Why the dollar may be weaker than most people expect

China’s the reason

The bout of dollar weakness that started a few days ago seems to me, contrary to the views you hear on financial talk radio/TV, to be tied directly to the Chinese announcement that it will soon issue renminbi-denominated government bonds to foreign investors through a Hong Kong offering.

This is a (small) step toward relaxing the iron control that China has exercised over its currency.  But it’s a significant one, given that such control is what allowed China to avoid any hint of contagion during the Asian currency crisis of the late Nineties.  The move is also a necessary step in China’s severing its currency peg to the US dollar.  And it comes faster, I think, than the markets had expected–hence, the weakening dollar.

Interest rate differentials will likely move against the dollar, but…

True, many other nations have been reporting recently that their economies appear to be exiting recession more quickly than anticipated.   These countries are actively planning to restore money policy to a normal footing by raising interest rates.  In contrast, the US, the ground zero of this financial crisis, is far from being in a position to follow suit.  The widening interest rate differentials that will result from differing policy actions should by themselves cause some dollar softness.  But China’s weak renminbi-strong dollar policy has been so significant a support for the greenback that I think a change in China’s stance is a much more powerful and longer-lasting factor in determining exchange rates.

Why is China acting?

Why is China doing this?  Why now? What are the implications for stocks?

Why

1.  The why is straightforward.  When a developing country pegs its currency to another, usually the currency of its main developed-country trading partner (see any of my posts on Asian development or on the origins of Bretton Woods), it does so to ensure a continuing labor cost advantage for its exports.  The price for this benefit, however, is the loss of control over domestic money policy.

The poster child for the difficulties of maintaining a peg is Hong Kong.   But the EU offers a more recent–and perhaps more relevant–one.

Look at young, vibrant, fast-growing Ireland.  It has been linked through the euro for many years to a stagnant Germany, which has struggling with the consequences of reunification of east and west.  EU money policy has been set to keep Germany, its largest member, on life support.  That has been ok for Germany, but much too stimulative for fast growers like Ireland and Spain.

Look how that has worked out.  Germany has muddled through, but Ireland suffered from massive inflation for years, finally overheating and melting down during the financial crisis.  The Irish banking system has ended up in tatters.  So, too, its property market.  And the country itself is so bereft of new policy ideas that it is calling on the Irish diaspora to come to a conference in Dublin to help figure out what to do next.

Un fortunately, the US looks a lot more like the moribund Germany of the Nineties than anyone would have suspected a year ago.  China may well see itself as the next Ireland if it doesn’t sever its tie with the dollar quickly enough.

Why now

2.  Why now?  For some time, China has been concerned about the creditworthiness of the US–that is, whether the huge pile of dollars it holds from trading with the US will hold its real value until China gets around to spending it.  One result of that worry is an increased effort by China to buy dollar-based assets.   One might also argue (I have no strong view myself) that China’s recent binging on industrial commodities, and the resulting immense stockpiles it appears to be building, is another consequence of its dollar unease.

China, however, has worries beyond the safety of its foreign currency reserves.  China sells mostly consumer goods–toys, clothing/home furnishings and computer peripherals–to the US.  It’s hard to see dynamic growth here over the next several years, even though in the past the US consumer has perennially surprised on the upside.

The export-oriented model as a source of growth for China was already nearing the end of its useful life before the financial crisis.  China has likely concluded that the ninth inning for this strategy has already arrived.  Therefore, it must redirect its economy away from dependence on the US.  If so, it no longer makes sense to “buy” economic growth by exporting its national wealth to the US in the form of too-cheaply priced goods.

The next logical step is to drain the economy of excess liquidity and refocus away from its labor-intensive, low value-added export emphasis.   The easiest way to do both would be to have he renminbi appreciate.  And the least politically dangerous way to so so is to make the appreciation appear to be the work, not of the Chinese political leadership, but of the global currency markets, i.e., to allow some sort of international currency trading.  This is the direction in which international bond sales are leading.

Implications for stocks

3.  Implications for stocks.  Broadly speaking, you want to own the stocks of companies that have revenues in hard currencies and costs in weak currencies.  For a weak currency country, which the market seems to be saying the US will continue to be, this has traditionally meant export-oriented or import-competing businesses.  In today’s world, it would also mean global companies with a large presence outside the US.  And it would include firms that deal in unusual products or services for which there are no close substitutes.  In the US, this means technology, medical services and entertainment.  Remember, too, that at least in the short run, a currency decline acts as an economic stimulus for the weak currency country.

Tourism and urban real estate are two weak-currency winners that investors sometimes forget.  In a weak currency environment, condominiums in New York or San Francisco will look increasingly attractive to foreigners.  Also, vacation destinations like Orlando or Las Vegas will likely draw increasing numbers of foreign visitors, as well as domestic tourists who find a foreign destination too expensive (I own DIS and WYNN).

Commodities are a more complicated question.  In a world dominated by demand from the US, it was probably right to say that most industrial raw materials were dollar-priced commodities.  But even twenty or thirty years ago, gold traders always tried to relate the metal price to both the dollar and the D-mark/euro.

In today’s world, in addition to precious metals, pricing for all industrial raw materials is probably going to be based on a cocktail of dollar, euro and renminbi.  If so, commodity miners/producers should get better pricing  than usual in a world upturn.  Commodity processors will be a mixed bag, and not the sure-fire winners they have been in the past.  They and commodity end users‘ fortunes will both depend on the currency they receive their revenues in.

I think the reorienting of US equity portfolios to benefit from dollar weakness, which I see as already underway, will continue to be a feature of market action for an extended time to come.

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