UBS Investment Research Economic Insights By George

A third US dollar bull market, 2008-2015?

I will bring you down baby, I will bring you down to Chinatown Jack Byrnes (Robert de Niro) in Meet The Parents

25 February 2013

George Magnus, Senior Economic Adviser [email protected]

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Economic Insights - By George 25 February 2013

A third US dollar bull market, 2008-2015?

I will bring you down baby, I will bring you down to Chinatown Jack Byrnes (Robert de Niro) in Meet The Parents The rise in the US dollar index (DXY), since the all-time low reached in March 2008, has so far been relatively restrained, partly because of QE, and focused largely on the Japanese Yen. But in two previous bull markets, DXY rose sharply for several years. If history is anything to go by, and the nascent signs of economic healing in the US become more convincing, the US dollar could yet rise significantly further over the next two to three years, perhaps reaching 120130 against the Japanese Yen, and parity to 1.05 against the Euro. More than likely, many emerging countries will be prepared to allow their currencies to decline against the US dollar too. This view sits uncomfortably with the widely held view that US trend growth and financial stability could be undermined by the political systems failure to address the crucial issue of debt sustainability. Again, things are coming to a head in March with sequestration all but imminent in the absence of a bipartisan agreement, and then the possibility of a government shut-down if the debt ceiling isnt raised at the end of the month. But the idea of the US facing a sovereign crisis, as such, is an opinion, not a prediction. In any event, according to the Congressional Budget Office, the budget deficit under current laws will drop to under $500 billion in 2013, or 5.3% of GDP, the lowest since 2008. The central forecast, based on an undemanding GDP growth rate, is that it will continue to drop to 2.4% of GDP by 2015. The CBO notes that the real fiscal and debt sustainability issues for the US are unlikely to become pressing until later in the decade and the 2020s1. If the deficit should halve in the next two years, as suggested, sentiment in US capital markets is likely to be buoyed, for a while at least. A higher US dollar, and an increase in US real interest rates would mark a significant shift in the financial and investment environment. But the most challenging implications might be for emerging markets and industrial commodity prices, both of which have prospered during the US dollar downwave since 2001. The two previous US dollar bull markets since the collapse of Bretton Woods, from 1978-1985, and from 1992-2001, had a detrimental effect on Latin America, and Asia, respectively. Drawing on the film quote above, where Robert de Niro is threatening his future son-in-law, this note asks if the third US dollar bull market poses another similar threat.

Biblical cycles
Since the collapse of Bretton Woods, the US dollar has competed three down cycles (famines) and two up cycles (feasts), with an average duration of a little over 7 years. The longest bear was the first one, from before the collapse in 1968 to about 1978, driven by the economic consequences of US guns and

1 Congressional Budget Office, The Budget and Economic Outlook: Fiscal years 2013-2023, Washington DC, 5th February 2013

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butter programmes (financing of the Vietnam War and Great Society social programmes), political turbulence in the Middle East and the oil price crises. The subsequent bull market, from 1978-1985, occurred on Fed Chairman, Paul Volckers watch. Vigorous monetary tightening to slay inflation exposed the frailties of the savings and loan institutions and larger banks at home, and made for an impossible environment for the financially-strapped countries of Latin America.
Chart 1:US Dollar Index (DXY)
170 160 150 140 130 120 110 100 90 80 70 Jan-71 Jan-73 Jan-75 Jan-77 Jan-79 Jan-81 Jan-83 Jan-85 Jan-87 Jan-89 Jan-91 Jan-93 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13

US Dollar Index (DXY)

Source: Bloomberg/UBS

The second bear market, from 1985-1992 occurred against a backdrop, comprising principally, the consequences of the Plaza Accord in 1985 to lower the US dollar against the Japanese Yen and the D-Mark, and a booming Japan. The second bull market, also the longer of the two, followed and lasted until 2001. Over this decade, the US experienced its longest peacetime expansion, enjoyed the productivity and other benefits of the technology boom, implemented important welfare reforms, and transformed its fiscal deficits into four years of surpluses at the end of the period. The third bear market kicked off in 2001 at the top of the technology boom and ended seven years later at the height of the financial crisis. During this period, as we now know, the seeds of the financial crisis were sewn. The current account deficit doubled from around 3% at the turn of the decade to 6%, or around $800 billion, in 2006. At the end of the period, the financial crisis drove the US dollar index down to a record low revisited in 2011. Meaningful shifts in asset allocation away from the US dollar took place in this period, perhaps driven by related developments. These included the pursuit of excessively easy monetary conditions in the US; the search for yield elsewhere, including from the financialisation of commodity markets; the creation of the Euro-system; Chinas turbo-charged growth rate and its ascendancy in the global economy; and the re-rating of emerging markets more generally. According to UBS, US asset managers, running about $40 trillion of funds, held the foreign asset component of their portfolios steady at just over 10% during the 1990s, but by the end of the 2008, it had climbed to about 22%, since when

