Global Economic Rebalancing

Later this week, President Obama and Treasury Secretary Timothy Geithner join other world leaders in a G-20 meeting in Seoul, South Korea.to address an agenda (http://tinyurl.com/24odlxl ) that includes "build on this less-than-robust recovery and further enhance international cooperation to generate strong, sustainable and balanced growth."  The world for some time now has grown in an unblanced way, with emerging countries like China enjoying above average savings and investment but below average consumption, while developed countries like the U.S. had high levels of consumption and low levels of savings and investment.

Certainly, a rebalancing must occur.  However if that rebalancing occurs too rapidly, the effects of reducing consumption in the U.S. could cause significant global economic problems including another dip into recession in the U.S.  Each country sees the manner and timing of this global rebalancing differently. 

China and the U.S. are the 2 most important players in this rebalancing.  In China consumption represents approximately 36% of GDP, while savings and investment is about 50% of GDP.  Consider the U.S. where consumer spending is about 70% of GDP while the savings rate is around 5%.  There is a neat diagram of components of GDP at http://www.moneychimp.com/articles/econ/gdp_diagram.htm.

It will take a long time to rebalance China and the U.S. to something significantly different than their present components of GDP.  Also, the rebalance will periodically happen in sudden and unsettling fashion.  As governments take different approaches to the rebalance we should all be hopeful that G-20 and other vehicles can help the world avoid problems as much as possible.

Quantitative Tightening

The emerging market economies of the world are taking tightening steps, in part to offset the effects of the U.S. Fed's "quantitative easing".  Yesterday Australia raised interest rates by 1/4% to 4.75%.  Australia is widely viewed as a proxy for China given their commodities exports to the Chinese.  India has also raised rates with their central bank rate for short-term funds now at 6.25%.

These countries are worried about capital flows from the U.S. (and other developed markets) being enhanced by the increased liquidity from the anticipated next step of  Fed quantitative easing.  As capital flows to the emerging markets it will cause inflationary increases in all goods.  Increased interest rates and increases in their currency relative to the U.S. are two ways these emerging economies can fight inflation.

All of this reminds us that the effects of any market or policy changes are global.  The key for investors is to keep this global point of view in mind as they make portfolio decisions.

Currency politics

Since the 2008 credit crisis we have seen central bankers all around the world reduce their policy rates and generally keep them low (remember the Federal Reserve has our fed funds rate presently at almost zero).  We have also seen "quantitative easing" where the central bank buys government bonds to push down long-term rates.  These low rates haven't generated the growth hoped for because businesses have been reluctant to borrow and banks have been tighter on their lending standards.

Also, there has been much fiscal stimulus in form of government spending, but such fiscal policy has its limits given the already high U.S. budget deficit.  Congress doesn't have much appetite for additional stimulus spending as voters are sending a message with every primary that they expect responsible decision making in Washington.

Now we are seeing currency considerations getting more attention.  The general idea is that every country wants its currency to go down to help growth by making exports cheaper to foreign customers with the stronger paper.  The U.S. continues to pressure China to allow its Yuan to strengthen.  Japan recently intervened with significant dollar purchases to try to slow yen appreciation versus the dollar.

It all gets very confusing, but one thing is clear.  If everyone tries to cheapen their currency relative to other countries then no one wins such a race to the bottom.

Currency exchange rates

Since the U.S. dollar is the reserve currency of the world, we as U.S. citizens tend to not think much about rates of exchange into other currencies.  Oil is priced in dollars, gold is quoted in dollars and there are many countries in the Caribbean and the Americas where prices at local shops and restaurants will be presented in dollars. 

We in the U.S. are beginning to understand that currency exchange rates matter greatly.  Currency is where the basic economics of any country come to rest.  Those countries with lower fiscal deficits (or even surpluses) and lower trade deficits will have currencies that grow stronger as compared to the weaker countries.  This means investments denominated in those strengthening currencies will also perform better, all other things being equal.

Sometimes governments and central bankers will effect policies intended to have a certain currency result.  For example, some countries may want a weaker currency to help stimulate exports or some may want a stronger currency to help attract and retain investment.  Eventually any such policies give way to the forces of the marketplace, if they are in any conflict with underlying economic facts.

Last Saturday China indicated it would permit its currency to float (within certain constraints) as opposed to their policies of the last 2 years of fixing the exchange rate to the dollar.  The market is responding today with increases in Chinese bonds and equities.   The Chinese currency situation helps point out the importance of giving serious consideration to the effect of currency exchange rates in the planning and implementation of any investment program.