A dismal world where oil and currencies are causing havoc

FLASHBACK 15 years to the time when the United States was in the midst of a disruptive digital revolution. By 1999, the country was having a time of its life – gross domestic product (GDP) was up 4% (double the rate of advanced nations) and unemployment was down to 4% (a 30-year low). Foreign capital flowed-in and US dollar and the SandP 500 stock index were up: US stock prices reached 30x earnings; and tech stocks went wild.

1990s all over again?

Sound familiar? Not unlike recent years, Japan slipped into deflation in 1997; Germany was then the “sick man” of Europe (now it’s the entire eurozone). Emerging nations were in crisis, culminating in the currency crisis of 1997/98 when many currencies (especially from Asia – from baht to won to the ringgit) crashed as foreign capital withdrew and servicing US dollar debt became unsustainable.

The parallels with today are not dissimilar. In the 1990s, Harvard’s Larry Summers warned that the world economy was “flying on one engine.” Today, Columbia’s “Dr Doom” Nouriel Roubini, echoes the same sentiment stating only the Anglosphere (the United States and the UK) engine is functioning.

Eventually US got sucked in: the tech-bubble burst in early 2000; business investment shrunk and share prices fell and consumers cut back. By early 2001, the United States and the rich world had slipped into recession – albeit a mild one. This time, China is different in the two periods: it was a bit-player in 1999; now it’s the world’s second largest economy and the world’s largest exporter.

Four trends were at work to destabilise the world economy – about the same as now. First, the growth gap between the United States and other advanced nations is stark, and is narrowing between the United States and big emerging economies, reflecting lack of demand in the face of a strong US dollar.

Second, dismal outlook for eurozone (reflecting the disastrous impact of austerity) and Japan (repeating the errors of 1997). Third, while Asian nations are now better equipped (floating exchange rate, lower debt and healthy reserves cushion), trouble is nevertheless brewing – Russia is a disaster; cheaper oil, low commodity prices and variable currencies are hitting big emerging nations hard. Investors have become a nervous lot, as the US dollar gathers strength. Fourth, the messy geopolitical scene has got worse in the face of rising inequality, reflecting income redistribution to those with a high propensity to save (the rich and corporations), and exacerbated by capital intensive, labour saving technological innovation.

Rising risks of upheaval are plaguing the planet – Middle East is on fire, the Russia-Ukraine conflict is disruptive; Islamic terrorism is on the rise, together with geo-economic threats from the likes of Ebola and global climate change. All work to cause “secular stagnation” that is making structural reforms politically difficult. One thing is sure – they weaken global growth.

Oil price has slumped almost 60% since early 2014, as the Organisation of Petroleum Exporting Countries (Opec) resisted cutting output amid US shale boom, exacerbating the glut by an estimated 1.8 million barrels a day. Having fallen from above US$100 a barrel to US$50 (and below), the price is still trying to find its place. Most analysts see US$50 as the floor, expecting a rebound to US$60 to US$80 in the course of the year. History tells an analytical story of two distinct pricing regimes: (i) 1974-1985 and then, 2005-2014 during which the “monopolistic” US dollar benchmark price fluctuated between US$50 and US$120; and (ii) 1986-2004, with the “competitive” price settling at US$20-US$50. The oil market is marked by a struggle between monopoly and competition. In this struggle, competitive pricing – recently led by low-cost Saudi Arabia and Opec, and Russia can go as low as US$20 (break-even marginal cost of “old” oil), outflanking shale-oil producers (mostly costing US$50 to produce) who are now cornered to take-on the role as swing “commodity” producers. So, realistically, a much lower trading range could stretch all the way down to US$20. Oil on New York’s Mercantile Exchange dropped to US$46.7 on Jan 20. I guess it can fall to US$38-US$40 by end of the first quarter amid the continuing “war” for market share. Rising supply, slowing refinery demand, geopolitical “shocks” and rising US dollar - these remain the constant factors driving prices.

Currency war?

It passed without much notice. On Jan 14, the euro slipped to US$1.17, the rate when it was first introduced on Jan 1, 1999. It then weakened rapidly. By early 2000, the euro hit parity with the dollar, plunging to US$0.83 by October. Fearing competitive devaluation and worried about inflation, the big central banks co-ordinated to stem the euro’s fall. Today, the euro’s slide has been more orderly but definitely persistent. Deflation has set-in in the eurozone (consumer prices fell 0.2% in 2014) and with Germany’s economy wobbling and others in Europe either stumbling or stagnating, the region’s prospects look ever so feeble. Indeed, it’s dead in the water. Parity with the US dollar is on the cards again. I am afraid both politics and oil are undermining the currency. Immediate threat comes from this weekend’s Greek elections. The possibility of Grexit (Greece exit from the euro) – though lower than in 2012 and deemed by most to be unlikely, casts a wary shadow over the euro’s value with no political leadership to kick-start the single market. Policymakers are running out of options. Instead, all eyes are on the ECB (European Central Bank) and its willingness to engage in some form of QE (quantitative easing), even “a QE-lite” version, to create enough money to buy sovereign bonds (now deemed legal). This is really a cop-out. Europe definitely needs to reform and have a balanced recovery based on more investment and spending at home.