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it has dropped back towards 20%2. Central banks are estimated to have lowered the US dollar component of their reserves by about 10% to 61%. And sovereign wealth funds with assets of perhaps almost $5 trillion diversified too, even though this is impossible to verify and perhaps more applicable to the more modest $2 trillion managed by non-commodity funds3.

The Third Bull Market?

Since DXY looks to have troughed in March 2008, past performance suggests the current up cycle may last a while yet, perhaps until 2015. In the light of Americas rather unseemly budgetary politics, with its implications for the sovereign rating, financial stability and economic risks, this might seem optimistic. Perhaps. But the US budget deficit as a share of GDP is falling anyway, and is considered far less important than the implementation of entitlement reform and changes to the tax code designed to improve debt sustainability in the 2020s and beyond. The Congressional Budget Office estimates that deficits and public debt are projected to increase more quickly later this decade because of the now familiar pressures of an ageing population, rising health care costs, an expansion of federal subsidies for health insurance, and growing interest payments on federal debt. This is clearly not an idle threat to US financial stability but, at the very least, the US still has some time for its political system to find a way to break the impasse. Of passing but significant interest, one credit market research firm, considering the likelihood of debt default over the next five years for a number of governments, reckons that at the fourth quarter of 2012, the United States was the fifth least likely country to default on its debt over the next five years, with a probability of 3.30%4. There are no grounds for complacency, of course, but several other parts of the US economic and financial kaleidoscope seem to be slowly falling into place. Nominal GDP growth from the trough in 2009 to the end of 2012 had moved up to 4%. The housing sector has stabilised, capital spending by companies is contributing more to GDP growth, and non farm payroll jobs have averaged a little over 150,000 per month for two years, topping 200,000 in the fourth quarter 2012. Clearly the Federal Reserve is not about to terminate QE in the immediate future and will continue to focus on lowering the rate of unemployment, and the closure of the output gap, the size of which the FOMC members do not all agree. But the OECD reckons it is about 3% of potential GDP in 2013. And if the economy remains on a growth path of around 2-3%, the debate about QE exit strategies will gather relevance this year and next, not least in the expectations of US bond investors. If US bond yields rise to reflect

Mansoor Mohi-Uddin, The End of Dollar Diversification?, UBS Investment Research, Foreign Exchange Note (11), 10th January 2012 3 Massimiliano Castelli and Fabio Scacciavillani, The New Economics of Sovereign Wealth Funds, John Wiley & Sons, 2012 4 Cited in Rebecca Nelson, Sovereign Debt in Advanced Economies: Overview and Issues for Congress, Congressional Research Service, Washington DC, 31 January 2013. For the record, the only countries with a lower default risk are the four countries of Scandinavia, while Cyprus, Portugal, and Spain are all ranked in the top 10 countries most likely to default. Greece wasnt ranked in this exercise. UBS 4

Economic Insights - By George 25 February 2013

more robust expectations of a turn away from QE because of the return of selfsustaining growth, they are likely to pull the US dollar higher. In any event, one of the seemingly most mis-priced assets in the market, US inflation protected securities, are still offering negative yields of -1.36% at 5 year, and -0.56% at 10 year maturities. From a more structural standpoint, there has been a lot of conjecture about the path towards US energy independence, courtesy of growing domestic energy output and foreign sales of natural gas and oil. The International Energy Agency expects the US to produce more oil (broadly defined) than Saudi Arabia by 20175. But whether or not the US achieves independence any time soon, the steady decline in the energy trade deficit is already fact.
Chart 2: US energy net imports $bn, and as % GDP
255 235 215 195 175 155 135 115 95 75 55 35 15 Q190 Q191 Q192 Q193 Q194 Q195 Q196 Q197 Q198 Q199 Q100 Q101 Q102 Q103 Q104 Q105 Q106 Q107 Q108 Q109 Q110 Q111 Q112 1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0

US energy net imports in USD Bln (lhs)

US energy imports as % of GDP (rhs)

Source: Haver/UBS

And similarly, the US technological lead in advanced manufacturing is an asset that should stand it in good stead for a long time to come, as cost structures decline, sharpening the countrys competitive edge and providing incentives to create output and jobs at home. Even if you want to reserve judgment about the prospects for US fiscal politics, energy independence, and leadership in advanced manufacturing, the US dollar may still appreciate against other major currencies. The US economy is, relatively speaking, in better cyclical and structural shape, the Fed will likely be the first central bank to exit QE, and the US dollar faces weak competition in the rest of the developed world.

