Reverse Coupling, Inflation From The Core and Current Account Deficits

``Only as you do know yourself can your brain serve you as a sharp and efficient tool. Know your own failings, passions and prejudices so you can separate them from what you see.” -Bernard Baruch (1870-1965), Financer, Speculator Statesman and Presidential Adviser

Finger pointing on policymaking is easy to do. Yet many analysts seem to forget that the global monetary regime functions under the US dollar standard system which runs on the fractional banking reserve system platform, whose underlying principle basically stems from leverage (reserves as a fraction of deposits).

Because the logistical agencies of the US monetary system have presently been undergoing severe deleveraging pressure, this has been spilling over into the real economy and equally reflected in the underlying asset prices which is likewise being felt worldwide see figure 5.

Figure 5: The Economist: Sinking Global Equity Markets

The Economist cites Standard & Poor’s estimates of the losses for the month June as having wiped out $3 trillion in global capitalization, mostly due to the horrific 10% losses in emerging markets.

And as we have been saying along-it’s all not about oil but a combination of factors from the softening economic growth, deteriorating profit outlook, rising interest rates and higher incidences of consumer goods inflation.

“Reverse Coupling”

Thus given these aggravating circumstances, the US Federal Reserves policies have been designed to keep interest rates at negative real levels considering the staggering amount of leverage built onto the financial system under the abovementioned environment.

And as we discussed last week in Global Financial Markets: US Sneezes, World Catches Cold!, this evidently could be the continuing policy thrust since authorities have in their radar screen the magnified view of heightened systemic deflationary risk. Apparently the central bank of central banks the Bank of International Settlements (BIS), have echoed the same risk and sees “inflation is a more immediate threat than deflation” (The Economist).

Hence, the Bernanke-Paulson tandem appear to be banking on a lower dollar and lever its economy through exports by turbocharging the economic growth to emerging markets via the transmission mechanism of US dollar linked monetary regimes and the expansion of the current account deficit. Essentially lower US interest rates have been stimulating emerging markets.

This excerpt from the commentary of Fred Bergsten, director of the Peterson Institute for International Economics at the Financial Times appears to corroborate our view,

``The improved US trade performance of the past two years is due partly to the substantial, if lagged, restoration of the country’s price competitiveness as the dollar declined by a trade-weighted average of 25-30 per cent since early 2002, reversing most of its excessive run-up during the previous seven years that produced unsustainable current account deficits exceeding 6 per cent of GDP. Equally important, however, is the continued robust growth of the world economy. Every percentage point by which the rest of the world expands domestic demand faster than internal growth in the US produces gains of about $50bn (€32bn, £25bn) for the US external balance. Weighted by US exports, foreign growth exceeded US growth by about 2 percentage points in 2007 and will do so by an average of about 1.5 points this year and next as decoupling persists. Taken together, these currency and comparative growth factors have already improved the real US trade balance, and hence GDP, by almost $150bn since 2006, with gains of another $150bn or so likely through 2009. (The nominal US trade and current account deficits will not improve as much because of the sharp rise in the price of oil imports.)

``The Organisation for Economic Co-operation and Development’s new Economic Outlook projects that more than 80 per cent of all US growth in 2008-09 will derive from continued strengthening of its external position. Exports have been climbing at an annual rate of about 8 per cent, at least six times as fast as imports. Unless domestic demand takes an unexpected further fall in the quarters ahead, reverse coupling of the global economy will thus have prevented the US recession that was so widely predicted and feared.”

So what you have is the US trying to utilize emerging markets to cushion its economic decline hoping that the global inflationary process from emerging markets would keep the US-UK deflationary forces at bay. However, the unexpected repercussion of this exercise is the risk of emerging markets to overheat and exacerbate the “inflation” in commodity prices particularly of food and energy.

An example, if you think record levels of oil prices have climbed enough to “destroy demand” in emerging markets, it’s definitely not showing yet. Car sales in June remained robust in India (+8%) Brazil (+30%), Korea (+9.2%), New Zealand (+5.5%) and Australia (+1.4%).

Inflation From The Core

If markets have been reappraising financial assets through policy actions shouldn’t it be the US that needs to be penalized more for its influential grip over other economies?

Yes, if you ask Doug Noland in his Credit Bubble Bulletin (highilight), ``I find it rather incredible that U.S. and European policymakers are increasingly pointing blame and calling upon their emerging economy cohorts to aggressively combat inflation. With the U.S. today stuck with intractable $700bn Current Account Deficits and European Credit systems still churning out double-digit Credit growth, the Periphery is not the root cause of today’s escalating global inflationary pressures. The global Credit system has run amuck, a process that evolved from years of Credit and speculative excess generated by, and tolerated at, the Core. It is today unreasonable to expect the Chinese or Asians generally to bring their booming economies to their respective knees to fight global inflation anymore than we can expect the Fed to tighten the economic screws to the point of balancing our Current Account and punishing the destabilizing speculators.

``Today’s inflationary dynamics have been developing for decades. Only discipline and stability at the Core of the global financial system would have stemmed the strong inflationary bias of contemporary fiat “money” and Credit. But the Core was instead egregiously undisciplined and unstable, setting the stage for the type of runaway inflation we are now experiencing. The Core came to love and rationalize asset inflation and consumption. The Periphery was forced along for the ride and happy to oblige.”

Of course, to a lesser degree the US dollar linked monetary regimes in emerging markets should bear some of these responsibilities for tolerating the US policy induced global inflationary environment.

Emerging Market Turmoil: From Carry Trade To Current Account Deficits?

On the other hand, perhaps the turmoil in today’s marketplace exceptionally seen in some emerging markets could be as a result of the shifting focus of the markets as the distortions from the carry trade in the face of heightened risk aversion fades while the market prices on the state of current account balances as suggested by The Economist see figure 6.

Figure 6: Economist: Current Account Balances Reshaping Asset Pricing In Emerging Markets?

From the Economist, ``ACCORDING to economic textbooks, the currencies of economies with large current-account deficits should depreciate relative to those of countries with surpluses. This will stimulate their exports and curb imports, thereby helping to slim the trade gaps…Increased concern about current-account deficits is also causing investors to discriminate much more between emerging markets. A popular argument in recent years has been that developing economies are less risky because, unlike a decade ago, they are no longer dependent on foreign capital. It is true that emerging economies are forecast to have a combined current-account surplus of more than $800 billion this year, but this is more than accounted for by China, Russia and the Gulf oil exporters. In fact over half of the 25 biggest emerging economies now have deficits. South Korea is running a deficit after a decade of surpluses. Brazil has also moved back into the red, despite record high prices for its commodity exports. Others such as India, South Africa and Turkey have had external deficits for many years.”

While some of the performances in emerging markets appear to affirm such theory, it hasn’t been linear. For instance, the Philippines have severely underperformed South Africa and Turkey both of which have had deficits even during the heydays of the markets.

The Philippines isn’t about to turn into a current account deficit yet though. Current account surplus is expected to narrow to $4.2 billion from $6.9 billion (Reuters) despite the expected broadening of the trade deficit to about $11 billion-highest in 9 years on higher fuel and rice imports and weaker exports. So the recent underperformance of the Philippine asset class does not tally will or could be fully explained by this theory.

Thus, if we read by the activities in the market, such expectations are likely to be wrong (we will turn steeply into a deficit) or the market is inaccurately priced (market is wrong).

For the Philippine setting my conjecture is that the recent bear market has been exacerbated by internecine politicking see Philippine Politics: The Nationalist Hysteria Over Energy Issues.