The Plaza Accord still stands as the best-known multi-national effort to manipulate foreign-exchange markets.

In 1985, the finance ministers of the world’s five most important economies met in the US to solve a problem. Representing France, Japan, the UK, the US and West Germany, they gathered at the Plaza Hotel in New York and their solution become known as the Plaza Accord.

Their concern? An overvalued US dollar, which had nearly doubled on a trade-weighted basis over the preceding five years, largely because the Federal Reserve had raised the cash rate to quell inflation.[1] Their problem? Much of US industry including agriculture was reacting to its loss of competitiveness by lobbying politicians in Washington for tariff protection, while the US was worried that its current-account deficit was swelling. Their answer? The Reagan White House pursued an agreement with these countries to undermine the greenback against the Deutsche mark and yen.

The Plaza Accord still stands as the best-known multi-national effort to manipulate foreign-exchange markets. Perhaps an agreement like this is needed today because the US dollar is soaring again. In fact, the yen is weaker now than it was in 1985 on a real-effective (inflation adjusted) trade-weighted basis – falling to 74.81 on this measure in September this year, its lowest since 1982.[2] But there’s no sign of a new pact, even amid talk of so-called currency wars. Investors can thus expect the greenback to add to its 6% surge since July that has seen it surpass four-year highs when judged on the Federal Reserve’s measure of the US dollar’s strength against widely traded currencies.[3]

It’s easy to explain the US dollar’s spurt– on December 1 it was trading at $1.25 against the euro, $1.56 against the UK pound and 119 yen, a gain of 8%, 4% and 15% respectively from a year earlier. The main driver is that the US economy’s faster growth has boosted expectations that the Federal Reserve will tighten monetary policy by raising the cash rate, at a time when policymakers in the struggling eurozone and Japanese economies are pursuing more promiscuous monetary policies. Investors propel the US dollar when they shift money from euro- or yen-denominated assets into US-dollar securities offering higher returns. It’s likely that the interest-rate differential in favour of US securities will be even larger in two years’ time than it is today. Another boost for the greenback is that the shale revolution has slashed the US current-account deficit to about 2% of output from triple that in 2006. This largely removes a net drag on the demand for the US dollar from the combined activities of importers and exporters. A third propulsion is the haven status of US securities in uncertain times. Higher inflation in the US, though, in theory undermines the greenback but the differential is almost too small to worry about – US consumer prices are rising at an annual rate of 1.3% versus 0.4% in the eurozone and 0.9% (for core inflation) in Japan.

The new era of the mighty US dollar will no doubt prove doubt-edged to the US and world economies. There are advantages for sure, especially for the US, eurozone and Japanese economies. But there are some drawbacks generally tied to rapid surges in the US dollar that investors need to be wary of; namely, pitfalls for the US economy, potential damage to emerging markets with currencies linked, even loosely, in some way to the US dollar and instability tied to the cementing of the US dollar as the world’s premier reserve currency.

Forex markets are notoriously difficult to predict so perhaps the US dollar’s climb will peak soon and all the analysis about what a strong US dollar means will be for nothing. The consequences of currency-induced trade and inflation effects often prove exaggerated because businesses can take cuts in margins and pocket the fatter margins rather than pass onto consumers the full movement in exchange rates. Changes in currency values also have less influence on profits when so much production is based outside developed countries. The US dollar is well short of its 1985 peak when judged against major traded currencies (i.e. not on a trade-weighted basis) so its strength is not the problem it has been in the past.[4] Any attempt at a Plaza-like accord would be harder these days because forex turnover is estimated to be 10 times what it was in 1985.[5] A surging euro would probably be a greater concern for the global economy, anyway, for a strong euro could be enough to send the eurozone into a damaging deflationary spiral. But it’s more likely that investors will focus on what a stronger US dollar means, for the greenback’s surge is well supported by fundamentals.

Plus and minuses

Investors have much to be thankful for if the US dollar keeps rising, even if a sturdier US dollar crimps the US-dollar-value of foreign earnings for S&P 500 companies. A major beneficiary is likely to be the US economy. A mighty greenback could attract so much capital to US-dollar-denominated securities (including US stocks) that long-term interest rates will stay lower than otherwise, even if the Fed is lifting the cash rate. This would mean the Fed has less chance of crunching the US economy as it boosts the cash rate from close to zero to more neutral levels. A stronger US dollar means the Fed would worry less about inflation, anyway, for lower import prices suppress consumer inflation. A rising US currency could even lift the confidence of US consumers, who are enjoying greater spending power due to a drop in the prices of imports and commodities, while some of the capital inflow would be in the form of growth-enhancing investment.

Another advantage is that a higher US dollar helps policymakers in Europe and Japan avoid deflation, their most urgent priority in terms of nurturing the longer-term health of their economies. The sliding euro and dropping yen boost inflation by driving up the prices of imports in Europe and Japan. Another plus is that the higher US dollar helps Japan and Europe trade their way out of their woes by boosting their export competitiveness and lowering appetite for costlier imports. The higher US dollar could thus be doing the world a favour by aiding two large sick economies and the world’s largest economy.

Investors, however, need to be aware of some of the possible drawbacks of a burlier US dollar. The stronger currency could attract so much capital to the US that longer-term US bond yields stay too low. Unconstrained US domestic demand may then re-widen the US current-account deficit and rekindle inflation as a medium-term threat. Thus a situation could arise where a stronger US dollar leads to talk that the Fed will need to raise rates faster than otherwise to stymie inflation and avoid the trade and capital-flow imbalances that bedevilled the world leading up to the global financial crisis of 2008. The opposite, however, could happen, too, when it comes to the Fed’s goal of maintaining price stability. A stronger US dollar could see the US struggle to avoid the deflation taking hold in its trading partners, if the US economy isn’t growing fast enough to generate enough inflation to counter the drop in import prices. If this were to happen, investors may well start to hear talk of another Fed quantitative-easing program, no doubt dubbed QE4.

Then there’s the drag on US exports. Congress, at the prodding of business and unions, could see the falling euro and yen as a currency war that the US is losing. It could take retaliatory steps against imports in consequence. A US dollar at, say, 140 yen could stir protectionism in the US, especially as major US export markets are in such limp condition that the appetite for US goods is curbed anyway.

Dilemmas for decision-makers

Swings on financial markets breed uncertainty and can often lead to global instability, especially when it is the world’s reserve currency that is gyrating. Emerging countries generally tie their currencies to the US dollar, so their trade positions deteriorate as the US dollar soars. China, among other countries, could do without the brake on growth a stronger US dollar threatens via reduced exports as it battles a financial crisis. It at least enjoys some of the benefits from a drop in the price of commodities in US dollars, unlike commodity-exporting emerging countries or Australia. A rising US dollar undermines commodities priced in US dollars because it makes them less affordable in other currencies.

Another problem for the world – and the US – of a rising US dollar is that it cements the greenback’s role as the world’s premier reserve currency, which is a currency that is widely held by governments and institutions among their forex reserves because it is seen as a store of value. While this enhanced status carries the advantages for the US that it reduces interest rates, transaction costs and forex risks and generates seigniorage profits (gains made when the cost of creating money is less than the face value of the money and that new money is used to buy government bonds and thus lower interest rates), it places a dilemma in front of US policymakers. They can either preserve the value of a currency by keeping monetary policy tight enough to keep inflation low or they can supply the extra money the world demands and be troubled by inflation and current-account deficits. US policymakers typically opt for the latter path.

Another problem for the rest of the world is that their banks mostly rely on borrowing in US dollars while their borrowers, in turn, are repaying them in local currency. This currency mismatch, where bank US-dollar liabilities rise with the climbing US dollar, could at the margin lead to instability in the financial sector. The Bank of International Settlements warned in a research paper in 2014 that exchange rates are a key influence on financial stability because of the extent to which local banks borrow in US dollars from global banks, which, in turn, rely on the US money markets for funding. “The pre-eminent role of the US dollar as the currency used to denominate debt contracts” explains why US “dollar appreciation constitutes a tightening of global financial conditions and why financial crises are associated with dollar shortages”, the bank says.[6] Emerging economies with large US-dollar-denominated debts battling slowdowns will not welcome a stronger US currency and the associated tightening of US monetary policy. The Bank of International Settlements estimates cross-border loans to emerging countries reached US$3.1 trillion in mid-2014.[7]

The most appropriate way for policymakers to react to the stronger US dollar, given these concerns? The best thing authorities can do is pursue policies that revive the eurozone and the Japanese economies, for a tighter outlook for monetary policy in these economies would reduce the allure of US-denominated securities. Other than that, they probably should do little if anything. For if officials were to meddle in forex markets, they could trigger unintended consequences. There is no better example of how intervention carries side effects than the Plaza Accord of 29 years ago. It was such a success in terms of lowering the US dollar over the following two years that countries hastily agreed to halt the greenback’s plunge when they signed the so-called Louvre Accord in 1987 – yes, the meeting was held in the Louvre in Paris. But this new pact was too late to stop wider damage, according to many. They claim that the yen’s ascension from 1985 hobbled Japanese exports so much that Tokyo was forced to implement the fiscal and monetary stimulus that led to the poisonous asset bubbles of the late 1980s. The ghost of these bubbles is hovering over the stronger US dollar even today.

Financial information comes from Bloomberg unless stated otherwise.

by Michael Collins, Investment Commentator at Fidelity

The post The mighty US dollar appeared first on AdviserVoice.

The end of (another) globalisation?

The world’s first great era of globalisation took place after the US emerged from civil war in 1865, from when the US and the more-dominant UK imposed capitalist principles on the world. The pair’s dominance of transatlantic finance was built on free trade, the unhindered flow of capital, the exploitation of the UK’s colonies and the fledging rise of mass consumption.

The internationalisation of trade and finance out of “The City” in London would never have occurred without concurrent leaps in transport, manufacturing and communications such as the laying of the first telegraph cable across the Atlantic in 1866 and the invention of the phone.

The second great modern epoch of globalisation has taken place over the past three decades. The true globalisation of finance, trade, economics, politics and even culture has been so ferocious and of such magnitude that global forces have swamped the national state, which had proved stronger in the first era at preserving national identity and control over the means of production. This era, too, was Anglo-American led, though, this time the US dominated from Wall Street and Washington. The epoch was tied to advances in technology that enabled instant and cheaper communications. In this era, globalisation became synonymous with global financial markets, where capital of vague ownership is directed to wherever it can earn the highest return commensurate with risk.