Other currency woes

The Japanese Yen has already depreciated significantly in the wake of political pressure from the new government on the Bank of Japan to double the inflation target to 2% and expand its balance sheet further. The central banks response was rather tepid, however, and provided for a very modest expansion from 2014. The incumbent governor and his two deputies are expected to be replaced from the beginning of April, and it would be a surprise if this did not result in a

International Energy Agency, World Energy Outlook 2012 UBS 5

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stronger reformulation of the BoJs QE strategic goals and objectives, with larger asset purchases of, say, 15 trillion Yen net, and starting in 2013. But theres a potential sting in the tail here. If the BoJ boosts its monetary liabilities, already over 30% of GDP, and succeeds in lifting the inflation rate, one of the unintended consequences could be a decline in the still positive real interest rates that have helped domestic investors remain committed to the JGB market, notwithstanding falling nominal GDP and a rise in public debt to over 220% of GDP. With the continuing change in Japanese demographics, aggregate savings are likely to decline as a share of GDP and public pension and life insurance funds that hold close to 20% of outstanding JGBs should be expected to liquidate some of their sizeable holdings. Moreover, the countrys famed external surpluses are fading, as suggested by the decline in export growth (deteriorating trade competitiveness based on exchange rate-adjusted unit labour costs and slippage in advanced manufacturing), and the slide in the trade and current accounts (partly energy policy-related, but also the relentless demographic transition).
Chart 3: Japan export growth, total, to US, EU, China and emerging Asia
80.0 60.0 40.0 20.0 0.0 -20.0 -40.0 -60.0 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jul-03 Jul-04 Jul-05 Jul-06 Jul-07 Jul-08 Jul-09 Jul-10 Jul-11 Jul-12

%y/y

Japan: Exports to US Japan: Exports to China

Japan: Exports to Euro Zone Japan: Exports to Developing Asia

Source: Haver/UBS

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Chart 4: Japan trade balance

15000 10000 5000 0 -5000 -10000 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13 JPY Bln, 12 month moving total

Chart 5: Japan current account as % GDP

5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 1995 1997 1999 2001 2003 2005 2007 2009 2011 Mar-12 Japan current account as % GDP 2013 Sep-12

Japan Trade Balance

Source: Haver/UBS

Source: IMF/UBS

The yen has already fallen a lot, and whatever the near-term movements in the currency, we believe it is likely to depreciate considerably further over the next year or so. If a falling Yen also ends up dragging down the JGB market, the Japanese authorities might yet face financial stability threats, calling for a regulatory as well as an economic policy response. But this is a matter for another day. The Euro is enjoying a stay of execution thanks to the revival of confidence in the systems integrity in the wake of Mario Draghis monetary policy stewardship at the ECB, and the official Greek debt restructuring late in 2012. These initiatives have persuaded investors that the Euro-system will stay together for the time being, and capital has returned to the Eurozone periphery, allowing bond yields and spreads to drop sharply. But even though the financial crisis, per se, has evaporated for now, the economic crisis has not been resolved. Leaving aside Greece, Portugal and Ireland (whose debt sustainability has been bolstered by the recent substitution of long maturity bonds for the contentious promissory notes), it is also evident that growth in France, Italy, Spain and even the Netherlands is faltering.
Chart 6: Real GDP growth for Portugal, Greece, Ireland
8.0 6.0 4.0 2.0 0.0 -2.0 -4.0 -6.0 -8.0 -10.0 Sep-07 Sep-08 Sep-09 Sep-10 Sep-11 Sep-12 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Real GDP growth, %y/y

Chart 7: France, Italy, Spain, Netherlands, Germany

6.0 4.0 2.0 0.0 -2.0 -4.0 -6.0 -8.0 Sep-07 Sep-08 Sep-09 Sep-10 Sep-11 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Real GDP growth, %y/y

