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Capitalism requires business cycles
There has been much admiration for the Chinese
state-controlled economic model. We predicted that
China in 2009 would be the anchor of stability for the
global economy and so it turned out. However, we
are not sure that the same can be said for the next
12 months. Yugoslavia showed that a statecontrolled
market economy cannot ignore the need
for business cycles to correct wasteful investment.
The business cycle works in the capitalist economy
as a quality control for the efficient use of resources.
Business cycles are necessary and useful. In its
2006 stability report, the IMF illustrated that delaying
cyclical downturns only makes the following
recession deeper and more painful. In this sense, the
absence of a Chinese business cycle is worrying and
implicitly suggests that there must be a certain
degree of wasteful investment in the economy which
at one point will have to be cleared out. What should
not be forgotten either is that wasteful investment
reduces efficiency, turning a competitive and noninflationary
economy slowly into a non-competitive
and inflationary one.
130
120
110
100
90
80
70
Graph 5: USD – CNY REER gap has Widened
by 30%
Jan-94
Apr-95
J u l -96
O c t -97
Jan-99
Apr-00
Jul-01
Oct-02
Source: Reuters Ecowin Pro, BNP Paribas
CNY Broad BIS REER
Jan-04
A p r- 05
USD Broad BIS REER
Chart 6: Chinese Shares have Underperformed
Jul-06
Oct-07
Jan-09
Apr-10
Does that mean the consensus has started the year
with a wrong distribution of risk preference? Most
think that the main risk of economic
underperformance should be associated with the US.
They have allocated their currency portfolios
accordingly, using the USD as a funding currency.
Along with a better-than-expected performance by
the US economy, Asia’s inflation rate could
undermine this investment strategy.
The meaning of inflation for currency markets
Indeed, the economic outlook for China and by
extension Asia depends on the seriousness of the
current inflation wave. The consensus sees inflation
as mainly driven by commodity-driven cost-push
effects. If this assumption proved correct, current
prices would stabilise within a year. What we find
disturbing is that the rhetoric has taken the same
angle as in the early 1970s when the Yom Kippur
war triggered the first oil price shock. Then, It was
argued that higher oil prices would reduce real
disposable income and would in fact prove to be
deflationary in the long run. Hence they did not
require attention from monetary authorities. This view
backfired in the 1970s, a decade when inflation
proved a real problem. Interestingly, the 1960s had
seen a sharp expansion of the monetary base,
exceeding GDP by a multiple. Over the past couple
of years, the same has happened on a global scale.
That is good enough reason in our view to discuss
what will happen on FX markets, should inflation
become a theme.
Changing the way we look at FX
Source: Reuters Ecowin Pro, BNP Paribas
First, we will have to change the way of analysing FX
markets. During the time of the ‘Great Moderation’,
central bank credibility advanced to ever-higher
rates, allowing us to use nominal interest rate and
yield differentials to predict currencies. At times of
corporate-dominated cross-border flows, we used
corporate bond market yields but, most of the time,
sovereign flows dominated cross flows anyway,
keeping the emphasis on sovereign yield
differentials.
When inflation comes back, it will be real yield
differentials that tell us if currencies have upside or
downside potential.
The relative credibility of central banks will
determine the value of FX
Secondly, central banks will be differentiated
according to their willingness to tackle inflation head
on. In the case of Indonesia and India, markets have
started expressing doubts, putting their asset
markets under selling pressure. The selling pressure
Hans Redeker 20 January 2011
Market Mover, Non-Objective Research Section
61
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