Greenspan triggers a rally in bonds and weakens the dollar

Given this backdrop, the testimony of the Federal Reserve Chairman, Dr Alan Greenspan, to the US Congress on the economic and monetary policy outlook appeared naively optimistic. Dr Greenspan had no room to manoeuvre and hence his testimony was mostly of academic interest. He voiced strong concerns about the erosion of fiscal discipline in the Congress and in the government. He was bolting the barn after the horse had fled. He had his chance in 2001 when a newly installed Republican administration was about to unveil its ambitious tax reduction plans and was looking for legitimacy of support from a non-partisan source. In his testimony to the House in January 2001, Dr Greenspan gave exactly what the administration wanted without adding any caveat. The results are there for all to see.

Dr Greenspan appeared comfortable with the weakness of the US dollar and expressed his optimism that it would help to reverse the US current account deficit. However, Dr Kenneth Rogoff, until recently the Chief Economist at the IMF, put the US current account deficit in proper perspective. He said that it was a remarkable achievement for an economy with a trade to GDP ratio of 20 per cent to run up a current account deficit of over 5 per cent. In our view, it signals that the currency had been massively overvalued and that the national savings rate had sunk to abysmal levels. The first one is correcting and there is no sign that the second is about to change. In the absence of that, the first — the dollar depreciation — is the only game in town.

Dr Greenspan had no scope to shift his stance on monetary policy and he did not, though he said that interest rates might have to rise some time in the future. That was stating the obvious. The economy is debt-laden and debt-driven. Higher interest rates would bring ruin. The US economy is trapped in a low interest rate-high debt `equilibrium' (only economists can call that situation `equilibrium'). Nor have recent data provided any reason for such a re-think on his part.

Overall, his testimony only helped to buttress bond prices and weaken the dollar — trends that were in place well before the Chairman spoke. Otherwise, it was a non-event.

G-7 meeting underscores its increasing irrelevance

Similar was the impact on financial markets of the meeting of the G-7 Finance Ministers — an increasingly irrelevant body given the changing global economic landscape. To have diminishing economic powers such as France, Italy and Canada deliberate global economics without China, India or Brazil participating appears increasingly anachronistic. That is a different story for a different occasion.

The fact remains that the G-7 expressed concerns about volatility and called for flexibility. I am sure most, if not all, of humanity detests volatility and prefers flexibility. One wonders if an expensive, security-intensive meeting in Florida is required to make these comments. It is amusing at best and a needless distraction, at worst. The market treated it as such and sold dollars. That was the correct response. Nothing that the G-7 said altered the fundamental outlook for the dollar. Indeed, their bland announcement underscored the lack of any other credible option in the world to reduce the imbalance.

More flexibility is called for, from China rather than Japan. The concern of Japan was that the statement released in Doha in September pointed the needle at Japan too. In Florida, it was modified to suggest that the G-7 was speaking of China and not Japan. This too is best ignored.

China will change its foreign exchange regime at a time and manner of its choosing. That China (or, for that matter, any country) cannot continue with a fixed exchange rate regime is the view of this author. A fixed exchange rate regime helps to win credibility after an economic or currency crisis and soon thereafter becomes a burden. The only question that remains after that is whether it is unburdened voluntarily or market will force the country to shed the baggage. The longer China delays it, the more likely it will be the latter. China cannot indefinitely sterilise its purchase of US assets to minimise the impact on domestic money. China and the rest of Asia will have to abandon their vendor-financing model. Only then, will the fundamental underpinnings of the Asian century be revealed and likely winners and losers sorted out.

For now, it appears inevitable that the euro will soon rise to 1.30 against the dollar. European governments will increase the volume and frequency of their expressions of concern at the currency strength. In reality, they should be happy that the euro is stronger when OPEC is reducing production. They should also be pursuing domestic structural reforms and the ECB should be lowering rates. Unfortunately, Europe will pursue these only after all other less reasonable alternatives are exhausted.

Reiterating gold

I continue to reiterate a role for gold in most personal portfolios. With the euro likely to become increasingly volatile in coming months, the pressure to shoulder the burden of US current account deficits would shift to Asian currencies. Most Asian governments are not in a position to accommodate currency strength.

Their economies are seemingly strong but fragile. Global financial system based on paper money and easy credit would come under considerable strain in the years ahead. In this context, gold offers insurance to investment portfolios.

History tells us that whenever the relative valuation of stocks to gold began to shift in favour of gold, the trend lasted for a few years. The current phase has just begun. Gold would surely do far better than American equities in the years ahead (see chart).

In this context, it is worth pointing out that the rally in global equities after US employment data for January and G-7meeting suggests a state of delirium among global equity investors. The dictionary (www.dictionary.com) describes delirium as follows:

(1) A temporary state of mental confusion and fluctuating consciousness resulting from high fever, intoxication, shock, or other causes. It is characterised by anxiety, disorientation, hallucinations, delusions, and incoherent speech.

(2) A state of uncontrolled excitement or emotion: sports fans in delirium after their team's victory.

(The author is Director, Global Economics and Asset Allocation in Credit Suisse, Singapore. His views are personal. Please send feedback to nageswar@singnet.com.sg)

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