Currency Crisis and Dollarization
In the past few months, there have been a lot of discussions about de-dollarization in response to the weaponization of finance, but in the markets, we have seen the exact opposite. Since November, the dollar index is up 8.5% and continues a precipitous rise.
So, What’s Going on?
Over the past several decades, the global economic order has been built on a strong US dollar financing large trade deficits with China. China, in turn, uses its trade surplus to buy US assets. This maintains the strength of the US dollar which subsidizes even more consumption of Chinese exports.
Chinese officials met recently to discuss how to protect their assets if the US were to levy sanctions as the US did against Russia, and they ultimately concluded that there is no way out. China can’t diversify its asset holdings without devaluing the dollar and hurting Chinese exports, but similarly, the US can’t afford dollar depreciation without a massive demand boost for US exports which would result in runaway inflation. And so, it seems that we are now on a collision course, and some things have got to give.
As interest rates increase in the US, other countries are faced with a dilemma: either increase rates to match US yields or face a flight of capital and the corresponding currency crisis. Countries that are pursuing additional stimulus (Japan) and lowering rates (China) are now facing the predictable consequences of going against the grain, their currencies are rapidly devaluing.
In 2021 as Turkey’s currency crisis unfolded, they pursued similar unconventional strategies of lowering interest rates while attempting alternative incentives to prevent capital flight. A vicious cycle broke out, as the Turkish Lira declined, citizens converted their Lira into Dollars to hedge their currency risk which further devalued the Lira, causing more citizens to convert their Lira.
The result was the Turkish Lira lost 97% of its value against the dollar since January 2021. As of March 2022, Turkey’s official inflation rate is 61%, but the independent economic research group ENAG claims it is actually 143%.
It is hard to predict exactly how this will pan out as opposing forces meet. Governments facing currency crises are incentivized to sell off their foreign exchange reserves, aka dollars or dollar-denominated securities (US Treasuries), and purchase their own domestic currency to prevent further decline. At the same time, investors and their citizens are incentivized to do just the opposite, ditch the local currency for dollars.
We’ve started to see this dynamic play out. Japan, the largest holder of US treasuries, has started converting their T-bills into Yen to support the currency from collapse. At the same time, the Fed is about to begin their balance sheet run-off, all while Boomers entering retirement are converting their investment assets into annuities for guaranteed income as they age. The results thus far is the steepest rout in US treasury history while the dollar continues to strengthen. Japan has $1.4 trillion in foreign currency reserves that it could use to prop up the yen, but it will likely have to go it alone. The G7 and the G20 have agreements in place to prevent countries influencing exchange rates.
Russia was able to successfully reappreciate the ruble to pre-invasion levels. But, it required an extreme increase in interest rates from 9.5% to 20%, along with a laundry list of other capital controls. And, it has only cost them a deep economic recession.
However, China is stuck. In 2012, China began its demographic decline, which hasn’t been noticeable until recently. They are now facing extreme worker shortages with 70% of businesses struggling to find labor. The Chinese government has responded to the situation in three ways. One, through territorial expansion and subjugation in Hong Kong, with its sights set on Taiwan. Two, by working to modernize their economy and invest heavily in emergent technology e.g. 5G, AI, etc… which generate more GDP per capita. And three, by restructuring their economy to slough off needless jobs that don’t actually contribute to meaningful GDP, i.e., their construction sector.
The slow and controlled demolition of Evergrande, China’s second-largest property developer, which has $300B in on-balance sheet liabilities and an estimated $150B in hidden liabilities, is being contained through lowering interest rates and providing other financial support. Hence, the double bind. Either, the Chinese government must continue to provide support to their economy so that the Evergrande collapse doesn’t spread throughout their entire economy or remove the rate support to deal with their devaluing currency and capital flight.
Some have argued that China’s currency devaluation might actually be a good thing for their economy, as it boosts exports. While that makes sense on the surface, the problem lies in who ends up with the money. China’s modernization efforts are an attempt to be more self-reliant and provide stability by strengthening its consumer class. A devalued currency does the exact opposite. Devalued currency lessens buying power at home and transfers wealth intranationally from consumers to their business sectors, which already have a glut of excess savings.
