the world's biggest debtor is finding out what happens when all that money comes home: a credit crunch in the US and soaring growth in Asia, says Russell Napier of CLSA.
The US Federal Reserve is locked in a great battle with inflation – and thereby triggering an exodus of private foreign capital to Asia, writes CLSA strategist Russell Napier, in a recent report.
The effect is damaging for the US, but beneficial for Asia, he points out.
Investors are leaving because fighting inflation throttles economic activity and is thus bad for growth and asset prices in the US. “Inflation will be a stubborn presence of the next decade or more," writes Napier. "I believe that the great disinflationary following wind (of the last 13 years in the US) is abating, and that the Fed is running out of easy options."
The notion of capital flight is clearly disastrous for the US, which relies on $476 billion in foreign funds per quarter to drive its credit-driven economy, according to figures produced by CLSA.
The effect on investors in Asia would be favourable, however. Instead of the tough, deflationary environment of the last 15 years, the inflow of capital would bring monetary easing and less stringent conditions for nominal growth. Asset prices would rise, representing a great buying opportunity for investors.
Napier gives the scenario a twist, however: as private investors switch out of US assets, Asian central banks step in. Otherwise, the dollar becomes too weak, and harms Asian export-focused economies. This intervention will further encourage asset price inflation in Asia.
Both the private and public sectors of foreign countries are major players in funding the US. But the private sector is, unexpectedly, far more important. Just 17% of the $13.8 trillion in assets owned by foreigners in the US are owned by foreign central banks. As a proportion of US GDP, non-US central banks account for less than 1%. But private inflows account for almost 3%. Napier also calculates that 90% of Fed funds paper and repos (that is, short term financing instruments) and 40% of checkable deposits are owned by foreign private investors.
As the central banks step in, explains Napier, they generate domestic liquidity, setting the scene for further domestic asset price inflation. “Central bank support for the US dollar must accelerate, and with it (the growth of) non-US dollar money.”
There are really two inter-related factors stimulating Asian inflation, writes Napier. Central banks are being forced to substitute for private capital by buying US dollars; and the same private capital is returning to Asian countries looking for a home – a double whammy. Both actions are inflationary, in the sense that they add liquidity. Assets become scarce relative to that liquidity and rise in price.
The effect on domestic liquidity works likes this: Asian banks print their own currency in order to buy US dollars. Printing and selling their own currencies to buy dollars maintains (or even increases) the currency weakness central banks want – but it also increases the units of their own currency in circulation, fuelling domestic inflation. “Central banks will have to pick up the slack, shifting more and more funds into US dollars to prevent their currencies standing out as the strong global currency,” he writes. In other words, those enormous forex reserves in the region will grow, since they are not sufficient to prevent the decline of the US dollar.
There is a range of currency systems in Asia. Under the Hong Kong system, for example, any inflow of US dollars has to be matched by the creation of the exact equivalent amount of Hong Kong dollar. This also stimulates liquidity in the financial system, eventually feeding into the stock and property markets. Territories and countries with such tight pegs are especially prone to asset inflation, says Napier, including Hong Kong, Malaysia and Singapore.
If foreign private capital does leave the US, the effect will be serious, since it’s a major factor keeping interest rates down and the dollar strong. That will make US assets even less attractive to investors and encourage further a switch by the private sector out of the US.
What about the evidence private investors are turning against the US? Napier reckons the credit crunch is merely a sign that foreign investors have suddenly realised that they are unwise to hold so many US assets. “The rising price of US mortgage credit is really just an indication of the finite appetite of Asian/petrodollar savings for US dollar assets. Mortgage backed securities (MBS) were one dish too many.”
He adds the likely trigger was the collapse of the US dollar to an all-time low against a basket of currencies in February this year. At roughly the same time, the Chinese government was making it easier for private – not state – investors to buy foreign assets. Napier reckons the realisation that Chinese investors would not be interested in crumbling US assets encouraged Japanese investors to switch out of US assets as well.
The great unwinding of the US credit bubble has been predicted many times before. The idea that Asia will continue to prop up the US is a tempting one. But if local asset prices get too high, one must fear that even Asian central bankers will have to tighten their purse strings. Whether the US will survive the resulting Asian slowdown is probably the key question of the next decade.