Portugal

Greece

Ireland

France

Italy

Spain

Netherlands

Germany

Source: Haver/UBS

Source: Haver/UBS

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Meanwhile, the prospects for a viable banking union, and for the creation of transfer mechanisms, such as generalised debt restructuring, mutual bond issuance, Eurozone deposit insurance and strong bank resolution powers, that would assure long-term stability, remain weak or absent. While Europe remains mired in economic stagnation and austerity, and the scope for significant institutional initiatives remains low, the risk of significant swings in financial market sentiment appears undiminished. Political risks and events that have a bearing on the integrity of the Euro are never too far away, and so, renewed depreciation of the Euro seems quite likely in due course. Last but not least, there are concerns that the currencies of some countries that dodged the financial crisis most successfully, such as Canada and Australia, are now looking much more vulnerable. Past exchange rate appreciation has contributed to a deterioration in external positions, and the commodity price boom, which is now threatened by both a rise in the US dollar, and by a structural shift in the commodity-intensity of Chinas growth, may further undermine the Australian and Canadian dollars.
Chart 8: Australia trade balance and current account as % GDP
30 20 10 0 -10 -20 -30 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 AUD Bln, 12 month moving total 0.00 -1.00 -2.00 -3.00 -4.00 -5.00 -6.00 -7.00 -8.00

Chart 9: Canada trade balance and current account as % GDP

70 60 50 40 30 20 10 0 -10 -20 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Canada trade balance Canada current account as % of GDP CAD Bln, 12 month moving total 4.00 3.00 2.00 1.00 0.00 -1.00 -2.00 -3.00 -4.00 -5.00 -6.00

Australia trade balance

Australia current account as % of GDP

Source: Haver/UBS

Source: Haver/UBS

Emerging markets - then, and now?

Major questions hang over the consequences of US dollar appreciation for emerging countries - not least because the circumstances surrounding the first US dollar bull market in the 1980s had a detrimental effect on Latin America, and those associated with the second bull market in the 1990s contributed to the Asian crisis. Because the latter wasnt that long ago, and was triggered by the US dollars appreciation against the Japanese Yen, it is worth a worth a short reminder.

Then
During the prior US dollar bear market, Asian economies, whose currencies were largely fixed or basket-pegged to the US dollar, experienced a rise in net

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capital inflows from 1.6% of their GDP (1986-1990) to a peak of 6.75% of GDP in the second quarter of 19966.
Chart 10: Net capital flows to emerging Asia as % GDP

5.0 3.0 1.0 -1.0 -3.0 -5.0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Private portfolio flows, net Other private financial flows, net

Direct investment, net Private financial flows, net

Source: IMF/UBS

What happened subsequently and why have been the subject of much debate ever since. Internal financial and credit system weaknesses explain the contagion and escalation of the Asian crisis, but these didnt suddenly appear in 1997. They preceded the crisis without triggering it. The 35% Chinese devaluation in 1994 has also been cited as a factor, but this change only applied to the then official rate, used to convert little more than a fifth of export receipts, not the floating or swap-market rate that was determined largely in the market. In our view, Chinas devaluation played only a minor role in the meaningful decline in Asian competitiveness. And the bursting of the Japanese asset bubble in 1990 and the economys subsequent decline could have had a deleterious effect on Asia, but we see no evidence that Japanese imports from Asia were in a slump before the Asian crisis. It is most likely, then, that the big competitiveness shock to Asia came from another source, which was the sharp appreciation of the US dollar, especially against the Japanese Yen. Between 1995-1997, the US dollar rose by over 50% against the Japanese Yen, from JPY81 to JPY135 (eventually peaking at JPY147 in 1998). This lead to substantial Asian exchange rate appreciation against the Japanese Yen and the German Mark.

Surging Capital Flows to Emerging Asia: Facts, Impacts and Responses, IMF, Working Paper WP/12/130, May 2012 UBS 9

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Table 1: Bilateral Exchange rate changes April 1995-April 1997 (%)

Appreciation versus-> USD USD JPY JPY DM DM

Nominal S Korea Malaysia Thailand Indonesia Philippines Japan Germany -16.2 -1 -6.1 -9.2 -1.3 -50.1 -23.9

Real -12.4 0 -3.2 -1.5 8.2 -54.9 -27

Nominal 29.2 48.7 41.5 37.5 48.1

Real 37.9 54.8 54.4 52.7 68.8

Nominal 6.6 22.7 16.8 13.5 22.3

Real 13 26.9 26.6 25.2 38.4

Source: International Monetary Fund (International Statistics Yearbook). Real exchange rates were calculated using consumer prices, cited in Joseph Whitt, The Role of External Shocks in the Asian Financial Crisis, Federal Reserve Bank of Atlanta, Economic Review, Second Quarter 1999 E

