The Hindu Business Line : Party is on in Asia

Asians are resisting their currency strength by buying debt of an already highly indebted US. That is setting off a heady asset price increase in Asia. But when other countries protest, the Asian game would be up and it would be left holding American assets whose intrinsic value would be a lot less than they paid for. The hangover could be painful, says V. Anantha Nageswaran.

THE capture of the former Iraqi President, Mr Saddam Hussein, was clearly the news highlight of the week. Of course, in India, it has been upstaged by the reported offer of the Pakistan President to abandon the demand for a referendum on Kashmir. It holds out exciting possibilities. International financial markets largely ignored the capture of Mr Hussein while Indian stocks celebrated the expanding terms of endearment.

Arm-chair pundits have begun to speculate whether the capture of the former Iraqi President justified the war, with opinion splitting along familiar lines. This column does not wish to join the debate elaborately. But, it is important to record that until the weapons of mass destruction were found, then the war, even in hindsight, would lack moral authority. Suffice to add that the capture does no harm to the re-election chances of the incumbent American President.

Foreigners grow weary of funding America's appetite for imports

However, it has had only a fleetingly positive impression on risky assets. It was more fleeting than expected. The Dow-Jones Industrial Average began the trading day on Monday strongly only to drift down south all day long. Then came the US Treasury report on the foreigner purchase of American Securities — stocks, treasuries, agency and corporate bonds. The report also includes foreigners' transaction with Americans on foreign stocks and bonds.

Net foreign purchase of US long-term securities rebounded from the low it sunk to in September but it was not high enough to erase the rising concern that foreigners are growing tired of funding the American current account deficit.

The net foreign purchase amounted to $41 billion — an increase of over 25 billion dollars from September. But, foreigners sold (net) US equities for the second straight month running. Even as foreign interest in US equities is waning (correctly), American interest in foreign equities is rising. This is as it should be.

However, this total purchase of US Securities is not adequate to offset the current account deficit that runs at a rate of 45-50 billion per month. In the past, foreign direct investment showed a net positive inflow into the US. Now, that too is negative.

In theory, a current account deficit can only be offset in the following three ways:

(a) Faster global growth relative to growth in the US;

(b) higher American domestic savings; and

The first two possibilities look remote. The US is growing faster than the rest of the world and American consumers do not seem to know how to spell `savings'. Recent revisions to American GDP data for the last 74 years show that the private savings rate has fallen more rapidly than thought, in recent years. Hence (c) appears to be the only viable option.

How much more upside left for the euro?

If the American dollar were to weaken, the obvious question is which currencies would strengthen? The euro had rallied all the way from a low of 0.82 in October 2000 to a high of 1.244 recently. Even if one were to accept that a peak in the euro would not be seen until it reached a level between 1.35-1.40, it must be acknowledged that the bulk of the gains for the euro against the dollar has been seen. The Guardian reported that the European Central Bank has no plans to intervene to stem the currency appreciation until the euro reached 1.35. It appears that the ECB views the appreciation of the euro to such a level as inevitable. What impact would it cause on the Eurozone economy has not been fully explained.

The Eurozone has practically no domestic demand. Its growth has been sustained by exports until 2001. In 2002, the currency began to recover and export growth began to suffer. Domestic demand shows signs of recovering now and that has partly to do with the fact that inflation had fallen, leading to a rise in real wages and a decline in short and long rates. Some of the leading Eurozone governments broke free of the straitjacket that the Fiscal and Stability Pact imposed on them, even if clumsily and budget deficits rose. Fast forward into 2004, it is not clear that many of these factors would endure. On its part, the European Central Bank — unhappy at the collapse of the pact that seemed to promise fiscal prudence but never really did so — has threatened to raise rates in 2004. That appears more like a churlish reaction than one dictated by economic logic. The strength of the currency should pressure the Central Bank to drop rates rather than to raise them. Governments have no more room left to use fiscal policy to support growth. Hence, the Eurozone recovery dynamics appears shaky and one that could easily be derailed by a strong currency and a sulking central bank. Sooner rather than later, euro strength would be unwelcome in Europe.

Asia's time to shoulder the dollar weakness is nearer

Where does that leave Asian currencies? Most of the East Asian central banks have continued to toe the line of their governments. They have repeatedly intervened in the currency markets to keep the value of their currencies down or to prevent them from appreciating too quickly. China and Japan have led the effort. Other smaller governments — Taiwan and Korea — have not lagged behind. According to revised data posted in the US Treasury Web site, as of December 15, 2003, India too has increased its holding of US Treasury assets from around $8.6 billion in January to around $13.5 billion in October.

In effect, Asian Governments have financed the US to buy their exports. It is the equivalent of vendor financing. It shows up as sales revenues in the short-term (it shows up as brisk GDP growth for nations) and the loans due are tallied as assets. However, when the vendors fail to pay, companies are forced to write down the value of their assets. Share prices fall. In the sovereign context, the US would not fail to pay. It would but the loss of asset value is more insidious. The US can erode the real value of foreigners' claim on US assets through inflation and through exchange rate losses. The former usually causes the latter but, sometimes, the latter can be achieved without necessarily setting off domestic inflation. The US is now engaged in this. It is debasing its currency through loose monetary policy and fiscal policy. Global and local excess capacity is not translating it into higher inflation for now. Instead, it is creating asset price bubbles in financial markets globally. Domestic inflation would cause interest rates to rise and bring the "house of cards'' American economy tumbling down. Hence, it is far easier to transfer wealth from foreign creditors to write down one's debt through exchange rate depreciation.

Possibly a nasty hangover awaits Asia

Aware of this danger, Asians are resisting their currency strength. Perversely, to do so, they are buying debt of an already highly indebted nation. That is also setting off domestic asset price increase in the near term in Asia. It all feels heady and pleasant now. The hangover would be quite painful.

When other countries (especially the Eurozone) start to protest, the Asian game would be finally up and Asia would be a lot poorer for having played it. They will be left holding American assets whose intrinsic value would be a lot less than they paid for. Asset price bubbles would burst and lower growth or recession would follow.

It may not necessarily happen in 2004. After all, it is an election year in the US and in many other countries. Politicians would be determined to maintain the feel-good factor and hence they would further fuel the bubble. So, it is hard to predict the climax. However, not to warn of this risk would be a danger.

Spoiling the party mood is not easy as it does not make one popular. However, as we near the end of 2003 when even the bottom ten stock markets in the world finished the year in the black, the words of Andy Xie, the Asian economist of Morgan Stanley, might prove prescient:

"Global financial markets, especially in Asia, are simply euphoric, in my view. We are probably witnessing another equity mania. Foreign funds have flowed rapidly into Asia, especially from the US. Initial public offerings are experiencing dotcom-like surges on their first day of trading. Investors are buying because they expect others to do the same. The `greater fool' game is at play again.

The loose Fed policy is the cause of it all, in my view. As the Fed is reviving the US economy without structural adjustment to cure the excesses, it has to keep its monetary policy looser and for longer than usual. The spillover into emerging markets is creating bubbles around the world, which may cause excesses and lay the foundations for future problems. When the Fed has to reverse its policy, we may see financial crises again." (Source: Morgan Stanley Global Economic Forum, December 19, 2003).

(The author is Director, Global Economics and Asset Allocation in Credit Suisse, Singapore. His views are personal. Feedback can be sent to nageswar@singnet.com.sg)

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