Both eras of globalisation, which can be defined as an increase in the flow of trade, investment, people and ideas around the world, led to massive change. Living standards leapt – the World Bank estimates the number of people living in extreme poverty halved between 1990 and 2011 to around one billion people, or 14.5% of the world’s population.[1]Countries became more interdependent. International law and global bodies, movements, conventions and even sporting events were created. Companies morphed into multinationals then became global enterprises.

The first era of globalisation ended with World War 1. Historians could well decide that the second epoch fizzled out this decade. For the phenomenon appears to have peaked for now. Sanctions are inhibiting international trade growth, which expanded at a slower pace than global GDP in the year to August this year.[2] Countries from Brazil to Iceland are restricting capital flows to protect their economies. More investment is staying in developed countries because wages rises are so reducing the competitive advantage of the emerging world that companies are “reshoring” rather than offshoring production. A popular backlash has stirred in developed countries against economic migration. The global financial crisis has discredited the ideology behind globalisation, especially the liberal democratic political model it promoted, while the internet’s ability to fracture consensus politics is boosting political barriers to globalisation. The fraying of the internet in some parts of the world is inhibiting the flow of ideas around the globe.

Foreign investment and international trade will still go on, of course, so globalisation is not dead. Nearly half of foreign investment goes to emerging countries while the growth of countries such as Brazil, China and India will boost trade over time. Sought-after trade agreements between Europe and the US and across Asia Pacific, if clinched, would signify the biggest liberalisation in global trade in more than a generation, even if a global agreement on trade would be better for the world economy. Global investors will still be ruthless and pitiless when assessing investment options. The computer, the internet and the digital world won’t be uninvented. Social media is a global rather than local phenomenon as is English, which allow the spread of ideas. But these points are all moot in a way for globalisation has triggered a political backlash that has put it in retreat.

Identity trumps ideology

If there was one action of recent times that signalled the climax of globalisation it was the imposition this year of economic sanctions against Russia to punish Moscow for its support of separatists in Ukraine and its annexation of Crimea. For these sanctions following the fighting over Ukraine exploded one of the great justifications of globalisation. This was the notion that the greater prosperity resulting from greater interdependence among countries would prevent wars. This optimism was encapsulated in Thomas Friedman’s sort-of tongue-in-cheek “Golden Arches theory of conflict prevention” of 1996.[3] This Panglossian “theory” claimed that countries that were integrated enough into the global system to have attracted McDonald’s restaurants have such mutual interests that they would never go to war against each other. It was as though self-interest, spheres of influence, the will to dominate, chauvinistic nationalism and ancient enmities and fears were concepts from the Middle Ages.

Russia’s apparent indifference to western sanctions and its willingness to retaliate show otherwise; that the politics of national self interest and honour can easily trump the political cost of withdrawing from mutually advantageous trade. China displayed the same contempt to doing business with Japan during recent sparring on the China Seas and could easily end up in a similar feud with the US as their interests are bound to clash. In response to these actions, demands for self-sufficiency are stirring within countries or regions that are vulnerable to foreign powers, as much of Europe is, say, when it comes to Russia’s natural gas. Defence, after all, is one of the most basic arguments for protecting domestic production, as Australians heard in September this year during a debate about buying submarines from Japan.

While conflicts are creating schisms in the global status quo, a bigger challenge to globalisation is the political backlash it has engendered over its three-decade advancement. Massive change means huge disruptions that have winners and losers. Foremost among these side effects is rising inequality and the consequent shift in political power away from the masses to those with money. Many people within wealthy countries feel left behind, even if they are materially ahead, while poorer countries are no longer catching up as easily with richer ones. These and other faults of globalisation were magnified to such an extent by the global financial crisis that the free-market ideology behind the concept has been discredited as a way to generate long-term prosperity. The collapse of faith in free markets and its associated political system of liberal democracy is giving rise to populist and authoritarian politics.

The resultant rise of the politics of identity, which mingles protest against the elites with populism, jingoism and aggressive nationalism, is destabilising governing in much of the world. Identity politics, as opposed to the politics of ideology, appears to be advancing in key countries as demagogues exploit economic insecurity. In Europe, especially, nationalist parties have become a force as skilled populists exploit the disappointment in the elite who strove to unite Europe on a promise of greater prosperity. Extremist parties from the left and right are winning voters by pledging to re-nationalise industries, quit the euro, shut out foreign bond speculators and block cheap foreign (Chinese) imports. The rise of insurgent parties makes it difficult to achieve the integration Europe needs to surmount its crisis. The recent solid performance of the anti-euro, right-wing Alternative for Germany party in three state elections, for example, makes it harder for German Chancellor Angela Merkel to steer a centre course, ease the austerity straightjacket on neighbours or approve quantitative easing by the European Central Bank.

Of particular note in Europe is the political backlash against the free flow of people within the EU. The EU’s open borders were always a long-term political risk so the unwinding of this key tenet of globalisation is no surprise in one sense. But while it might be expected that fringe parties in depressed bailed-out southern countries such as Greece would turn on immigrants, the backlash is extending to prosperous northern countries. Angst is building in countries such as France, Germany, the Netherlands and the UK about the inability of governments to limit immigration from other EU members, as populists exploit the resentment that their nationals feel towards these newcomers over their eligibility for welfare payments and their ability to grab jobs from locals. In a referendum in February this year in Switzerland, which is not part of the EU but is entwined into the 28-member bloc, Swiss voters approved immigration quotas against fellow Europeans even though the country’s elite opposed the measure. In the EU elections in April, the xenophobic UK Independence Party and France’s National Front came first in their countries, while similar fringe parties in other countries scored their best-ever votes. In September, in progressive Sweden, the neo-Nazi and anti-immigration Sweden Democrats party came third in national elections with 13% of the vote, the same month that France’s National Front won its first-ever seats in upper house elections.

While nationalist parties are well short of holding office in the EU part of Europe, those in power elsewhere are less shy about pushing a jingoism that clashes with globalisation. China’s ideologically devoid rulers are stoking nationalism to divert the masses from the country’s economic crisis. Japan’s government is appealing to nationalism as a way to counter China’s greater muscle. Hungary, Turkey and, obviously, Russia are other countries where rulers are uniting people against abstract forces and other grievances based on identity rather than an ideology. One destabilising byproduct of national identity politics is that it tends to fan secessionist movements, especially when nationalities absorbed into countries such as the Scots, China’s Tibetans and Uighurs, the Italians of Tyrol, the Basques along the Franco-Spanish border or the Catalonians in Spain have such distinctive cultural, social, ethnic and political identities.

The politics of identity have gained hold because there appear to be few ideological alternatives to the discredited free-market liberal democratic system since communism and socialism collapsed as viable options. The other reason is that the relative military decline of the US and UK since the Iraq war of 2003 and their relative economic decline since the global financial crisis of 2008 have damaged the credibility of globalism’s biggest advocates. After all, the recent era of globalisation was born of the Thatcherism and Reaganism that took hold in the UK and US respectively from the late 1970s.

The irony of the internet

Globalism would never have happened without technological advancement culminating in the invention of internet and such like. Innovations from better container ships to instantaneous communications helped trade and investment flourish and capital swish around the world in a flash. No less important was the advocacy of globalisation by a respected elite, who were able to present their message across a globalising media, via new Bloomberg and Reuters screens or the greater worldwide reach of US and UK publications and broadcasters. These forces, too, are peaking.

The biggest blow to advancements in technology that would enhance globalisation may well have come from the revelations this year from Edward Snowden that the US government spies on allies. These disclosures prompted victim governments such as Brazil to impose country-level restrictions on servers regarding data protection, which in essence fragments the fundamental design underpinning the web. US internet-based powerhouses are facing a legal, bureaucratic and popular backlash in Europe for seemingly acquiescing to Washington’s surveillance and, it must be admitted, just for being too successful. Google, for instance, is under investigation in Europe due to competitor complaints that it exploits the dominance of its Android mobile operating system. Uber faces a ban in Germany because taxi companies said it was ignoring rules on other taxi services. Amazon confronts legal hurdles in France to deliver free books after French bookshops complained. In Europe, the court-backed “right to be forgotten” now forces the Googles of the world to comply with requests to remove links to old information. The ease with which hackers appear to operate is prompting greater government scrutiny of the web that can only add to the cost and ease of, say, Apple operating its iCloud service. Autocratic countries such as China and Russia are taking control of local digital platforms and developing local-use-only technology because they are, well, oppressive. Many trends point to global communications being less integrated than they were.

Technology, by and large, is a neutral force; it can do good or otherwise. Ultimately technology helped drive globalisation because a consensus emerged among the elite that argued the case for free-market reforms. In Australia, for instance, some of the biggest decisions that globalised the economy (floating the Australian dollar in 1983 and reducing protection during the 1980s) were taken by the Left side of politics with the agreement of the Right. The internet unwittingly now works against the emergence of an elite consensus in two ways.

The first is that people holding extreme opinions can find like-minded thinkers more easily. Thus they can more readily form the mass needed to kick up a noise to fracture political consensus on abstract issues such as economic reform. The other is the slow collapse of the print media, which via its front pages sets the agenda for electronic media. The change in habit from reading newspapers, and possible disappearance of many of them before too long, to viewing news online, where stories change in order all the time, diffuses the power of the media to help form a consensus for abstract ideas or reforms (among other consequences).

In a way globalisation overreached and is being pulled back so its consequences can be digested. Its retreat will probably go too far. Economies are likely to stagnate without the impetus to reform. A more certain forecast is that nationalistic populists will prove charlatans if they gain power. It’s almost predictable that in coming decades there will another spurt of globalisation, in reaction to the backlash against globalisation now.

by Michael Collins, Investment Commentator at Fidelity

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Financial information: comes from Bloomberg unless stated otherwise.

Important information: References to specific securities should not be taken as recommendations.

The post Globalisation has peaked appeared first on AdviserVoice.

Is autocracy built on the misconception that tyranny does away with some of the perceived economic shortfalls of liberal democracy?

Autocratic capitalism as an economic development model has won converts in recent years, especially as the increase in wealth achieved by China’s dictatorship swamps that of, say, India’s system of democratic capitalism.