3 Bilateral Exchange Rate Changes, April 1995Apr

Now
This time, though, it seems much less likely that emerging Asia would follow the US dollar sharply higher against the Japanese Yen and other currencies. Moreover, some important things have changed since the Asia crisis. Emerging Asian countries trade with one another now accounts for around 45% of total trade, compared with 30% in 1990. China now imports between a fifth and a quarter of emerging Asian foreign shipments (excluding the extremes of Hong Kong and India), compared with 10% or less before the Asian crisis. There are no notable cases of strong currency over-valuation. There are other differences from the 1990s. Emerging countries have high levels of international reserves. Many of them have refinanced a lot of their US dollar debt in to local currencies7. Relieved of the pressure to stop their currencies rising against a weak US dollar, the foreign-asset dominated surge in central bank balance sheets should stop, or even reverse8. This could give central banks the opportunity to try and unwind funding mechanisms, such as the extensive use of required bank reserves, and sterilisation operations, which are believed to have contributed to the faster expansion of off-balance sheet and shadow banking, especially in China, and to the dominance of the central bank in what are more sophisticated but still often immature and shallow local financial markets. 9 And, importantly, the overall picture of emerging country external balances is, in the main, re-assuring for the moment with the notable exception of a few countries, including South Africa, Turkey and India.

Bhanu Baweja, Who is Vulnerable in EM Debt?, UBS Investment Research, Emerging Markets Navigator, 25th January 2013. 8 Andrew Filardo and James Yetman, The expansion of central bank balance sheets on emerging Asia: what are the risks?, BIS Quarterly Review, June 2012. The authors report that in HK and Singapore, the central bank balance sheet is of the order of 100% of GDP. But leaving these special situations to one side, it estimates that in China, Malaysia and Thailand, the central bank balance sheet is around 50% of GDP, while for emerging Asia as a whole it is about 35% of GDP, with India and Indonesia at the bottom of the list. 9 Tao Wang, Risks in Chinas Shadow Banking, UBS Investment Research, Macro Keys, 16th October 2012, and Edward Chancellor and Mike Monnelly, Feeding the Dragon, GMO White Paper, January 2013 UBS 10

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Chart 11: FX reserves

3500 3000 2500 2000 1500 1000 500 0 Turkey South Africa Malaysia Mexico Russia Brazil Indonesia Thailand South Korea Poland China* Chile India

Chart 12: Current account as % GDP

8 6 4 2 0 -2 -4 -6 -8 Malaysia Mexico Turkey South Africa Indonesia South Korea Russia Jul-12 Brazil India Poland Thailand China Chile

USD Bln

Current account as % of GDP

FX reserves, Dec 2012

1997

2012

Source: Haver/UBS, China = Sep 2012 data

Source: Haver/UBS

It is a little early to fret. On the other hand, it seems complacent to imagine that the capital flows that have poured into emerging market real estate, local currency bond and equity markets, and piled up in their central banks, will be benign when they reverse as the US dollar appreciates. If the idea of a strong US dollar becomes more widely shared, this is likely to be trigger of financial instability, much as it was in the previous two bull market cycles. And the reason we should expect some sort of flare-up is that there are grounds for economic caution, based around weakening trends in exports and current account balances, and strong credit growth, which, among other things, has helped to fuel significant asset inflation, especially in real estate and local fixed income markets:
Chart 13: Developing Asia and Latam exports
50.0 40.0 30.0 20.0 10.0 0.0 -10.0 -20.0 -30.0 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jul-07 Jul-08 Jul-09 Jul-10 Jul-11 Jul-12 %y/y

Chart 14: China, Brazil and India exports

80.0 60.0 40.0 20.0 0.0 -20.0 -40.0 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Brazil Jul-07 Jul-08 Jul-09 Jul-10 Jul-11 %y/y

Developing Asia

Latin America

China

India

Source: Haver/UBS

Source: Haver/UBS

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Chart 15: Current account as % GDP

11.0 9.0 7.0 5.0 3.0 1.0 -1.0 -3.0 -5.0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Brazil Jan-04 2013 Jan-05 Jan-06

