September 22, 2003
Nikkei Pummeling
By Brady Willett & Todd Alway

As intoxicating as it is to buy into the U.S. Government’s Party Line, one has to wonder if investors will sober up.

We are told on a weekly basis – by Treasury Secretary Snow, President Bush, and (depending on his mood) Fed Chairman Greenspan – that since the U.S. economy is on the mend that this bodes well for economic activity in 2004.  Backing up this rhetoric in recent weeks has been a flurry of positive (although not spectacular) economic reports, a series of economist’ GDP upgrades, a mostly rosy outlook from the IMF, and a global stock market rally (led by the Nasdaq). Suffice it to say, if you close your eyes and listen closely enough - to Snow, Bush, Greenspan, isolated government statistics, and Wall Street economists - it feels like the good times are here again.

Yet if times are really so good, why is the U.S. threatening a currency war, why are Americans still losing their jobs, and why is the U.S. government running record deficits? For some – meaning those inclined to argue that a ‘jobless’ or ‘job-loss’ recovery is not really a recovery at all – these negatives have been covered up by a temporary U.S. recovery that is most foul; a recovery fueled by desperate, unsustainable, and politically driven stimulus measures.

Quite frankly, it is difficult to argue with the ‘unsustainable’ recovery theme. After all, US second quarter GDP (+3.1%) was underpinned by a 13.7% increase in defense spending, a 13.6% jump in household home mortgage debt, a 10.9% jump in total household debt, and a 10.1% increase in total Federal government debt.  Say what you want about debt being a facilitator of growth, but if these debt growth rates were to continue there comes a point when debt will quickly become a burden.  Such is why speculation that interest rates will rise as foreign investment dries up is so important; without the combination of low interest rates and rising asset prices the U.S. debt machine could become bogged down.  Under such a nightmare scenario the U.S. economy would no longer be recovering, but sinking.

Will the Issuance of More Debt Spark a Sustainable Recovery?

Whether or not you believe that the U.S. can print enough dollar bills to spark a sustainable economic recovery before interest rates spike higher (and put a stop to such a recovery) is entirely subjective. To be sure, never before has the world been so dependent on a single engine of growth, and never before has so much U.S. debt been held in foreign hands.  Making sense of the potential scenarios is vexing, because although high debt/GDP can be problematic for smaller developing nations, if they become a problem for the U.S. (again, foreign capital investment flows) the global revival would be crippled without an alternative engine of growth. And although foreign governments are reluctant to force fiscal discipline on the U.S. due to the fact that this could concurrently amount to shooting themselves in the foot, one cannot help but wonder if there is a breaking point when foreign interest in U.S. debt wanes.  Indeed, one cannot help but wonder whether enough U.S. debt can be issued first without damaging the favorable interest rate environment the U.S. currently owns.

Nevertheless, the question that will undoubtedly be given more scrutiny in the weeks and months ahead, especially after what looks to be a developing debacle over the weekend in Dubai, is currency prices. What impact will currency prices have on U.S. interest rates? 

Currency Battleground

"We emphasize that more flexibility in exchange rates is desirable for major countries or economic areas to promote smooth and widespread adjustments in the international financial system, based on market mechanisms"  G7 communiqué. September 21, 2003

Notwithstanding Japan’s signature on the above communiqué, hours after its release Japanese vice finance minister for international affairs, Zembei Mizoguchi, had this to say:

“Japan's foreign exchange policy hasn't changed. Japan will continue to watch the foreign exchange market closely and take appropriate action when necessary.”

To be fair, Mr. Mizoguchi didn’t contradict the intentions of the G7 statement for no good reason. Rather, since the Nikkei got pummeled by 4.24% - its worst loss in more than two years – Mizoguchi’s had to say something to try and calm the markets.  Regardless, the story for Japan remains much the same: ‘Yen rises, exporting stocks  fall’.  Japan spent 9.03 trillion yen ($80.5 billion) in the first seven months of the year manipulating the price of the Yen, and investor’s are waiting for the next intervention to better understand how ‘freely’ Japan intends to allow the Yen to float.

Following the above G7 Statement – which was clearly aimed at Asian nations - China also joined the battle of words:

“A relatively stable renminbi (Yuan) exchange rate is not only beneficial to us, it's beneficial to the neighboring economies and it's beneficial to the whole world.”  
Li Ruogu, deputy governor of the People's Bank of China, Reuters.

Li Ruogu went on to say that China is planning on adopting a more flexible exchange rate, but concluded by saying “I can't give you a very clear cut timetable how long it will take”.

As entrancing as the Japan/China reaction was to the G7 statement, equally exciting were some of the comments from Treasury Secretary Snow on the topic of European Growth. Apparently the U.S. is so in need of finding an outlet for their soon to be competitively priced exports that Mr. Snow has taken to dictating other countries’ policy:

“Governments need to take actions ... to knock out blockages to faster growth. We also need, in the case of Europe, more accommodative monetary and fiscal policy.”

A Treasury spokesman quickly tried to fix Snow’s gaffe by arguing that Snow “was not calling for a change in monetary policy. He was simply underscoring the broad idea that you need good monetary, fiscal and regulatory policies to grow.” Nevertheless, and considering that ‘more accommodative monetary and fiscal policy’ is about as blunt a statement Snow could make, the European response was swift:

“Europe shouldn’t get it wrong.  Hoping bigger public deficits will help European economic growth ignores the risks of higher interest rates and very quickly higher taxes, and secondly it’s not producing growth”. Spanish Economic Minister Rodrigo Rato

Suffice it to say, Snow – who wasn’t “particularly concerned” with the dollar’s fall earlier this year – is turning out to be quite the aggressor.  One has to wonder whether by imploring others to follow the U.S. scheme for economic revival he wants to ensure the U.S. remains the attractive destination for foreign capital? After all, if every nation is running debt/GDP readings of 5%-6% at least the U.S. would not be alone…

Conclusion

The U.S. party line is simple: monetary and fiscal stimulus is saving, and will continue to save the day. So long as investors believe this line and are willing to ignore the dangers of debt creation there is nothing to talk about.  However, when global currency prices begin to heave, it is important to monitor the pace of the dollar’s decline. Too rapid a fall would carry with it grave consequences for the U.S. economy.

Snow has not had to comment on a falling dollar since early 2003.  His vague comments at the time set the stage for a dollar decline, and up until recently such a decline had not yet reached its second coming. As this second coming is upon us all eyes are glued on the Dollar, the Yen, the Yuan, the Pound, the Euro, the Loonie, etc.  All eyes are glued on how heated the battleground will become. Clearly Japan is suffering, if only in the near term, as the U.S. dollar adjusts lower, and as investor’s become less intoxicated by a currency that could prove toxic.

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