The developed world’s financial crisis, political dysfunction in the US and the inability of the eurozone to formulate solutions for its crisis add to those losing faith in liberal capitalism as a path for economic advancement.

The case for the economic prowess of autocracy, when power resides in one person or one party, is built on the misconception that tyranny does away with some of the perceived shortfalls of liberal democracy. There are many myths behind the case for autocracy but two stand out when analysing China’s economic risks. The first is that dictators don’t have to bow to public opinion as do elected lawmakers. Tyrants can supposedly implement whatever changes are needed to spur economies, no matter how unpopular they are. Despots, in reality, are rightly paranoid for they survive by keeping people either happy or frightened. Either way, they are attuned to the popular mood for they have more to lose if their people become miserable and less terrified. In democracies, politicians beaten at the polls trudge unwillingly into comfortable retirement and their parties generally regain power within a couple of elections. Few dictators, however, die of old age in their palaces, metaphorically speaking. Mao Zedong, Stalin, Haiti’s “Papa Doc” Duvalier, Spain’s Franco, Syria’s Hafez al-Assad and North Korea’s Kim Il-sung and his son Kim Jong-il died this way, due largely to the effectiveness of their brutality as did China’s more humane though still purge-prone Deng Xiaoping. The rule of most tyrants, though, is usually cut short, even if they are ruthless (and sometimes happens via foreign invasion). Their chaotic ends include suicide (Hitler), firing squad (Ceau?escu of Romania), shot soon after capture (Mussolini and Libya’s Gaddafi), hanged (Saddam Hussein), jail (Noriega of Panama), exile (Cambodia’s Pol Pot, Haiti’s “Baby Doc” Duvalier, Iran’s last Shah, Paraguay’s Stroessner, Uganda’s Idi Amin and Zaire’s Mobutu) and house arrest amid legal harassment (Chile’s Pinochet and Egypt’s Mubarak).

The second myth spouted by autocracy advocates that is relevant when looking at China’s risks is that supposedly enlightened tyrants can enforce their will – as in, they don’t have a judiciary, free media, interest groups, trade unions, constitutions, state governments, opposition parties, independent MPs holding the balance of power, upper houses or even coalition partners blocking their policies. Only dictators with total control over all facets of society, such as Hitler, Mao, Stalin and North Korea’s Kims achieved, can boast such supreme enforcement of will. Most authoritarian systems are insecure dictators sitting atop a balance of power between fiefdoms that can generally block changes that will hurt their interests. Within a one-party state, most of these fiefdoms reside within the party and the major organs of power, such as the army, it controls.

These two myths about autocratic (or state or illiberal) capitalism are being exposed as such in China these days. While Beijing talks about reforms, rebalancing and other applauded intentions, the reality is that the government is failing to fully pursue the steps it advocates. Fears of a public backlash and countermoves by lower levels of government are nullifying much of any advances China’s central government has taken to diffuse the damage wrought by the excessive lending that insulated China from the global financial crisis.

This is not to underplay the economic achievements of autocratic societies in recent times. These regimes take many forms so it can be an oversimplification to generalise about countries such as Bolivia, China, Ecuador, Hungary, Russia, Singapore and Turkey that use different blends of coercion, populism, nationalism and centralism to rule. Autocratic regimes can change over time too. China’s dictatorship has moved from a Communist to a capitalist economic model since 1978 and has eased some political restrictions, all the while holding onto total political power. China’s government has allowed China’s economic growth to cool below double-digits so it has some credibility when it says it’s righting its economy. Perhaps President Xi Jinping will engineer such power that he can enforce his will throughout the country – he’s already being described as the most powerful and popular leader China has had for decades.[1]  Democratic systems are not perfect systems, either. While China has other political risks to monitor, especially the crackdown on corruption aimed at the highest echelons of the Communist Party, there’s little doubt that China’s autocratic model carries flaws that are adding to China’s longer-term economic risks.

How will the masses react?

China’s leaders have acknowledged in recent years that their investment-driven, construction-biased and debt-fuelled economic model that relies on low-cost and low-valued-added exports is in crisis. They accept that the economy’s distortions, financial weaknesses and inequalities this model spits out means the country needs to upgrade to a consumption-driven, services-led value-add-industrial prototype that will produce “slower but safer” growth, in the words of the IMF.[2]

Beijing, however, for all the good moves it has made, is failing to swiftly reform its economy for it worries that growth might slow too much and lead to excessive unemployment. It is sacrificing steps that would generate longer-term stability in favour of moves that will fan immediate growth. The regime has declared a 7.5% growth target for 2014 and has succumbed to the temptation of more stimulus to ensure the economy attains this goal. Recent plans to spur the economy include more fiscal stimulus including extra money for infrastructure, more lending for rural poor, pruning bank reserve requirements and reduced taxes for small and medium-sized businesses. A Bloomberg gauge that weights average loan growth, real interest rates and China’s real effective exchange rate shows that China loosened monetary conditions in the second quarter at the fastest pace in two years.[3] The central People’s Bank of China, which is just another arm of the Finance Ministry rather than being “independent”, is loosening monetary policy to help the economy. Over 2014, the central bank has steered loans to public housing and infrastructure. It recently gave about 1 trillion yuan (US$180 billion) to China Development Bank to stimulate lending[4] and injected 500 billion yuan into the country’s five largest banks to prop up lending.[5]

The risk is that more fiscal and monetary stimulus will add to the vulnerabilities and inefficiencies of China’s economy and make any reckoning more shattering. The IMF warns Beijing is “increasing the risk of a disorderly adjustment” – its jargon for crisis – if it to relies on government intervention to underpin growth and fails to rejig its economy and haul in the credit boom that has boosted total debt from 130% of GDP in 2008 to 207% of output now.[6] Yet the recent slowing in industrial production, investment, retail sales and sentiment and the slump in property construction, sales and prices is only likely to compel Beijing to do more prodding (possibly too via a devaluation of the yuan).

China’s rulers feel pressured to keep the economy humming now rather than worry about where it will be in the medium term for two reasons. The first is that leaders are under pressure from vested interest to indulge in more of the investment and lending that buttress their wealth and power. The bigger reason, though, is that the Communist Party is afraid of the consequences of breaking its compact with its 1.3 billion subjects that goes something like; trust us with political power and we will enrich you. While the Chinese know that the ruling classes gorge themselves first, this agreement has held because hundreds of millions of citizens have risen from poverty in recent decades. Beijing’s fear is that the compact may crumble if lower growth spells unemployment and renewed impoverishment for the masses. Deeper despair, it frets, may add to the disquiet in China about land grabs, pollution, corruption and the inequality that each year is triggering, by the government’s count, about 180,000 “mass incidents” of unrest (demonstrations involving protests of more than 500 people) at a time when unemployment is officially 4% and wages are growing at a 10% pace.[7] While democratic leaders burdened with a sagging economy face losing the next election, China’s autocrats fear another Tiananmen, which started over concerns about inflation before encompassing wider political grievances. The protests in Hong Kong will only serve to rattle them more.

Unruly lower tiers

China’s central government has numerous national organs (or fiefdoms) clashing over the direction of economic policy. The outcome of the infighting in recent years has been a decision to reform the economy, even at the cost of growth. In November last year, for example, China’s rulers announced their biggest package of reforms since the 1990s that aim overall to boost the role of market forces in allocating resources. China’s leaders said they would ease price controls, relax the curbs on the exchange rate, liberalise interest rates, bolster financial regulation and supervision, reorganise fiscal management and rules of government land ownership and rein in local government excesses.

If only they had the power to do all this (assuming they had the will). China’s multi-tiered system of government includes 34 provincial governments (if you include Beijing’s claim on Taiwan) and almost countless lower levels of governments below that. This term “local” covers thousands of governments controlling provincial-level cities, counties, county-level cities, county-level districts down to villages. Officials in charge of these lower tiers are often in competition with neighbouring peers to achieve faster growth and build better infrastructure, to further their own careers, feed local prestige and to placate vested interests. The way China works, these lower-tier officials often ignore central economic directives that clash with their self-interest (though they are more in step on political matters). “Far from surging like a single river out of the capital, the transmission of economic policy is more like a series of locks, in which each locality takes what they want out of the policy waterway,” writes Richard McGregor in his book The Party. The secret world of China’s Communist rulers.[8] “Feigning compliance with the centre … they then let the policy stream flow downwards to the next level of government.”

Total central control in China or elsewhere is not necessarily an appropriate way to run a society or economy. But in China today the rulers in Beijing appear more attuned to China’s economic and financial instabilities than are local authorities. The list is growing of worthwhile actions decreed by the centre that are being unwound in the peripheries of government. As this count grows, so too do China’s risks.

Of special note is that local authorities are adding to China’s debt load and heightening the risk of a financial crisis by countermanding central directives on how to deal with collapsing businesses. In July this year, for instance, the government of northern Shanxi province bailed out Huatong Road & Bridge when the construction company faced being the second Chinese business in four months to default. Apart from the moral hazard in shielding businesses from bad decisions, this step was against Beijing’s request that small and medium-sized business should be allowed to collapse to prevent the misallocation of resources. It conflicted with Beijing’s goal to reduce total public liabilities, so as to lower the risk that the central government will need to prop up local or regional governments. It heightens the risk of a greater reckoning by encouraging more excesses.

Analysis at a macro level highlights how Beijing is failing to enforce its will on lower levels of government. A Bloomberg study in July found that 20 of 25 provinces and provincial-level cities in China reported a largely debt-fuelled pickup in growth in the first half of 2014, which basically shows provincial governments are undermining Beijing’s plans to rebalance growth and rein in lending.[9]

More micro analysis shows the same pattern. The Wall Street Journal reports that Beijing is having trouble reducing overcapacity in the 19 industries it classes as producing excessive supply because of countermoves by subordinate governments. In the debt-laced steel industry, for example, government officials in the northeastern city of Xingtai in July reopened a steel mill that Beijing had ordered shut eight months earlier. Government officials in the steel-making Hebei province that surrounds Beijing are stalling to obey orders to shrink an industry that provides 10% of its tax revenue and about 200,000 jobs for locals.[10]

These moves against central directives and Beijing’s timidity when it comes to confronting popular opinion do two things and will probably achieve a third. Firstly, they boost China’s short-term economic growth prospects. Secondly, they undermine China’s longer-term wealth by boosting the damage of any reckoning. Thirdly, they will probably eventually help those arguing that liberal capitalism is the best way to achieve sustainable prosperity.