Meanwhile in Asia, the Japanese yen – as a result of Bank of Japan’s unprecedented massive and aggressive QE, is considered undervalued against most currencies of emerging nations, including the Chinese yuan. It’s now 117.5 yuan to the dollar compared with 80 yuan in mid-2012. Japan’s October 2014 move was perceived as unfriendly, beggar-thy-neighbour, provoking neighbours to react. China has since allowed the yuan to moderately weaken (down 3% in 2014). Beijing is in a bind as it seeks to grow the slackening economy in the face of on-going structural reforms.

It needs to deflate its previous wild lending boom and overheated housing sector, which rules out aggressive monetary easing. Fiscal policy runs up against the need to slow down capital spending and rein in local government excesses. For China, with growth slackening to 7.4% in 2014 (lowest since 1990), devaluation remains one clear policy option. Most other emerging nations feel vulnerable, especially commodity-based economies like Indonesia, Brazil, Malaysia, South Africa and Nigeria. Even Russia. Already all of them have accordingly devalued. Malaysia, for example, has seen the ringgit fall close to 14% against US dollar since last August. The real problem is that if everyone devalues, no one wins (a zero-sum-game). In the event this becomes aggressive and disorderly, it can create systemic risks world-wide, with disastrous consequences. US dollar borrowers would struggle to find adequate funding. US firms would be furious to see their exports “evaporate.” And emerging markets would be forced to raise interest rates to prevent their currencies from collapsing. Short of global monetary reform (unthinkable even today), nothing can be done to stop competitive devaluations once they begin.

Still, currency markets remain in turmoil. The recent abrupt move by Switzerland to remove the cap on its franc peg to the euro sent global markets reeling. This prompted the Wall Street Journal’s leader: “Murder in Zurich.” The Swiss franc had since revalued 20% against the euro.

Pressure is now on the Danish krone peg. It signals an end to stable money and a setback for growth. It blew a hole in Japan’s quantative easing (QE) strategy by undermining the credibility of central banks. So, the Swiss National Bank had to move or get run over. Currency market tumult harms. How will China respond to the challenge posed by a much weaker euro, yen and won? If Beijing caves-in and adopts the already in vogue beggar-thy-neighbour stance, ripples can become tidal waves. As I see it, the world has little choice but to go for a globally managed exchange regime.

What then, are we to do

The political scene and economic dynamics have since changed – not in a good way. At the end of the 1990s, many in the advanced economies and in some of the big emerging economies had enjoyed the fruits of the boom. Median US wages rose by 7.7% in real terms in 1995-2000. Since 2007, in contrast, they have been flat in the United States and fallen in the UK and much of the eurozone. There is much discontent, even anger as a result. On top of this, the global geo-political dynamics have also changed, the most serious being that we are now “at war” against unpredictable terrorism and radical Islamism. This year may look much like the late 1990s but the politics and economics have probably turned for the worse. String together indicators like weak gold prices, falling oil prices and weak commodity prices, low gilt-edge bond yields, strong US dollar and downward revisions to growth forecasts and they point to deflation. The key question is: how to avoid deflation and promote growth in 2015? Given the failure of ultra-low interest rates to stimulate investment and growth, and recognising that the United States is the only place where real demand is, policymakers in Europe and Asia are trying their darnest to make exports cheaper to help their economies grow.

Whilst competitive devaluation is a zero-sum-game, monetary easing is not purely zero-sum. Easy money can boost demand by lifting asset prices (equities and housing), reduce borrowing costs, and limit risks from inflationary expectations. The cause of currency turmoil is clear: as public and private sectors deleverage from their high debts, monetary policy (and QE) becomes the only game in town to boost demand and hence, growth. All this only leads to further strengthen the US dollar, as growth in US expands and as the Fed prepares to raise interest rates sometime in 2015. But if global demand and growth remain weak, and US dollar too strong, the Fed may defer (with growing “patience”) raising rates to moderate US dollar appreciation. The world is still flying on one engine. To navigate the menacing “storm clouds,” the pilot needs to be nimble (less fiscal austerity), bold (more public spending on infrastructure) but disciplined (less reliance on QE). But that’s not what the world is doing. Small wonder global growth keeps on disappointing. Are we all Japanese now?

Obiter dictum

Looking ahead, silent demographic shifts are taking place to redefine the future. Already in 2000, Germany and Italy had more people aged 60 and above than those below 20. In 2010, Japan joined them as did many nations across Europe including Switzerland and Spain. By 2025, 46 countries will have more old people than young. China and Russia will join by 2030; Indonesia by 2050 and India by 2070. That’s not so far off. By 2050, old people world-wide will triple to 1.5 billion, 16% of the world’s total. Much of this will take place in East Asia (China, South Korea and Japan) where one billion old people will live.

This means more wealth will be concentrated on the elderly, especially elderly women, and because of them, consumer behaviour, product preferences and social demands will change drastically. Societies now have the new task to prepare and deal effectively with the empowerment of this new class of consumers. Tomorrow, all eyes will be focused on the elderly.

¦ Former banker, Dr Lin is a Harvard educated economist and a British Chartered Scientist who speaks, writes and consults on economic and financial issues. Feedback is most welcome; email: [e-mail].