Category — Asia

One of the popular predictions of the past few years has been to declare China as the next world superpower. The most populated country in the world has experienced tremendous growth for some time, and given their size, growth, and stability, many view China as the United States’ next competitor for worldwide dominance. While I am not speculating as to China’s social or political future, I strongly believe that their growth-oriented policies will eventually – and inevitably – bring about economic consequences.

As children we all learned the saying “don’t put all your eggs in one basket.” By pursuing policies aimed at maintaining their meteoric growth, China has consistently cast inflation aside. With rates currently hovering around 8%, China will eventually have to work harder to contain this figure. Their growth of over 10% per quarter has been able to overshadow most other economic problems. However, in response to those numbers I’ll put forth another saying from childhood, “nothing lasts forever.”

China’s astronomical growth will slow, with some – including myself – believing that this slowdown will take place after the Olympics this summer. At that time, the following question will take center stage: will the Chinese economy be able to grow rapidly enough to make up for high inflation, an appreciating Yuan, and a swiftly rising standard of living? I predict no, and hence foresee and economic slowdown occurring in China by the onset of 2009.

Upcoming Figures
EUR German Consumer Price Index (Jul)
EUR German IFO Business Climate Survey by Industry (Jul)
USD Consumer Confidence (Jul)

Many in recent years have pointed to a “global market” that has emerged in the past few decades. While this term is typically a reference to increased global trade and international economic cooperation, the expression is also becoming applicable to the status of the world’s economy. After several years of widespread economic boon, it is becoming clear that the status has shifted. This has occurred not solely in economic powerhouses such as the U.S., the Euro-Zone, and Great Britain, but in many of the emerging markets throughout the world. As I reported here, India’s rupee has been slammed recently, and many other up-and-coming economies’ currencies are sharing the rupee’s fate of late.

Until recently, one of the “hotter” currencies in the world was the Brazilian real. However, it is expected to experience significant losses in the coming months, along with the currencies from many other emerging markets. From this trend, it is clear that the effects of a “global market” are not all positive. Similarly to how they import goods, so too it seems that these growing economies import the economic health of the major economies. Despite having vastly different economies, many are suffering from the familiar problems of rising inflation, high commodities prices, and rising unemployment. In other words, problems that seemed so close to home for many Americans and Europeans are nonetheless beginning to afflict peoples halfway around the world.

Still, unlike the U.S., the Euro-Zone, and Great Britain, growth is not as severe of a problem for many of these emerging economies. Hence the central banks do not have the complex task currently facing the Federal Reserve and the ECB: rising inflation and decreasing growth. This will allow them to just focus on combating inflation, yet the obstacle of high unemployment may limit any potential effectiveness of their actions. With investors starting to exhibit a preference for investing in U.S. markets in lieu of emerging markets, these growing economies must figure out a way to solve their economic problems soon. Otherwise, it could take some time to entice foreign investors to return, which could make any recovery of currencies such as the rupee or the real a long, arduous process.

Upcoming Figures
CHF Trade Balance (Jun)
CAD Retail Sales (May)

My assignment for the day: write 200 times “Next time I will not get too excited when I write about India’s short term economic situation.” For those who have been following India in the past few days, the developments seem anything but the rosy picture I painted last time around. Sure, in the long run, India is still poised to have solid and sustainable growth. However, their current battle with inflation may be more than just a bump in the road.

The rupee has been slammed in the past few days, as many see the Reserve Bank of India (RBI) having made insufficient actions, and being too slow to respond. The rupee’s fall is testament to the economy needing more rate hikes in order to limit its rapidly rising inflation. Limiting inflation is seen as being one of the keys to fixing the myriad of problems in India’s economy: a rising budget deficit, a current account deficit, a weak rupee, rising import costs (including energy), and diminishing spending power. However, concerns exist for the RBI (similar to the worries of the U.S. Federal Reserve) when considering rate hikes: the role of energy costs and the related adverse effects of rates that are too high.

