Emerging Market Inflation: Brace for Turbulence, Part II
History shows that when the governments grow desperate to finance deficits, they get creative.
During WWII, the US government needed investors to buy an unprecedented amount of Treasury bonds. Commercial banks loaded up on Treasuries, which limited the amount of credit that could be granted to the private sector. It may have been the patriotic thing to do, but the real returns from war bonds were very poor. Napier said, “That’s the type of society [the US and the UK] had to run to sustain our government debt. And I’m suggesting to you that these are exactly the sorts of things we have to look out for in our future.”
Napier then summarized one of the conclusions that economists Carmen Reinhart and Ken Rogoff reached in their book This Time is Different. Financial crises morph into fiscal crises. But the thing that has yet to frighten investors is the next stage: financial suppression. This is the process of forcing private sector savings into public sector debt. Most investors will tell you that this is impossible. But Napier ticked off two potential tools the government could use to strong-arm investors into Treasuries:
1. Capital controls: An example of this comes from the UK in the 1970s. For most of this decade, the yield on UK government bonds was below inflation. The government wouldn’t let investors take money out of the country.
2. The “Buffett tax”: Political leaders would say, “We love capitalism. It is the best thing America has ever had. And we would really, really like to promote it. And the best way we can promote capitalism is to get all you capitalists to invest with a long-term holding period.” The idea would involve a 4% “transaction tax.” This effectively forces shareholders to engage more deeply with corporate executives, rather than trading shares aggressively. The authorities would say, “This is a wonderful thing because Warren Buffett does it. And if Buffett does it, it has to be good. So as of tomorrow, we’ll have a 4% ‘Buffett’ tax for the trading of all financial instruments except for government debt.”
Napier says the government can’t get away with inflating away its debt in a free market. If it were attempted in an aggressive fashion, yields would soar, making the process self-defeating. So the government will make the Treasury market a “less free” market. In other words, it will stack the deck in favor of Treasuries, to the detriment of all other financial assets.
But the authorities should know that this type of action would have huge consequences for global financial markets. A big driver of the global economic growth over the past three decades has been the liberalization of capital. Capital could easily migrate across borders to seek out the highest risk-adjusted returns. Today, the international flow of capital is just as important as the flow of international trade. Capital controls, if they get too onerous, could wind up leading to a 21st Century version of the Smoot-Hawley tariff.
As distasteful as it is, investors must pay close attention to politics and policy. “We’ve spent our professional careers analyzing supply and demand,” Napier explained. “Now, we must analyze supply, demand, and government. [During the 2008 financial crisis], the government didn’t like what supply and demand were doing; supply and demand were inducing deflation and creative destruction, so the government stopped it.”
Napier thinks that the catalyst to end the unsustainable status quo of the developing world financing US trade deficits will be inflation in the emerging markets. Emerging economies believe that they can export their way to prosperity, but they cannot. “40% of the world’s population has a great plan to get rich by selling stuff to 14% of the world’s population,” Napier observed. “That can work for several years, and it has – particularly if 14% of the world’s population is prepared to gear like crazy to buy all of this stuff.”
Now that US consumers are deleveraging, Asia’s mercantilist economic and currency policies aren’t as effective as they once were. These countries will not be focused on undervaluing their exchange rates forever. If aggressively debasing your currency were a guaranteed road to high growth and low inflation, paper money would have a much better reputation among historians.
The downside of this currency policy is that it can lead to inflation at the local level. Eventually, the supply of existing and new money will overwhelm the growth of productivity in China’s industrializing economy. These emerging markets will have to eventually allow currencies to rise to prevent inflation from getting out of control.
We’re seeing more examples of rising imported commodity prices hurting Chinese industry. The price of iron ore is soaring, thanks to China’s aggressive infrastructure investment and its suppressed currency. International iron ore markets are so tight that supply contracts are switching from yearly to quarterly pricing adjustments. The Financial Times this week reported on this evolution in the pricing of iron ore, which will feed through to higher steel prices: “The new price system will lift the cost of iron ore to Asian steelmakers to about $110-$120 a tonne during the April-June period, up between 80 and 100 per cent from the $60 level at which the 2009-10 annual contracts were settled.”
If China allowed its currency to appreciate, it would pay less to import iron ore and other crucial imports like oil. A strengthening Renminbi would increase demand for imported oil, which translates into more expensive oil for US consumers. A few years from now, Washington, DC may come to regret its push for China to appreciate its currency.
Napier also addressed the subject of Europe, Greece, and the Euro. He said, “The creation of a single currency is not an economic event, it’s a political event. Unfortunately, the ten guys in Europe who run this currency have all got Ph.D.s in economics.”
Napier then told us about his experience working in Hong Kong in 1998. That year, the French senate sent a delegation to Honk Kong to investigate the Asian financial crisis, and consult Napier about the evolving project that was the Euro.
The French delegation was convinced of the merits of establishing the Euro, because it would supposedly bring lasting peace along with economic integration. WWII was still a searing memory. The delegation asked whether the Euro would help “iron out the inefficiencies” across Europe. Napier replied, “The things you call ‘inefficiencies’ here in Hong Kong are the things in France you call ‘culture.’” He knew that currency integration without political integration wouldn’t work.
Napier fears that the political will to save the Euro is forcing “economic deflation” in Greece and the other spendthrift countries within the Eurozone. Those running the ECB may rightly note that wages in Greece might decline to achieve a healthier Eurozone equilibrium. But Napier believes that if too much harsh austerity is imposed on the Greek economy, the democracy in Greece might be destroyed in the process. Napier points out that democracies very rarely deflate. They instead devalue their currencies and push new money supply through the channels of commerce.
Napier is concerned that “the ECB will not change its mind on hard money until it destroys one of the democracies in Europe.” Then came the most shocking thing Napier said in his hour-long speech: a prominent Greek businessman confidently assured him that the United Nations will be running Greece by September. If so, this should keep fear in financial markets at healthy levels through this spring and summer. Greece is not resolved, yet the markets appear to believe so.
When asked for a forecast of the best potential asset class over the next decade, Napier’s replied: “A basket of Asian currencies.”