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The Eurozone may be headed for stagnation: Fidelity.

When pessimists want to express the utmost gloom ahead for the eurozone they often cite Japan’s lost decades as their most-feared outcome for the 18-member area.

The worriers invoke a familiar tale when they talk of Japan’s endless stagnation since an asset-bubble popped from 1989. From the early 1990s, real estate values and stock prices plunged and banks wobbled under bad debts. Even though Japan’s export success persisted, the country’s economy failed to flourish despite massive fiscal stimulus, interest rates being slashed to almost zero and the invention of quantitative easing. A potent symbol of Japan’s malaise is that deflation became entrenched from 1995 to 2013 (with the exception of 1997).[1]

Europe’s economic performance is so lacklustre that the financial crisis that European Central Bank President Mario Draghi doused in mid-2012 with his “whatever it takes” pledge has become an economic and political crisis. The eurozone recorded no growth in the second quarter, when the Germany and Italian economies shrank 0.2%. Deflation is shadowing the region. Eurozone prices only rose 0.3% in the year to September, deflation having already taken hold in eight countries including Spain, Italy and Portugal. Deflation would prove Ebola-like for the eurozone because net government debt now amounts to 87% of output. All but two euro-users have net government debt ratios above the prescribed rate of 60% of output, while the number where net public debt exceeds GDP is six, now that Belgium (102%) has reached the triple figures that make default a possibility for a slow-growth economy. Unemployment for the eurozone is 11.5%, and soars as high as 27% in Greece and 24% in Spain. Eurozone banks reek with bad debts and are reluctant lenders. Needless to say, the economic calamity is poisoning politics. So is Europe heading for Japan’s popularly ascribed fate? You bet. But there are two twists when comparing the eurozone’s fate to the story of Japan’s lost decades. One of them may surprise investors. The other could calm their concerns.

There is always hope that eurozone policymakers will do more to resurrect their economy and puncture the pessimism. The split in France’s ruling Socialist Party over imposing austerity could spark a welcome backlash among euro users against the self-defeating fiscal straightjacket enforced by Berlin, whose resistance may weaken as Germany’s economy stagnates. The ECB, watching the collapse of inflation expectations, is sending signals that it will launch a quantitative-easing, or full-blown asset-buying, program before too long. Perhaps authorities will heed the calls from respected economists that, to boost growth, central-bank-financed fiscal stimulus is justified (real money printing via fiscal policy and a surefire way to generate inflation). The more the economic crisis intensifies, the greater the pressure on politicians to compromise over the political, banking, fiscal and other integration the eurozone needs to surmount its debt crisis and secure the euro’s future. The problem for the eurozone is that politically viable remedies, such as relaxing fiscal targets and quantitative easing, are only half-hearted solutions while true cures appear politically impossible. Thus the lost years since 2008 will turn into a lost decade soon enough.

The despair

Almost incredibly given the woes of the eurozone economy, many media reports and commentators refer to a eurozone recovery because they use the flawed system of judging the business cycle by looking at growth from one quarter to the next. (The flipside of this misleading oversimplification is to define a recession as two consecutive quarters of negative growth.)

The best way to adjudicate economic performance is to look at how an array of indicators such as output, employment, income growth, industrial production and retail sales perform over time. This is the flexible method by which the National Bureau of Economic Research declares recessions and expansions in the US to no dispute, often well after the troughs and peaks in activity have occurred. The same method is applied to the eurozone by the UK-based Euro Area Business Cycle Dating Committee. This body, rightly, won’t declare the eurozone out of recession even though its economy has expanded during four of the past five quarters. In a sense, what the body is saying it that it’s too early to say that activity has troughed.

While such informed judgements of business cycles are the most credible way to call recessions and expansions, they don’t readily allow for comparisons across regions or time. The best way to do that, for all its flaws is firstly to look at how long an economy takes to regain its previous peak in output in gross and per-capita terms and, secondly, to calculate the maximum drop in output over a recession. On this basis, for instance, the US regained its 2007 output peak in 2011 in gross terms and two years later on a per-capita basis. The worst of the downturn was in 2009 when GDP was 0.7% below 2007’s level. The US economy is thus rightly described as being in recovery, for output in 2013 was 5.9% above the level of 2007. (The National Bureau of Economic Research will call the end of a recession before GDP has fully recovered its previous peak when comparing quarterly output. It dates the most recent recession as ending in the June quarter of 2009 when GDP was 1.3% below that of the fourth quarter of 2007. It made this decision 15 months after the trough in activity occurred.)[2]

The eurozone’s GDP peaked in 2008 at 13.6 trillion euros (A$19.3 trillion) and it is yet to regain such heights for 2013’s output was 1.8% below the pinnacle of 2008. The worst of the slump occurred in 2009 when the eurozone’s GDP was 4.4% below the height reached the previous year. The IMF, which does not provide GDP-per-capita figures for the eurozone, predicts that the eurozone’s GDP will only regain its 2008 apex in 2015.[3]

Among the three biggest and most populous eurozone economies, Germany regained its 2008 peak in 2011 and by 2013 its economy was 2.3% above the highs of five years earlier. France reclaimed its 2007 high point in 2011 but by 2013 its economy was only 0.1% above its level of six years earlier. Alas, Italy’s GDP in 2013 was 9% below the record it set in 2007. On a per-capita basis, only Germany is ahead, having clawed back to 2008 levels by 2011. By 2013, Germany was 4.9% ahead on this, the best, measure of prosperity. Last year, France’s GDP per capita was 2.3% below its record of 2007 while Italy’s was 11% under on this basis.[4]

How does this compare with Japan? This may well be the surprise. Japan’s economy expanded in 16 of the 18 years from 1990 to 2007 – it contracted 2% in 1998 and shrank another 0.2% the following year – so there was never post-crisis drop in output. In the decade after the asset bubble peaked in 1989, Japan’s economy swelled 15.5% in gross terms. On a per-capita basis, Japan’s expansion was 12% over these 10 years, while the jobless rate only ever got as high 4.7% over that time, in 1999.[5]

Admittedly other economies outshone Japan over this period – Australia recorded 24% per-capita growth from 1989 to 1999, the US 22% and Germany 17%. But the figures for Japan show that talk of a lost decade in the 1990s is an exaggeration to say the least.

The same goes for the following 10 years. After the slight dip in 1999, Japan’s economy grew every year from 2000 to 2007, even though, it’s worth pointing out, the country was in mild deflation from 1999 to 2005 – the annual decline in consumer prices averaged 0.5%.[6] (The GDP deflator would show deflation stretched from 1998 to 2013 but it’s real economic growth that counts.) All up, from 1989 to 2008, Japan’s GDP jumped by 29%. The country’s output swelled 24% over these two decades on a per-capita basis. The highest the jobless rate ever climbed over these two decades was to 5.4%, in 2002.

Nobel-Prize-winning Paul Krugman is among those who call talk of Japan’s two lost decades a “myth”. He found that using GDP per working-age population – an adjustment that takes account of Japan’s shrinking and aging population – Japan recorded “not bad” growth of 1.2% a year from 1990 to 2007.[7]

If anything, Japan’s worst economic patch since 1989 has been the past six years because its economy contracted in 2008, 2009 and 2011. But since 2007, Japan has still performed better than the eurozone for by 2013 Japan’s GDP had regained its 2007 peak.

The consolation

Europe’s economy is thus already worse than Japan’s in just about every way, even if Tokyo’s net government debt stands at 144% of GDP.[8] So too is its political and social situation. Japan has its own currency and monetary policy (including its own central bank) and can make its own decisions on fiscal policy rather than operate within constraints set by Brussels. Asia’s second biggest economy is still a strong exporter. Government debt in the country is largely owned by locals, which helps insulate the country against foreign speculators. Japan has beaten deflation, for now at least, as consumer inflation excluding food reached 3.1% in the 12 months to August. Japan is a homogenous country, even if an aging one. It is politically stable and its low unemployment has never allowed extremists to flourish.

Sadly, the best comparison for the eurozone’s stagnation is the 1930s. As Nobel-Prize-winning economist Joseph Stiglitz says: “The only way to describe what is going on in in some European countries is depression.”[9] Even more startling perhaps, in terms of time taken to regain the previous peak, the eurozone is on track to surpass the worst-performing group of countries of that era; those that stayed on the gold standard, the closest thing to a fixed-currency regime as damaging as the euro. (The euro is worse because it’s proving impossible to quit.) The eurozone has already overtaken the time taken for the gold quitters of that era to recover.

Work by UK economic professor Nicholas Crafts shows that the group of European countries that stayed on the gold standard – Belgium, France, Italy, the Netherlands and Switzerland – while admittedly suffering a steeper contraction of 10%, took 7½ years to recover their previous group peak. In comparison, the so-called sterling bloc, namely Denmark, Norway, Sweden and the UK that quit the gold standard, only took 4 ½ years to recover. The eurozone’s downturn is five years old as of 2013.

But that doesn’t mean that stock investors should despair (though Europe’s unemployed can be forgiven for being despondent). There is something to the Japan story to calm investors. This comfort is how well the global economy and global share markets coped with the troubles of the world’s then-second-largest economy and the collapse of its stock market.

At the end of 1989, Japanese stocks accounted for 41% of the MSCI World Index.[10] After the Nikkei 225 Stock Average fell 80% from its peak on 29 December 1989 to its post-bubble low on 31 March 2003, Japan’s weighting in the MSCI World fell as low as 7.8% in May of that year.[11] How did global stocks fare over that time? They rose. The US S&P 500 Index surged 140% over those 14 ½ years, helping the MSCI World Index in US dollar to climb 32% over the period.

However you assess Japan’s economic performance over the decades after its bubble popped, these returns show that the global economy and a portfolio of global stocks can survive the stagnation of a big economy if the US economy is doing well enough, other parts of the world are expanding and no shocks emerge. As long as the woes of Europe don’t lead to jolts and no other shudders emerge, a US recovery and decent performance elsewhere – including in Japan! – should be enough to propel global stocks in coming years. By then, the most pessimistic outcome you could paint for a modern developed economy would be that it’s facing lost decades like the eurozone.

by Michael Collins, Investment Commentator at Fidelity

All GDP figures are real. As footnoted, GDP and GDP-per-capita figures come for the IMF World Economic Outlook Database. April 2014. http://www.imf.org/external/pubs/ft/weo/2014/01/weodata/index.aspx.