So, let me revise my earlier statements. In order to correct the problems that their country is facing, the RBI should (and most likely will) continue to raise rates. As they are very dependent on oil imports, it would be a very worthwhile long-term goal to try to utilize alternative energy sources. As the country is still becoming industrialized, by pursuing these alternative energy methods while the country is still growing, the new energy sectors could grow along with the country. Finally, most analysts are saying that India is not in the same position as it was in 1991, when it suffered another economic downturn (and rupee devaluation). In other words, though the Indian economy may suffer a downturn or even a recession, India is still well situated – as long as they utilize smarter monetary policy – to stabilize and expand in the future.

Some days, I know exactly what I’m going to write about. On days that I don’t, I usually peruse through the news, trying to find something that piques my interest. Today’s top headlines in the currency sector centering on the US Dollar not doing anything as there’s little to trade on… thanks for the help world. So, I have decided that on days such as this, a day with little of note on the economic calendar, I would focus on a country (and its currency) that rarely gets much discussion in the world of FOREX. Today, that country is India.

For those of you who were unaware, the currency in India is called the rupee. Should you be traveling to India soon, it would be in your best interest to know that the USD is currently worth about 43 rupees. The country is dealing with high inflation, rising energy costs (who isn’t?), and a weakened rupee. As a response to all three, the Reserve Bank of India recently increased its benchmark repurchase rate and raised interest rates. As a result of this responsible policy move, many analysts now expect the rupee to strengthen against the USD to around 41:1 by the end of the year.

Like many other countries around the world, India has suffered from crude oil prices. As they import about 70% of their oil, their rupee has suffered in kind. Still, not all is bad, as India has produced very impressive growth over the past decade. While that growth is crucial to India’s long term development, the Reserve Bank of India has sent a message that it is willing to sacrifice some of that growth today for improved economic indicators tomorrow. Unlike its neighbor, China, whose policies have led to – and sustained – very high inflation, India has decided to confront the problem.

As for the long term, most analysts remain optimistic. With its enormous population, the economic potential for India is still very strong. The country does sustain a sizeable current account deficit, but much of this could likely be attributed to energy costs. Personally, I applaud India’s commitment to keeping its inflation and rupee at acceptable levels. Instead of just continuing to focus on growth regardless of the long term consequences (ex. China), India is positioning itself to experience excellent growth for a long time by fixing its economic problems now.

Upcoming Figures
CHF Trade Balance (May)
CHF Swiss National Bank Rate Decision
GBP Retail Sales (May)
CAD Consumer Price Index (May)
USD Phildelphia Fed Business Survey (Jun)

The People’s Bank of China may be in a position to use its $1.33 trillion currency reserves as a bargaining tool against U.S. lawmaker demands. Xia Bin, director of financial research at the State Council Development Center, believes China can use its holdings of U.S. government debt to its advantage. As the world’s second-largest holder of U.S. Treasuries of $407 billion, the selling of U.S. asset holdings would significantly lower their value. U.S. Treasuries fell yesterday after traders cited in a U.K. Daily Telegraph report that China may threaten to sell its holdings in U.S government debt if the U.S. imposed trade sanctions (see more in an article by Kathy Lien).

On July 26^th, the U.S. Senate Finance Committee approved legislation that would place higher duties on Chinese imports. These higher duties should compensate for the undervalued yuan. U.S. lawmakers since the beginning of the year have expressed concerns that an undervalued yuan is hurting U.S. companies. The People’s Bank of China has bought huge sums of U.S. government debt in order to keep its yuan artificially low.

With a high foreign currency reserve, a central bank is able to issue more than sufficient amounts of its domestic currency to stifle demand. If demand decreases when the economy bottoms out, the central bank would have plenty of foreign reserves to buy back the domestic currency. The enormous influx of capital from its incredible trade surplus is what has allowed China to maintain the world’s largest foreign currency reserve.

