little doubt that we are in the midst of a "Santa Claus rally" on Wall Street or that Australian stocks are generally not expensive, the timing and force of the American reckoning will be the key to investment markets in 2006."
To the extent fewer US export dollars are going to Asian countries who turn around and reinvest them in US treasuries, there will be increased pressure on longer term rates to go up in the US, which is not stock-friendly nor real estate-friendly. To the extent the US dollar depreciates, it will have to pay more for the foreign goods it is addicted to, which is an inflation threat, and would only encourage further Fed hikes. None of which sounds very market-benign to me.


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