Figures on eurozone consumer inflation, unemployment and government debt come from Eurostat (http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home). Other financial information comes from Bloomberg unless stated otherwise.

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Oil prices have responded to political volatility in the Gulf.

In 1973, Egypt and Syria launched a surprise attack on Israel during the Jewish religious festival of Yom Kippur. The swift arrival of arms from the US helped Israel repel the assaults.

Opec nations, upset at US support for Israel, cut oil production and placed a sales embargo on the US and any European country that helped Washington funnel arms to Israel. Oil prices surged nearly 400% over the next 12 months in what became known as the first oil shock of 1973-74.  The result was the stagnation of the 1970s.[1]

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France’s turbulent politics make economic reforms tricky to implement: Fidelity

While the plan to unify Europe after World War II began with two Italians,[1] the French pounced on the idea. The first concrete step occurred in 1950 when the French government called for the creation of a unified military in western Europe as a step towards a political federation along the lines of Australia’s. The same year Paris proposed the joint administration of French and German coal and steel resources to shift these war-making ingredients out of German control.

The six-member European Coal and Steel Community that was formed in 1951 is considered the birth of the EU. Its “common assembly” is now the European parliament. Along the way, the French drove the creation of the euro, a currency Germany adopted to gain Paris’ support for German reunification in 1990.

But the fate of the proposed pan-European military force could provide more lessons for what lies ahead for the eurozone. In 1954, the French parliament failed to ratify a treaty allowing the military pact, in part due to concerns about threats to French sovereignty. With it went any chance of forming a proper federation across Europe.

Over the years, the French have taken other steps to stymie European integration. In 1961, Paris vetoed the UK’s admission into the then European Economic Community. In 1964, Paris sabotaged a US-led effort to form a political and military union across Europe by making economic threats to thwart German participation. In 2005, it was the turn of French voters to reject European integration, when they voted against a treaty designed to transfer more power from national to central control.

The danger for Europe is that France’s ailing economy is making its politics volatile and as antagonistic towards Europe as it was during these episodes. It’s possible that a collapse of support for the ruling Socialist party and an intra-party rebellion that led to the government’s dissolution in August, a paralysis of French leadership in Europe, Paris’ policy frictions with Germany and the rise of populist parties at a time when France’s right-wing mainstream party is mired in corruption scandals will block or even reverse the meshing that Europe needs to restore its prosperity. The political climate could even lead to France quitting the euro.

Given how much the French have woven Europe together, it’s hard to believe a French government under the mainstream political parties would torpedo the euro, unravel Europe’s integration or idly allow outside forces to wreak similar damage. Any economic recovery could derail the rise of populist nationalistic forces. In the past, France and Germany fought over policy even as they integrated Europe. Surely, they can weld Europe closer together nowadays even as they stoush over solutions. The truth, though, is that France’s politics are haywire enough for the country to pose indirect and direct threats to the eurozone and the euro in particular.

Woes and blows

France’s political turmoil is due largely to its economic ills but it also stems from the country’s long disquiet about globalisation because of the challenges modernity poses to uncompetitive monocultures and the power of “the state”, which has elevated status in France.

France’s high-tax, over-regulated, protectionist and government-heavy economy – public spending amounts to a eurozone-high 57% of GDP – is sick enough and big enough to threaten any European recovery as the country of 63 million amounts to 16% of the eurozone economy. France is basically in its sixth year of recession or near recession. The economy is barely above its size in 2007, having recorded zero growth in 2012 and a meagre 0.3% rise in 2013, partly because the government is imposing austerity.[2] Concerns about deflation are mounting – French consumer prices only rose 0.6% in the 12 months ended July this year. Unemployment is hovering around 11% or 3.4 million registered jobless. The ratio of government net debt to GDP has soared to 97%,[3] even though (or perhaps partly because) Paris has withdrawn stimulus worth an estimated 5% of output over the past three years. Labour costs rising at triple Germany’s rate over the past decade (30% versus 10%) have made the country less competitive and it now runs a persistent current-account deficit.

France’s economic woes have helped make François Hollande the country’s most unpopular president of the Fifth Republic that began in 1958 – his approval rating is just 13% – even more so now he has upset his Socialist Party supporters by untangling France’s rigid labour market and giving business tax cuts. France’s economic troubles and Hollande’s poor standing have led to Paris exhibiting little sway in eurozone political decisions that could have long-term consequences. Hollande, for instance, was absent from the debate over appointing federalist Jean-Claude Juncker as EC commissioner in July, even though UK Prime Minister David Cameron warned that Juncker’s selection could lead to the UK pulling out of the EU.

The divergence between the economic performance of France and Germany is leading to clashes within the partnership that wove European integration. One big quarrel is over fiscal policy. France’s central government, which hasn’t recorded a budget surplus since 1974, is struggling to meet EU laws to rein in its budget shortfall to 3% of GDP by 2015. The desire by Paris (and Italy) to loosen Europe’s fiscal compact of 2012 angers Berlin, which is mustering economies in far worse shape than France to comply with the financial oversight it has implemented to protect German taxpayers from bills to backstop the euro.

The other big collision is over monetary policy. France wants the European Central Bank to engage in quantitative easing to stave off deflation, help fight unemployment and undermine the high euro. Germany, with its inflationphobia, expanding economy and less reliance on price-sensitive consumer exports sold outside the eurozone, rejects such demands. Berlin thinks that, as well as risking inflation, ECB asset-buying will allow France and other laggards to ease back on structural reforms – in strike-prone France’s case, such measures include trimming the public sector and labour reforms. Given such tensions, it came as no surprise when Germany in July blocked France’s push to install its former finance minister Pierre Moscovici as the EC commissioner for economic and monetary affairs.

The Paris and Berlin clashes, which extend to disputes over other remedies such as EU-financed stimulus spending, eurobonds, a fiscal union and a banking union, pose an indirect but existentialist threat to Europe. If the two biggest euro-using economies are feuding, hopes fade that eurozone countries can agree to the political decisions and compromise that are needed to nurture Europe through its debt crisis. “A crisis in (France) could … push the eurozone to breaking point,” warns UK-based think tank, the Centre for Economics and Business Research.[4]

The target

French politics is an even bigger direct menace for the euro, even if that dénouement might still be three years away and it might appear a low possibility. But, if the threat materialises, it will be lethal for the euro. The peril stems from the collapse in standing of the two mainstream parties, the centre-right Union for a Popular Movement (UMP) and Hollande’s Socialist Party, and the simultaneous rise of Marine Le Pen’s populist, right-wing and euro-hating National Front. So upbeat is Le Pen, now almost the de facto opposition leader, she hopes to win the presidency in 2017.

Le Pen’s optimism is based on the triple shock that France’s political system suffered in May that The Economist says “could affect French politics for years”.[5] The tremors were that the National Front won the European elections after garnering 25% of the vote, the Socialist Party scored its worst result at a national election, receiving just 14% support, (after having flopped at council or local elections in March), and a party-financing scandal ripped through the UMP and forced its leader, Jean-François Copé, to resign.

Since then things have got worse for France’s political elite that Le Pen paints as corrupt, out of touch, uncaring and incompetent. For the UMP, the post-election blow came on July 2 when former French president Nicolas Sarkozy (2007-12) and, still a possible UMP 2017 presidential candidate, became the first former head of state to be detained in a criminal investigation, which led to charges against him of corruption and abuse of power. Sarkozy’s defence that he is being set up by a rotten state, judiciary and police, implicitly justifies Le Pen’s venom towards the political class.

For the Socialists, there have been two post-election lows. The first occurred on August 25 when a left-wing revolt erupted over adhering to austerity policies. Arnaud Montebourg, then minister for the economy, sparked a crisis when he rebelled against the “absurd” austerity policies that spring from the “excessive obsessions of Germany’s conservatives”.[6] Hollande’s order for Prime Minister Manuel Valls to form a pro-austerity cabinet, the fourth of his presidency, pits the government against the social unrest brewing over fiscal stinginess. (France has a so-called semi-presidential system, where the cabinet, though controlled by an elected president, is responsible to parliament. The government needs to be dissolved to allow a cabinet reshuffle.) The other post-election nadir came in early September when Hollande’s former partner, Valerie Trierweiler, triggered a political storm when she published a tell-all book of her relationship with the president.

France’s austerity bias will drag on the economy. Its turbulent politics make economic reforms tricky to implement. So it’s hard to see the country bursting out of its malaise. Some of what irks the French is tied to Europe’s integration and its flawed currency. Of note in this category are Europe’s open borders, petty ruling from Brussels that annoy voters, austerity and the free-market bias of the EU. But much of what riles the French is more tied to globalisation. Job losses to emerging countries, the resulting insecurity about employment and conditions in France, the threat to the welfare state from the need to boost competitiveness, the shrinkage of French’s global power, the dwindling of the state’s reach within society, rising inequality and the buffetting (Americanisation) of the traditional French way of life would exist without the EU and the euro.

Le Pen’s danger to Europe is that she is talented enough to direct all French angst, no matter its source, against one enemy and to get away with posing just one solution. Her political chicanery is to blame all France’s woes on the euro (admittedly, Europe’s biggest post-war mistake). Her remedy is to restore the franc. How Europe would cope if France were to ditch the euro is anybody’s guess. (Some analysts advocate breaking up the eurozone to save the EU.) Investors and others will need to form their own judgments if polls show Le Pen is heading towards the presidency – in July she took the lead in the first-round polls for this election; in September she beat Hollande in a second-round matchup, according to one polls.[7] Just beware that if Le Pen should win, she has pledged that on her first day in office that she will take steps to rid France of the euro and that she is willing to let “financial Armageddon” rip if other eurozone countries won’t agree to a joint breakup. “What are other countries going to do (to stop me),” she taunts. “Send in tanks?”[8]

by Michael Collins, Investment Commentator at Fidelity

———–

French economic statistics largely come from the IMF’s World Economic Outlook Database. Other financial information comes from eurostat, Capital Economics and Bloomberg unless stated otherwise. The history of France and the development of the EU largely comes from Brendan Simms’ book Europe, the struggle for supremacy 1453 to the present. (Allen Lane 2013).