This is all complicated by China’s wave of COVID BA.2. Imagine the US Omicron’s wave, but without a vaccine and a population that is several times larger. In a desperate effort, they are attempting extreme lockdowns to control a virus that most believe can’t be controlled at this point.
These lockdowns are grinding much of their manufacturing economy to a halt. It is in a worse situation now than it was in March 2020. The downstream effect is that the supply chains won’t be fixed for the foreseeable future. Intel announced recently that the semiconductor shortage isn’t likely to be resolved until 2024 and we should expect more such announcements in the future.
From Boomflation to Bustflation (stagflation)
2021 was the year of boomflation, high economic growth from the recovery along with high inflation. In contrast, 2022 is the year of bustflation, stagflation, or the new normal, characterized by low economic growth and high inflation. US GDP contracted by 1.4% annualized in Q1, while global economic growth is expected to slow to 3.2% for the year.
The biggest defining feature of this year will be the bullwhip effect. This is when small changes in consumer demand are amplified through the supply chain. Every link in the chain has its own safety stock or bulk ordering process that flows through to the producer. The result is a pattern of too little followed by too much with some players ending up with whiplash. Today, that player is the US trucking industry which is heading for a recession.
Throughout the last year, demand for physical goods was at an all-time high and that demand overloaded the transportation infrastructure. Retailers became fearful of when they would get inventory and decided to over-order which further clogged the supply chain. Today, inventories are at capacity just as consumer demand shifts from consuming products to consuming more services. Combined with China’s manufacturing shutdown, the US trucking industry has little to do. Certain metrics might give a false impression that the supply chain is recovering, but as you can see above, lead times are longer than a year ago and as soon as China comes back online, we’ll see another crack in the bullwhip.
Zooming out, what we are witnessing is a virtuous or vicious cycle depending on where you stand. As regionalization and demographic decline take hold there will be strong demand for labor, as witnessed by the ever-increasing job openings, which now stand at 11.5M. While the labor pool continues to shrink with unemployment dropping to 5.6M, wages continue to be pressed upwards. As we witness the rebirth of the American middle class through wage gains, those individuals will drive continued consumer demand for goods and services, which is only compounded by the appreciation of the dollar. The increased consumption at the bottom of the economic ladder then increases the demand for labor, and on and on we go. Given this dynamic, the Fed will be hard-pressed to stop interest rate increases at neutral and will likely blow past 3% by the end of the year.
In March, the Fed adopted the ratio of job openings to unemployed persons as an official measure that will be monitored and managed. They believe getting that ratio to approach 1 will limit wage growth and thus inflation.
The thing the Fed fails to appreciate is that the excess job ratio isn’t a measure of wage growth, it is a measure of leverage, and as long as it is above one, then employees will maintain the advantage. We should expect sizable wage growth in the near future. I maintain my prediction of the de facto minimum wage will be $23-25/hr by the end of 2022 and $28-30/hr by the end of 2023. As employees hold the leverage we can expect mass unionization will be sweeping across the country over the next several years.
What Companies Can Do To Thrive During Disruption
We are at the turning point from one global macroeconomic system to another. The last time the world experienced this level of disruption was from 1971 to 1985. The way to stay ahead is through scenario planning and constantly adjusting one’s forecast in the presence of new information, for example:
- So far, businesses have been successful in adapting to rising costs by raising prices in excess and experiencing margin growth. Yet, in the past month, consumer patience with rising prices has worn thin and they are finding alternatives by either consuming cheaper products or diverting their dollars elsewhere.
- Even as wages increase in the aggregate, the process of wage appreciation can be slow to convert to actual consumer demand. The start-stop process is likely to generate bull-whip effects going forward, with employers struggling to maintain internal wage equity while recruiting and retaining new workers at higher wage rates.
- Businesses need to internalize the boom-bust cycle in their forecasts and anticipate an extended worker shortage for the foreseeable future.