Developing Asia

Latin America

China

India

Source: Haver/IMF/UBS

Credit expansion is robust, and monetary policy may become tighter partly to address this, and partly to deal with any untoward inflation impulses if local currencies depreciate too fast.
Chart 16: Private credit as % of GDP
135.0% 130.0% 125.0% 120.0% 115.0% 110.0% 105.0% 100.0% 95.0% Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 40.0% 30.0% Jan-03 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Brazil Jan-12 70.0% 60.0% 50.0%

Chart 17: Private credit as % of GDP

90.0% 80.0%

China

Developing Asia

India

Source: CEIC/Haver/IMF/UBS

Source: CEIC/Haver/IMF/UBS

But the two biggest worries, perhaps, are much harder to measure, let alone predict. One is China. During the Asian crisis, Chinas growth rate slowed down from 10% to about 6% by the end of the 1990s. Its resurgence to 12% by 2007 is also history now. GDP growth has slowed to about 7-8%, and as discussed at length in previous Insights, the 2013 bounce is real enough, but most likely a stepping stone towards a slower underlying growth rate of around 5%10.

10

George Magnus, China: the end of extrapolation, UBS Investment Research, Economic Insights, November 2012, and Hitting a BRIC Wall, January 2013 UBS 12

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Although economic rebalancing is still hesitant, we believe there isnt any viable alternative outcome for China. The major questions are about the pattern and speed of rebalancing, and the overall (slower) growth context in which it has to occur. However it happens, the commodity intensity of Chinas growth looks sure to decline, not least because the commodity import multiplier for consumption is lower than it is for investment. The shift in GDP shares from investment to consumption, therefore, will spread weakness to industrial and energy exporters to China. It will also impact those countries most integrated into Chinas supply chains. The IMF has estimated that for every 1% fall in Chinese investment growth, the biggest negative growth effects are on Taiwan, Malaysia, and S. Korea. The biggest effects among commodity exporters are on Chile, Zambia, Saudi Arabia, Kazakhstan and Iran (and Perth, presumably)11. Rebalancing is expected to have a significant impact on the path of Chinas external surplus, and by extension, to the exchange rate. If the investment rate falls precipitously, Chinas surplus will start increasing again, dragging the Yuan higher. If the savings rate does, China will start running deficits, pulling it down. The political context in which China rebalances occurs is significant, therefore, and not least for the rural population of 650 million, the bulk of which depend on the agricultural sector, the urban migrant population of 250 million, powerful families, SOEs and the Communist Party itself. The other worry is basically about issues discussed in Hitting the BRIC Wall, which is about what major emerging markets are going to do for an encore as far as growth dynamics are concerned now that that they are higher up in the income league, having already largely exploited unique or non-repeatable development initiatives over the last decade or two. Credit expansion has always been a poor and ultimately risky alternative to structural and political reforms, but this is the direction in which public policy has tilted since 2007. When the credit cycle eventually rolls over or is brought to a more abrupt end (cue stronger US dollar?), some countries may face more significant political challenges related to income inequality, and a more equitable distribution of the income and benefits flowing from economic development.

Conclusion
The balance sheet of arguments about the effects of US dollar appreciation on emerging markets does not yet point to an imminent outbreak of financial instability and interruptions to the growth cycle. But this may be the equivalent of the unsustainability warnings about the Western credit cycle in 2005. There are a lot of moving pieces. For the time being, credit-driven growth still seems a workable way to avoid having to take more difficult structural reforms, and there is a fairly firm resistance to a pre-emptive tightening of monetary policy in most countries, while others, for example India, are still cutting policy rates. But these easy options will fade with a rising US dollar, Chinas quite particular domestic economic and political transition, and, in many emerging markets, slower trend growth, and rising social and income redistribution pressures.

11

IMF, Resilience in emerging market and developing countries: will it last? World Economic Outlook, October 2012 UBS 13

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Emerging market growth cycles typically flounder in response to advanced economy shocks, but more likely outcomes in the next two years also include a rise in US real interest rates and a stronger US dollar as the Federal Reserve distances itself from QE, and a decline in local terms of trade and capital inflows, and an end to rapid credit expansion. Perhaps the most confident conclusion is that the upshot of these developments should see a puncturing of the commodity cycle, at least as far as industrials and metals are concerned. This might prove to be a blessing for most emerging markets, since the majority are net oil and commodity importers. But as and when this happens, the source of weakness will have to be identified carefully. Lower commodity prices resulting from a rise in the US dollar alone might be welcome. But a strong US dollar, based on higher US real interest rates, and perhaps also reflecting concern about the shift in Chinas economic model and performance, would be a different matter.

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Economic Insights - By George 25 February 2013

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