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US recovery going strong.

Some may be surprised that US stocks took just over 5 ½ years to regain previous highs after the so-called Great Recession compared with the 25 years it took the Dow Jones Industrial Average to recover from the Great Depression.[1]

The losses triggered by the US sub-prime crisis were recouped on 10 April 2013, when the S&P 500 Index climbed back to the pre-Lehman-crash intraday high of 1,576.09 it set on 11 October 2007. Since that April day last year, the bellwether US index had added another 22% by July 31 just gone when it ended at 1,930.67.

Amid some talk that central-bank asset buying is fuelling asset bubbles including stock prices, there is a more fundamental reason why US stocks are at record highs; healthy earnings growth. In fact, profit growth has been so strong that US profits have reached a record share of GDP, at the expense of wages.

The encouraging news for US stock investors is that earnings are poised to grow in absolute terms in coming years as the US economic recovery appears durable, even as some of the forces that have driven earnings growth become less helpful. If there’s any link between profits as a percentage of GDP and share prices, then investors can look forward to more years of a rising S&P 500 Index, for chances are that profits as a percentage of GDP will crack fresh record heights in the coming era.

The US economy could, of course, crumble and retard earnings growth. Some other shock could sink shares. Quantitative easing, which shaves longer-term interest rates, played some role in helping stocks so any rise in long-term yields due to its upcoming end could dampen enthusiasm for stocks. There is no ironclad relationship between stock prices and earnings as a percentage of GDP. Profits can never reach 100% of output so there must be some limit to their rise on this basis against wages, even aside from the political consequences that steeper inequality would inspire to reverse the shift. Analysis that focuses just on earnings doesn’t necessarily take into account what’s already priced into share prices. But overall, if the outlook in coming years is one where earnings rise in absolute and in relative terms, the environment for stocks will be more inclined to be favourable.

At labour’s expense

US earnings have risen in recent years largely because supportive low interest rates and overlooked fiscal stimulus have engendered an economic recovery that has just entered its sixth year.[2] US companies have enjoyed low short-term interest rates since December 2008 because the Federal Reserve was quick to slash the cash rate to close to zero to make borrowing costs out to five years as favourable as possible for business once Lehman Brothers collapsed. To ensure longer-term borrowing rates supported the economy, the Fed embarked on three quantitative-easing or asset-buying programs; from 2008 to early 2010, from late in 2010 to 2011 and since 2012.

In economic terms, these low interest rates made more businesses profitable, reduced company debt repayments and encouraged consumers to spend. As far as the stock market goes, puny interest rates justify higher valuations such as elevated price-earnings ratios. Low bond yields prompt investors to look for higher returns from other asset classes – in particular, they helped property and infrastructure stocks whose bond-like qualities make them proxies for fixed income when yields are negligible. Low rates fanned IPOs and M&A activity that are fuel for stock rallies. They encouraged investors to re-rate mediocre companies to higher multiples. They prompted asset allocators to switch money away from rising assets – in this case, bonds – to stay within strategic limits. Lastly, low interest rates combined with pledges by central banks to keep rates low appear to have engendered a complacency about the outlook that is reflected in low readings on volatility, which in turn helps shares. A more stable outlook for prices justifies paying a higher price for an asset and the price stability attracts other, warier, investors. As the low cash rate has the most powerful spurt for the economy and stocks via its dampening effect on bond yields out to three to five years, the ending of the Fed’s asset-buying in coming months shouldn’t be detrimental to stocks. Any unforeseen jump in the cash and thus other short-term interest rates, however, would be harmful.

On the fiscal side, the boost to the US economy and US stocks is staggering when the sum is totalled over the past five years. From 2009 to 2013, US federal fiscal stimulus amounted to 41% of US GDP in aggregate.[3] This US$7.1 trillion (A$7.5 trillion) equivalent of stimulus at 2014 prices[4] that ranged from tax credits to “shovel-ready” projects helped fill the demand void created when workers lost their jobs and businesses and households focused on reducing their debts rather than spending, even if US state governments reduced the stimulus a touch by imposing austerity policies to meet laws that required budgets to be balanced. The US recovery has been robust enough to survive the austerity imposed by Congress over the past year or so. These cuts and higher tax receipts are expected to help lower the fiscal deficit to below 5% of GDP this year from a peak of 10% in 2010.[5]  

Three other forces that boosted earnings growth are worth mentioning too. The first is that companies engaged in cost-cutting to protect margins. Another is that technological improvements allowed business to become more efficient; in economic jargon, innovation cut the labour intensiveness of production. Goldman Sachs analysis shows that from 1998 to 2011 the ratio of spending on technology to labour grew in auto, oil and gas, communications, mining, retail, wholesale trade and warehousing. The other boost is that globalisation created fresh foreign markets for US companies and eased access to long-standing ones. In 2012, US companies earned 21% of their profits from abroad, triple the 7% share recorded in 1969, according to the US Bureau of Economic Analysis.

These stimulants helped US profits expand at a much faster rate than earnings did in other developed countries in absolute and relative terms – hence the outperformance of US stocks in 2012 and 2013. Minack Advisors says profits at US listed companies surged from about 3% of GDP in 2009 to about 5.5% of output in early 2014, while listed profits in other developed countries have only hovered around 3% of GDP over the past five years.[6]

This jump in US earnings has boosted the share of profits from all US companies to a record 11.1% of GDP at the end of 2013, according to the Federal Reserve Bank of St Louis, compared with an average of about 6.4% since 1947. At the same time that US profits have soared, the percentage of wealth heading to workers declined to 43% of GDP at the end of last year from a peak of 52% in 1969 and from an average of 47% since 1947.[7]

There is one key reason why increased US profits have headed to shareholders at the expense of workers. Labour has lost its bargaining power over the past 30 years as right-wing ideology triumphed and globalisation expanded the pool of cheap workers for hire, and thus lowered wage pressures. Labour’s negotiating power weakened ever more during the Great Recession, when the jobless rate peaked at 10.0% in October 2009 when looking at the most-watched (U-3) measure, or at 17.2% in April 2010, when looking at the wider (U-6) gauge that includes reluctant part-timers and those dropping out of the workforce in despair.[8]

Piketty’s insight

Even after five years of recovery, there’s no sign that US wages are rising in real terms, let alone relative to GDP, even though the most-watched jobless rate was 6.1% in June just gone, when the wider unemployment measure stood at 12.1%. This wage stagnation reflects job insecurity and the fact that many middle-class jobs have been replaced with poorly paid, even part-time or temporary, ones. Fed Chair Janet Yellen in April even remarked on the “historically slow pace” of wages growth in this recovery.[9]

Even if wages were expanding at a pace to trouble inflation, it would be hasty to assume – as fans of mean reversion seem to – that somehow US profit share will drop towards its long-term average, or even lower. There’s no automatic force in play that returns the profit and labour ratios to GDP to some fairer equilibrium. Outside of wars and other such catastrophes, financial or otherwise, that destroy wealth, only human endeavour that coalesces into a political force capable of effecting changes in labour’s favour can eat away at profits’ share in GDP.

The money in US politics that buys the rich a veto over threats to their wealth, recent Supreme Court decisions empowering the political power of this cash, another high-court decision that eroded the ability of unions to collect fees from all the workers they cover, the weakening of minimum wage standards at state level even amid a push to raise the federal minimum hourly rate and the ability of business to get away with underpaying staff are just some of the forces suppressing wages growth and wages’ share of GDP in the US. The probability is high that Republicans will regain control of the Senate and hold the largely gerrymandered House of Representatives in Congressional elections in November. These results would only add to the power that capital has enjoyed over labour since the early 1980s no matter which party controlled Congress or the White House.

On top of these political pressures, workers face a sub-par economy – it expanded at an annual pace of about 2% in the first six months of 2014. For an historical perspective of how the pace of economic growth affects the relative splits of wealth and income between capital and labour, investors can turn to the book by French economist Thomas Piketty Capital in the Twenty-First Century, an analysis of inequality that is topping best-seller lists.[10]

Piketty has tracked inequality since the 18th century by looking at the breakup of wealth and income across key western societies. His findings on the US show that the recent political shift in favour of capital is pushing inequality towards its peak in 1910 for capital[11], when the top 10% owned 70% of wealth, and its highest for income[12] which was around 2007, when the top 10% earned just under 50% of income. (Income’s previous peak was in the late 1920s. Inequality fell over the middle of the 20^th century because world wars, a Great Depression and government intervention in the form of higher taxes and increased welfare payments made for a more egalitarian society.)

Piketty’s central thesis, which is grounded more in observation than theory, is that the returns flowing to the owners of capital grow faster than GDP and this fact means that capitalism’s natural state is one where inequality rises. Over time, the return on capital is, say, 3% to 7% (profits, dividends, rent, etc.) versus about 1% to 2% for economic growth (and thus wages). Other things being equal, the slower the economic growth, the faster inequality rises. “It is an illusion to think that something about the nature of modern growth or the laws of the market economy ensure that inequality of wealth will decrease and harmonious stability will be achieved,” Piketty says.[13]

The US outlook is only one of modest economic growth – the recovery is robust enough to survive a decline in fiscal stimulus and less promiscuous monetary policy. No political forces are marshalling to tilt laws or regulations in labour’s favour. Therefore, capital’s saunter to a second Gilded Age appears unhindered for now. That’s better news for investors in US stocks than US workers in coming years.

Financial information comes from Bloomberg unless stated otherwise.

by Michael Collins, Investment Commentator at Fidelity

———-

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Global threats are mounting: Fidelity

The hazards confronting the world economy are mounting. The US economy is recovering at an unspectacular pace of about 2%[1] and a sub-par labour market, sluggish wages growth, renewed doubts about the housing market and weak demand for the country‘s exports only portend more modest growth ahead.

On top of this, inflation is accelerating, the Federal Reserve is only months away from ending its asset buying and rate increases appear inevitable before too long. The defeat of House majority leader Eric Cantor in a Republican primary election in Virginia in June by a Tea Party candidate is expected to cement gridlock in Washington and could lead to more showdowns on raising the government’s debt ceiling. The eurozone is still in recession,[2] disinflation could fester into deflation, government debt loads are at default levels and banks are so crammed with dud loans they are restricting lending, while some are wobbling in Austria and have failed in Portugal. Even if European Central Bank Governor Mario Draghi’s bluff to protect the euro is soothing investors, the financial crunch in the eurozone has morphed into a political crisis revolving around a jobless emergency that is fanning support for nationalistic and fringe parties, the opposite environment needed to create the political jelling the euro needs to assure its survival. Housing is bubbling in countries from the UK to New Zealand.