Despite numbers for April and May this year showing cuts in PCB U.S. Treasury holdings after 17-months of purchases, the central bank has indicated it would cut holdings anytime soon. President Bush and Henry Paulson agree it would be “foolhardy” for China to cut holdings in U.S. debt. Selling off these assets would strengthen the yuan significantly and thereby lower export value. Both have indicated that a mutual trade flow without penalties on imports should persist. Yet, with its true actions always a secret to the public, it remains to be seen what the PCB will decide if U.S. import duties do come into play. The PCB could use its huge foreign reserves to put a dent into the U.S. economy. The situation has turned from a question of economic policy into a potential political showdown.  

We’ve been talking about the carry trade unwind for the past couple of days.  The moves in the forex market yesterday and during Asian trading last night ran counter to that assumption.  There was a reversal upwards in the yen crosses, especially CADJPY, AUDJPY and NZDJPY.  The late rebound in the Dow also buoyed USDJPY, as that currency pair has assiduously followed the ups and downs in the equities markets for some time now.  But I am here to tell you that the prognosis with regards to the currencies in the United States and Japan is still yen-positive and dollar-negative.

Let’s starts with the bad news for the US dollar.  The bond market is pricing in a 100% chance of an interest rate cut in January.  DailyFX.com has a fascinating take on the interest rate speculation through a look at the comments of various US monetary policy makers, with the ultimate scenario suggesting a more dovish outlook for the Fed.  The ADP survey shows terrible job growth numbers, coming in at only 75K.  Earnings for most US corporations continue to be relatively stellar, but the money refuses to trickle down, and dollar bulls may have to come to terms with a slowdown in US expansion.

Coming to the yen, most currency analysts see still more room for the room to grow.  The Chicago Board Options Exchanges’ market volatility index (VIX) hit a yearly high yesterday, and greater volatility is a death knell for the carry trade.  Kathy Lien of FXCM posts a two-year chart of USDJPY that will not provide comfort for yen bears.  The interesting thing about the chart is not that it necessarily signals a move downward in the currency pair but that it demonstrates the potential of a possible drop.  And that drop would be disastrous for those still long on the carry trade.

For some months now, dips in the yen crosses have not really been something to worry about; rather, these dips have been seen by Japanese retail investors as opportunities to short the yen.  There has been talk all over the market about “Japanese housewives” beating the pros and serving to stabilize the market by keeping carry trades alive.  But a recent Bloomberg report claims that the risk appetite for Japanese traders is dropping.  They are wary of selling the yen now because they anticipate still more appreciation for the currency, which has the potential to be a self-fulfilling prophecy.  And contributing to the growth of the Japanese yen are the losses all over the hedge fund market in the United States.  The hedge funds were some of the primary drivers of the carry trade, and their exits from the forex market (at least in this limited capacity) might serve notice to the rest of the market that the carry trade is, indeed, unwinding.

A worldwide credit crunch and economic problems (mainly in the United States) have torched the equities markets for the past two weeks.  There are fears that the subprime mortgage crisis and the housing problems will escape their respective sectors and infect the market as a whole.  The losses are magnified by the uncertainty of many traders, exemplified by the VIX volatility index surging past previous levels.  As is usually the case in a situation like this, risk aversion is controlling the market.  With regard to foreign exchange trading, two phenomena emerge: a flight to safety for capital and a carry trade unwind.  As Boris Schlossberg of DailyFX.com notes, the only winners in this scenario are the US dollar and the Japanese yen.

Flight to safety in the forex markets is beneficial to the US dollar, at least temporarily.  This is because investors pare back from riskier investments and park their capital in dollars for the time being.  The result is a peculiar situation where the crumbling of US markets is actually a boon for the US dollar.  But traders should realize the dollar strength will not last.  As for the US stock market, there is a sense that the credit crisis is reaching other areas; there are reports in Bloomberg that situation with subprime mortgages are hurting the earnings of companies across the spectrum.

