Policy divergence, the strong dollar and trade war with China
I have heard some commentators say that the concern over a strong dollar is overblown. I don’t think it is. In the context of heightened tensions with China, the strength of the US dollar will be a key issue affecting Asia in particular. I want to flesh out a few thoughts here, especially regarding the pivot by the US toward Russia and away from China.
First, there’s the pivot toward Russia. And I see this as something that reverses tensions between the US and Russia that have been building since Russia’s intervention in South Ossetia in 2008. If you recall, back in 2001, then US President George W. Bush famously lauded Putin and the US relationship with him:
I looked the man in the eye. I found him to be very straight forward and trustworthy and we had a very good dialogue.
I was able to get a sense of his soul.
He’s a man deeply committed to his country and the best interests of his country and I appreciate very much the frank dialogue and that’s the beginning of a very constructive relationship.
But by 2008, Vladimir Putin was accusing Bush of provoking Georgia into the South Ossetia conflict to help John McCain become President. This is very important in thinking about the aggressive Russian foreign policy since that time. Here’s how Putin put it:
It is not just that the American side could not restrain the Georgian leadership from this criminal act. The American side in effect armed and trained the Georgian army.
Why spend years holding difficult negotiations and looking for complicated compromises in ethnic conflicts? It’s easier to arm one of the parties and push it to kill the other party, and the job is done.
The suspicion arises that someone in the United States especially created this conflict with the aim of making the situation more tense and creating a competitive advantage for one of the candidates fighting for the post of US President.
When McCain lost in 2008, Obama came into office and attempted a reset with Russia. This effort failed – in large part because Russia had changed. It no longer trusted the US. It saw thew US as an enemy. And Russia’s moves in Crimea, Donbass and Syria have made it impossible for there to be detente with the US. Instead, what was a US-Russian deterioration became a wholesale deterioration in relations between Russia and the EU as well.
Donald Trump changes all of that. His views on Russia are such a departure from not just US policy but also EU policy toward Russia, and he is so cozy with Russia that it has sparked conspiracy theories about whether he is being controlled by the Russians. At the same time, Trump has been talking negatively about China as a currency manipulator, even making recognition of Taiwan a bargaining chip for trade relationships. I think this abrupt shift in policy is dangerous, not just because it drastically resets relationships with the two nuclear-armed countries, but also because this reset will have far-reaching unknown consequences.
Right now, China is having a very difficult time keeping its currency from depreciating. And interest rates are at punishing levels in order to keep the currency up. For example, 3-month Hibor is now at an 11-month high of 8.45%. China’s 10-year bond has been getting crushed since just after the Deutsche Bank inspired rout in global bonds began in October.
— Holger Zschaepitz (@Schuldensuehner)
Here’s what I think is happening. When Deutsche Bank was seen to be safe, yields on safe assets put in a double bottom, whose first bottom was post-Brexit. Portfolios moved to a fully-risk on position because the most obvious tail risks seemed off the table. Stocks have rallied, high yield has continued rallying, and sovereign bonds have tanked.All of this has occurred against a backdrop in which the US Federal Reserve was the only major central bank tightening policy. And it is still the only one tightening policy. This has put upward pressure on government bond yields everywhere – including in China.
But the Chinese are trying to make sure they hit their growth targets – in an environment in which bad debts are pervasive. This creates a lot of downward pressure on the currency and capital flight. In the first 11 months of 2016, foreign currency bank deposits owned by Chinese households rose by almost 32%, as the yuan fell to eight-year lows against the US dollar.
The Chinese are fighting the downward pressure, so as not to have an uncontrolled situation. Just today, the onshore yuan strengthened 129 basis points to 6.9445 as the US dollar index retreated. But what happens when Donald Trump takes office? China can’t afford to have its currency appreciate in tow with the US dollar. It would kill their economy. So it sets us up for tension – especially in an environment where there are not just economic tensions, but also geostrategic ones.
In Asia right now, there is tremendous economic and political risk. For example, when Trump attacked China’s US naval drone capture on twitter, MSCI Asia Pacific stock index volatility spiked. In South Korea, there is huge turmoil surrounding a corruption scandal engulfing the leader. Right now Indonesia’s ringgit is at the lowest level since the 1998 Asian Financial crisis.
I see a strong dollar, therefore, derailing the risk-on rally and hitting Asia in particular because of the pivot toward Russia and away from China. Trump’s economic policy, if successful, would create the pre-conditions for a strong dollar and a rising trade deficit in the US. That creates a recipe for US-Sino tensions. The known unknown is how Donald Trump reacts to Chinese trade relations in a strong dollar environment. And then how China reacts in turn will be a defining issue for Asia in 2017.