The emerging world isn’t in much better shape, especially as it is riddled with conflicts. A civil war has broken out in Ukraine, only months after Moscow seized Crimea from its neighbour, and Russia could yet invade. Western sanctions against Moscow in response will damage more than Russia’s economy. In the Middle East, Syria’s civil war rages on. Islamists control much of northern Iraq and a third of Syria and the fighting pitting Shias and Sunnis could spread into other countries such as Jordan. Israel has been to war against Gaza for the third time in six years. Iran could still gain nuclear weapons. In Africa, Libya has become ungovernable. In Asia, China is creating tension, especially with Japan, as it seeks to broaden its ownership of the China Seas. Due to China’s flexing, military spending in Asia has inklings of an arms race. Nuclear-primed North Korea is as loony as ever while nuclear-armed Pakistan grows more unstable.

Financial and economic challenges are no-less menacing in the developing world. Argentina has defaulted for the second time in 13 years after a legal feud with “vulture funds”, an outcome that will damage South America’s second-largest economy. China’s property market is deflating, while Beijing is only making half-hearted attempts to police out-of-control lending because it worries that proper regulation might make the country miss its 7.5% growth target. So challenged are many emerging countries by current-account deficits, inflation, sluggish economic growth and plunging currencies that labels of the past such as BRICs that flagged the potential of developing nations have given way to “fragile” plus a number; i.e., the “fragile five” are Brazil, India, Indonesia, Turkey and South Africa.

Could any of these challenges morph into a shock as damaging as the collapse of Lehman Brothers in 2008? Or could some other threat not yet evident emerge? Maybe it will be a jump in interest rates. Some analysts say it’s only a matter of time before Saudi Arabia is engulfed in the political turmoil of its neighbours. Just think what that would do to oil prices. Whatever form any shock could take, if one should occur, it’s not so much the shock that should worry investors. It’s the powerlessness of authorities to respond. There is, however, one hope that shines out from the events of recent years.

It must be said that there are always dangers to the global outlook and most of them are overhyped and fizzle out. So most likely will today’s perils. Since World War II, global politics has been far more volatile than today, even when the nuclear armed superpowers confronted each other as during the Cuban missile crisis in 1962 or the Yom Kippur War of 1973 that led to the first oil price shock of the 1970s. Even amid all the current hazards, the World Bank still expects the global economy to expand this year, even if that expected pace of growth for 2014 was reduced to 2.8% in June from the 3.2% forecast the bank made in January.[3] Other good news is that inflation is only a menace in a few countries. Japan’s radical economic experiment is going well so far. In India, the dominant election victory of BJP has sparked hopes the government can enact reforms that will rejuvenate the world’s second-most-populous country. Indonesia, the world’s biggest Muslim country that only 15 years ago was an economic and political basket case, is expected to advance further under new president Joko Widodo. US banks are better capitalised and are under tougher regulation. Across the globe, current accounts are better balanced, thus removing the savings mismatch that was a key cause of the global financial crisis of 2007-08. Any shock these days would have to be huge to outdo the jolt to consumer and business confidence that was inflicted by the collapse of Lehman Brothers, most likely a once-in-a-generation event, for people are hardened to alarms nowadays. Even allowing for all this, though, the world appears more precariously placed to cope in the unlikely event of a shock than it was six years ago.

All together now

When the US sub-prime crisis morphed into a global financial crisis in September 2008 policymakers in affected countries responded almost in unison. Central bankers slashed interest rates. They provided emergency funding to banks. Those in the US and the UK embarked on unprecedented asset buying or quantitative easing, a cure invented by the Bank of Japan in 2001. Political rulers provided massive fiscal stimulus. They nationalised banks. They guaranteed bank deposits even, mistakenly in Ireland’s case, backed bank debt.

These steps succeeded in avoiding another Great Depression, a feat in itself, but some harm was unavoidable and unintended consequences arose. The resulting Great Recession ushered in double-digit jobless rates while low interest rates fanned housing and other asset bubbles around the world. Policymakers made mistakes too. Austerity policies implemented in Europe and elsewhere have hobbled economies, boosted the ranks of the jobless and worsened government debt levels. The ECB could well turn to asset buying too late to stave off deflation.

These side effects and errors could add to the severity of the next downturn in the unlikely event of a shock. The greater problem, though, is that if another jolt comes authorities are much more handicapped than they were six years ago. Most of the steps that supported economies and banking systems in 2008-09 have lost their muscle. Major central banks already have reduced cash rates to record lows, so on this score they are immobilised. Quantitative easing has been unmasked as no miracle cure, even if it can help avoid a catastrophe or deflation. Research in 2012 out of John Hopkins University found that any reduction in interest rates from asset-buying programs was fleeting and “quite modest”.[4] While other studies might be kinder to central-bank asset purchases, it’s hard to believe that the Fed would do much for the economy if , say, it restored its monthly asset buying to US$85 billion again to limit shockwaves. Such a policy retreat might even deal another blow to confidence for the Fed and other key central banks have swelled their balance sheets to levels that approach the limits of investor tolerance, or at least to levels that provide fodder for scaremongers. The new (old) world of macroprudential controls, or financial regulation, to fight asset bubbles is fraught because it injects central bankers into the centre of political decisions.

Politicians and the executives they control appear just as toothless. Many governments are so debt laden they would be challenged to pursue the fiscal stimulus matching that of 2008 to 2010. Net debt sits at 74% of GDP for advanced economies, about where the average stands for the 18-member eurozone.[5] The US government net debt has reached 82% of output, while Japan’s ratio has soared to 137%. The straightjacket that such ratios put on governments is shown by events in Japan. Fiscal pressures forced Tokyo to raise the sales tax by three percentage points in April this year, a move that acts against the consumer spending that propels the economy, thus jeopardising the gains won so from the radical monetary experiment to engender inflation and economic growth. The US debt pile is the defining restriction on Washington’s ability to stimulate the US economy, which post-2008 was helped by annual fiscal deficits averaging 9.2% of GDP from 2009 to 2011.[6] The fight over US government finances has already produced the brinkmanship over the so-called fiscal cliff and two debt-ceiling showdowns that took the country to the brink of default. Perhaps more worrying, austerity advocates are winning the political battle in countries where government debt is low. There would be few better examples than Australia, which promoters of smaller government claim is facing a budget emergency (rather than just a persistent gap between outlays and revenue) when net government debt is all of 16% of GDP. Consumers won’t be able to rescue economies either. Households are still burdened with near record debts as a percentage of GDP and, come a shock, will own plunging housing assets.

What hope then for the world if a thunderbolt materialises? Most likely this. Policymakers the developed world over know they are at the limits of their power. They must have thought of possible remedies if something bad happens. If not, they have proved they can whip up palliatives if economies and banking systems shudder. The years after the global financial crisis struck ushered in unprecedented amounts of quantitative easing and emergency lending to banks under central-bank lender-of-last-resort facilities and massive fiscal stimulus. The era produced soothers such as zero interest rates and the invention of negative interest rates, which Sweden introduced in 2009 followed by Denmark in 2012 and the ECB this year. Central banks entered into bilateral currency swaps with the Fed to ensure enough US dollars to support banks in their spheres. Other central-bank tonics were so-called forward guidance to soothe any concerns about rate increases, ECB repurchase agreements designed to shove massive amounts of money at banks, Fed purchases of mortgage-backed securities to help revive housing, Fed lending facilities for borrowers and investors in crucial credit markets and cunning bluffs such as timely pledges by policymakers to do “whatever it takes” to save this and that, as the ECB did for the euro. These cures may not be enough if strife hits again but they give hope that policymakers have the inventiveness to limit the damage in the unlikely event that a threat materialises.

Financial information comes from Bloomberg unless stated otherwise.

 by Michael Collins, Investment Commentator at Fidelity

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Shinzo Abe’s “third arrow” radical plan to revive Japan’s economy.

Japan’s parliament in June began debating legislation that would allow for the country’s first casinos. Whatever the merits casinos are as tourist attractions as the bill’s backers claim versus the social ills that opponents allege will flow from their opening, they form part of the so-called third arrow, or economic reform part, of Prime Minister Shinzo Abe’s radical plan to revive Japan’s economy.

Other measures are more standard fare in a package of economic reforms that was announced in June by Abe, who started his second term as prime minister in December 2012. They include changes for the labour market, cuts to company taxes, plans to enter into more trade agreements to open up sectors such as agriculture, special zones where red tape is reduced and changes that allow for economies of scale in the ownership of farm lands.

The third arrow could well be the most revolutionary in terms of how it could change Japanese society and the economy for years, bearing in mind that it can include (and exclude) any of the proposed regulatory changes or economic reforms that are often announced ad hoc. The first two arrows of Abenomics are fiscal stimulus, which is now being reduced, and further loosening of monetary policy – a radical change in itself because it involves central-bank asset purchases that aim to double the monetary base within two years to turn deflation into inflation and achieve consistent GDP growth per capita.

The Abenomics experiment was begun in May last year to resuscitate the economy of a politically stable country beset by two decades of stop-start growth, a decade or so of deflation, the world’s biggest pile of government debt, falling real wages and a shrinking and aging population. The results, so far, are promising for an economy that Bloomberg estimates is 3.5% smaller than when Abe first came to power in September 2006. (He lasted two years.) The economy has expanded for five straight quarters and generated inflation. Investment, production and business confidence have improved and a lower yen is helping exporters. Readings of these measures, however, are not improving enough to lift Japan’s long-term growth projections.

One big challenge for the economy now is that, in an effort to tackle its debt, the government boosted the sales tax by 3 percentage points to 8% on April 1 this year. The resulting drop in consumer spending is expected to shrink the economy over the second quarter. (The tax rise boosted core consumer inflation to a 23-year high of 3.2% in the 12 months to April this year. Core consumer prices are rising at an estimated 1.3% pace when tax effects are excluded.) This means the vague third arrow has taken on greater significance as a means for reviving Japan’s economic future, particularly as Tokyo wants to become a stronger regional economic and political counterweight to China.