And the economic reports have been mixed.  The regional manufacturing surveys (Philly Fed and Chicago PMI) have disappointed, confounding observers who thought the weak dollar would allow exports to support the manufacturing sector.  But unemployment is in line to grow by 100K for the NFP report later this week.  How traders react to that data will determine the long-term direction of both the US economy and the US dollar, but on a short-term basis, the dollar looks good.

Growing risk aversion also creates problems for carry trade longs.  Yen bulls have killed the fx market for the last two weeks.  There has been a 1000 pip decline in GBPJPY (from its record high), and the yen has also gained 700 points against the three commodity currencies.  In fact, the yen improved against all 16 most highly traded currencies last night.  Carry trade lovers cannot start crying over their losses yet, however; Kathy Lien of FXCM claims there is still plenty of room for the yen to appreciate.  Fear is the dominant factor ruling the currency market right now, signaling a strong near-term weakness in the Australian dollar and the New Zealand dollar, two currencies that have gone up significantly on the back of the yen-based carry trade.  I am not one who believes that the credit crunch puts us in line for a global slowdown (and the great thing about trading currency is that it doesn’t matter—there is the same opportunity for profit in a bear market as there is in a bull market).  But I think traders should be wary of high risk investments and focus instead on more stable currencies and economies.

Global equities markets took a beating last week. The phenomenon began in the United States (on the back of subprime mortgage concerns) and it spread to the financial markets in other countries. For the forex market, the primary impact of the losses was a return of risk-aversion. The risk appetite of currency traders has waned, and as a result, the yen-based carry trade has begun to unwind. The US dollar has also appreciated significantly as investors run to the safety of US assets. But the search for yield and the changing fundamentals of the market complicate matters, and the current trends may not last.

Regarding the carry trade, it is risk aversion driving the FX market. Japanese fundamentals stink, with Retail Sales disappointing to the negative and deflation sill a concern. But the yen continues to gain as greater market volatility hurts the carry trade. But this is all dependent on the equities market. If the Dow recoups its losses this week, we will see a renewal of the yen carry trade.

The US dollar also saw some improbable gains this past weekend. With investors more conscious of risk, the stability offered by dollar-denominated assets is more appealing. Americans, concerned about losing their gains overseas, repatriate their holdings into US dollars. For international traders, the US dollar becomes a store of value, just like holding gold or silver. Emerging markets in Asia were especially hard hit as overseas investor sunned riskier assets in favor of American ones. This particular phenomenon is controlling the currency market, overpowering economic factors that would pull back the US dollar (like the disastrous Existing Home Sales report).

But the forex market changes very quickly, and if last week’s equities market decline proves temporary, then we could see both a resumption in the carry trade and a plunge in the US dollar. The yen already began giving back some of its gains in European and Asian trading this morning with EURJPY, GBPJPY, AUDJPY and NZDJPY all riding upwards. And the US dollar cannot maintain its status as a store of value forever.

The latter situation is pretty interesting. The dollar benefits from its use as the currency of choice in international trade and as the primary denomination in foreign reserves. We have talked in the past about how other countries are starting to move away from the US dollar both in terms of international trade and in terms of foreign reserves. And there are reports in Bloomberg today of increasing protectionism with regard to foreign ownership of assets in the United States and Europe. This hurts the dollar and the euro because it makes dollar- and euro-denominated assets less attractive. And US fundamentals do not look like they are going to get better anytime soon. A recent Fed report suggests that even the weak US dollar may not help the trade deficit. We may see temporary gains in the greenback and the yen, but a long-term outlook does not bode well for either currency.

Yen carry trades have dominated the forex market for the past couple of months.  With international equities markets booming and high yields to be found in other countries, traders have been borrowing the yen on the cheap to finance their investments.  That has brought the yen to multi-decade lows against all the highly traded currencies.  But yen crosses look to be in line for a corrective decline.