Shadowy arrow

The reforms announced in June were generally vague. The government, however, was most specific in saying that it wants to reduce the corporate tax rate from 35.6% to below 30%, where Australia’s rate sits. It is still to outline, however, how it will replace the lost revenue to stop adding to the government’s gross debt that amounts to about 240% of GDP.

The more-abstract announcements cover tougher corporate governance rules, including measures to untangle crossholdings among companies, to boost shareholder returns. They embrace enhanced ability for super funds to buy equities. Among others are changes to farming that allow for the consolidation of small farms and proposals to end utility monopolies to make the energy industry more efficient. Proposals for the labour market could be among the most contentious because they comprise proposals to allow more immigrants in a monocultural and homogenous society, tax changes to encourage higher female participation and steps to boost their numbers at executive level (which might be counterproductive to the government’s hopes to boost the birth rate) and more flexible labour laws. “In my growth strategy, there are neither taboos nor sacred cows,” Abe said in a televised address on June 24.[1]

Abe’s government needs to prove it can turn announcements into regulatory and legal achievements. The vested interests Abe confronts are significant. The severity of the challenges facing Japan may well give him the best-possible environment to succeed.

The fate of the legislation covering casinos may well provide a gauge as to whether or not Abe can overcome vested interests. For among the opponents of Las Vegas-styled and owned casinos are the Japanese businesses that operate various forms of legal gambling, from lotteries and gaming machines to sports betting, who fear foreign competition more than they are troubled by any social ills that might come with casinos.

Financial information comes from various media sources including The Wall Street Journal and Bloomberg.

[1] The New York Times. “Shinzo Abe’s bid to shake up corporate Japan.” 24 June 2014. http://www.nytimes.com/2014/06/25/business/international/shinzo-abes-bid-to-shake-up-corporate-japan.html?hpw&action=click&pgtype=Homepage&version=HpHedThumbWell&module=well-region&region=bottom-well&WT.nav=bottom-well&_r=0

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Michael Collins

Amid all the threats and counter-threats between Russia and the west over recent events in Ukraine was a warning by Kremlin aide Sergei Glazyev that Moscow might orchestrate the end of the US dollar’s role as the world’s foremost reserve currency.[1]

While Glazyev’s threat was risible, he is one of the many to give voice to a likely shift in the international payments system in coming years. This is the mooted decline of the US dollar’s premier reserve status as the yuan becomes a reserve currency, which is one that is widely held by governments and institutions among their foreign-exchange reserves because it is seen as a store of value. At the moment, about 61% of the world’s official forex reserves are held in US dollars, while 24% are held in euros.[2] Other reserve currencies are the UK pound and the yen (each 4% of total reserves), the Australian and Canadian dollars (2% each) and the Swiss franc (0.3%). The currency officially known as the renminbi – the primary unit is the yuan much like the pound is for sterling – barely figures.

China’s significance as the world’s second-largest economy and the biggest global trader and official moves to “internationalise” the use of the yuan – essentially when it is used between non-residents – and to liberalise China’s financial system fan talk that before too long the yuan will become a reserve currency. After all, China is the only one of the world’s six largest economies not to have a currency with such status. So preordained seems the yuan’s ascension that European Central Bank board member Yves Mersch said in February that the yuan might one day “challenge” the US dollar’s prominence as the world’s foremost currency.[3]

Much needs to happen before the banknotes that feature Mao Zedong attain reserve standing, let alone shove aside the US dollar. The yuan is not market determined – the currency is set daily and trades within a daily 2% band – and the government restricts capital flows, two breaches of prerequisites for reserve status. Other missing essentials are deep capital markets and sound political and macroeconomic settings, for investors need to have faith in yuan-denominated securities if they are to hold reserves in yuan. Wider use of the yuan and, by definition, the freeing up of capital flows in and out of China, could come with turmoil that retards the currency’s ascension – after all, in the words of Philip Lowe, deputy governor of the Reserve Bank of Australia, “there is no historical precedent for an economy of China’s size and relative stage of development integrating itself into a global financial system”.[4] But events are moving towards the yuan gaining reserve stature as the Chinese are relaxing controls on the currency and capital flows.

If China’s financial liberalisation is extensive enough to promote the yuan to reserve heights, China will benefit in many ways. Reserve status will make global trade and financing cheaper for Chinese businesses. It will create better foundations for China’s macroeconomic management, deliver more diversified portfolios for Chinese and foreign investors and generate better risk-management (hedging) products and markets for investors. Importantly, when judging the motivation of China’s leaders, it will bolster the country’s international political power.

The gap

The title of being the world’s foremost reserve currency is rarely passed on. The last handover was from the UK pound to the US dollar in the decades after World War 1, a shift that only became official in the post-World War II Bretton Woods system. But there is usually room for other currencies to reach reserve status and, by default, diminish the prominence of the incumbents. Now is such a time.

US Congress has done more damage to the US dollar’s reserve allure than Moscow could ever do by, twice in the past three years, taking the country to the brink of default during negotiations to raise the debt ceiling. Investors and officials in other countries were aghast that infighting in Washington put at risk the US$5.8 trillion of US Treasuries they own so they are looking to diversify their holdings into other currencies. (China is the largest US creditor holding US$1.3 trillion of US government bonds, held mainly as foreign-exchange reserves.) The euro’s drawback is that no one can guarantee such a structurally flawed currency will survive.

Even before the debt showdowns in the US, the Chinese were undermining the US dollar’s reserve role. Chinese officials were panicked when, during the credit crunch of 2008, Chinese companies struggled to borrow scarce US dollars. The People’s Bank of China was forced to make the yuan available through currency swaps with other central banks, agreements that now number about 20 (including one with the RBA). Soon after that trauma, Zhou Xiaochuan, the head of the central People’s Bank of China, blamed the US dollar’s dominance as a reserve currency as the root cause of the global imbalance that triggered the crisis because it led to perennial US current-account deficits.[5] Thus Xiaochuan in March 2009 called for the use of IMF special drawing rights, which are based on the value of the US dollar, euro, UK pound and yen, as a global reserve currency as a way to diminish the unsettling role of the greenback.[6]

Booming bonds

Even if Xiaochuan’s speech was of little help, the yuan in recent years has advanced its ability to achieve reserve status. The first step in this process was for the yuan to become widely used in trading and investment. The country’s export prowess has led to the yuan’s elevation to a trading currency while the government is helping it accomplish a bigger role in investing.

The yuan’s use in commerce is spreading because Chinese companies offer discounts when trading is settled in their currency. Accordingly, the yuan in 2013 overtook the euro as the world’s second-most used currency in traditional trade finance. The Belgium-based Society for Worldwide Interbank Financial Telecommunication said the yuan had an 8.7% share of letters of credit and collections in October of that year, compared with 6.6% for the euro.[7] While well short of the US dollar’s 81% share, the yuan’s share had jumped from 1.9% only 20 months earlier – and zero if you go back to 2009 when the first trade was settled in yuan over the Hong Kong border. HSBC estimates that about 25% of China’s trade is now settled in yuan and this portion could reach one third by next year.[8]

China’s trade performance promotes the yuan’s use in investment and the government is doing its best to capitalise on this trend by nurturing China’s financial markets. Among other steps, officials have relaxed controls on foreign institutional investors buying Chinese securities, eased restrictions on interest rates and the exchange rate, allowed capital to flow freely into and out of the just-launched Shanghai Free Trade Zone and are trying to develop China’s money and bond markets. The latter is meeting with some success. International companies are happy to sell bonds denominated in yuan for their China-related financing and risk-management needs. Global investors are keen buyers because these securities offer attractive yields and the yuan has been viewed as a currency that only rises – which it did until recently, anyway. HSBC estimates that the amount of bonds denominated in yuan sold outside China has doubled each year since 2008 and the pool of such assets, which includes deposits, bonds and bank certificates of deposits, now totals 1.8 trillion yuan (A$315 billion).[9]

Another promising sign of the yuan’s wider use in investing is that there are now four “offshore” yuan trading centres; namely Hong Kong, London, Singapore (the largest)[10] and Taiwan – and Sydney could be one soon. An official yuan “trading centre” gives Chinese and other businesses the ability to convert yuan directly into other currencies via an official clearing house rather than pay the higher transaction costs of swapping into US dollars as an intermediate step. Less encouraging signs are that the ability to hedge the exchange rate risk of the yuan is still limited as such markets are underdeveloped and that the market for yuan-denominated equities sold outside China is still a fledging one.

The Brookings Institute of the US names five factors that determine the speed with which a currency attains reserve status.[11] The first is the size of its economy and China’s easily passes on this score. China is making progress on opening its capital account, adopting a flexible exchange rate and deepening its capital markets, key determinants two, three and four. It’s the fifth factor that could prove problematic even though China’s has met this hurdle in recent years. This is that investors must be confident that authorities will achieve sound macroeconomic outcomes such as tame inflation, steady growth and sustainable debt levels before they will invest in a country’s financial assets (and thereby demand the currency). China’s wobbly financial system could undermine confidence in China’s economy in coming years.

A more long-term challenge for investors is that China’s political risks are bigger and different from those emanating from the liberal western democracies that boast the other reserve currencies. Financial markets depend on the rule of law for their smooth operation. China’s government is one-party dictatorship so, by definition, rule of law is absent, as is proper corporate governance. It will be harder for Beijing to convince investors that the People’s Bank of China is an “independent” central bank in the way they perceive the Federal Reserve and RBA to be. These flaws could give other governments and official bodies pause before investing too much in yuan-denominated reserves.

It is unlikely that the US dollar will soon give way to the yuan as the world’s foremost reserve currency. Chinese policymakers will be careful to make sure liberalising interest rates, the capital account and the exchange rate don’t get ahead of domestic conditions – the removal, say, of ceilings on interest rates would disrupt China’s state companies and banks that are a large part of the economy. Who knows when the yuan will be market set, when capital flows will be fully convertible or when Chinese government and corporate bonds will be readily available and easily traded. But at the very least, policymakers and investors everywhere should prepare for a world where the yuan will play a mightier role.

by Michael Collins, Investment Commentator at Fidelity

Financial information comes from Bloomberg unless stated otherwise.

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