The engine for carry trade demand has been the search for higher yields elsewhere in the world.  And the relative ease with which those yields could be found encouraged currency traders.  However, global equities are falling and credit spreads are beginning to widen.  Forex investors are seeing these developments and reacting with worry.  They are paring risk and liquidating their carry trade positioning.  As evidence of this situation, USD/JPY touched 119.12 per dollar in New York trading this morning, its lowest level since May 1.  EUR/JPY has regressed as well, falling to as low as 163.88 per euro.

The other factor contributing to the carry trade unwind is the possibility that shorting the yen will cease to be a one way bet.  There is growing speculation that Japan may intervene in the fx market to prop up its currency, and it certainly has the foreign reserves to do some damage.  Bank of Japan board member Tadao Noda spoke yesterday about the risks associated with a weak currency.  Hiroki Tsuda of the Finance Ministry warned the market that currencies should reflect economic fundamental and that the government would be watching the forex market for irregularities. The impact of both of these statements is that, if believed, they could serve to lower capital outflows from Japan.

There are fundamental signs that the Japanese economy is ready for an appreciation of its currency.  Consumer spending seems to be recovering, with CSPI printing at a year-over-year growth of 0.6%, a 10-year high.  Household spending has been in positive territory since the beginning of this year, suggesting that price action is likely to drive yen crosses even lower.  Forex professionals have been predicting movement in the yen to 115 for months now, and there have been reports in Bloomberg about Japanese housewives keeping the carry trade afloat.  It has been very tempting to be short the Japanese yen in recent times; you can earn the carried interest without threat of a swing back in favor of the yen.  And while you may have made a good deal of money this way, it might be time to look elsewhere for your investments.  One of the worst moves a forex trader can make is to fall in love with his own trades, and the time is now to unwind the carry trade and find some other vehicle for growth.

Inflation has always been an important concern for currency analysts, if only because it has a direct relationship with interest rates.  Central banks have a mandate to keep inflation under control, and so signs of rising inflation indicate a strong currency.  But the new paradigm of an increasingly international economy could leave monetary policy makers impotent in the face of global inflationary surges.

Commodity prices are near record highs, and interest rates do not have the power to completely moderate supply-side inflationary pressures.  Oil is selling for almost $80/bbl, and there are market analysts who believe we are likely to see $100 oil by 2008.  That would put oil at the $100 level one full year before Goldman’s now infamous oil projections of last year.  Gold and food prices are also through the roof (they are the primary driver of high prices in Australia and New Zealand).  With growing demand for commodities from developing economies, price pressures are not in line to let up anytime soon.  In the forex market, the most prominent consequence of the commodity boom is the incredible rise of the three major commodity currencies (Canadian dollar, Australian dollar and New Zealand dollar).

But more troubling for fans of domestic monetary policy is that inflation is also being stoked by rising prices for finished goods and services.  This phenomenon has surprised many observers because it seems counterintuitive to the idea of globalization.  Free trade was supposed to lead to higher efficiency and lower prices.  But with emerging markets all over the world on the rise, we are seeing more and more wealth in the developing world.  A booming economy naturally leads to higher prices, and the Chinese yuan, Indian rupee and other emerging market currencies have appreciated significantly this year.  Goods from these countries are now more expensive, and so as we buy imports from the rest of the world, we see China and India and Brazil exporting inflation.

Growing wealth in the world’s developing areas has other consequences of inflation as well.  Rich foreigners buy assets in the developed economies, and more buyers drives up the price of these assets.  This is partly the cause of exploding real estate prices in London.  For those concerned about the US dollar, we should note that the weak dollar makes US assets especially attractive.  It is as if US products were being sold at a discount relative to prices in the past.  This is why foreign ownership of US securities reached record levels last May.  But forex traders should still keep track of the current state of the US dollar.  Traders like to invest in markets that are growing (and economies that are healthy.  So while a weak dollar might be good for the US economy, a weakening dollar is bad.  And with central banks less powerful in the face of the new global economy, we might not be able to do anything about it.