Quantitative Easing (QE2) and the Inflationary Winds in Asia
November 20, 2010
Criticisms of QE2 have centred on its inability to increase growth and reduce unemployment while stoking inflationary pressures in the economy through an increase in money supply. As pointed out in last week’s newsletter, the impact of quantitative easing on the economy is likely to be muted while its impact on increasing asset prices can be significant. However, it is unlikely to have any impact on inflation in the developed world due to prevailing excess capacity and lack of credit growth. But, most importantly, it does have a significant impact on increasing asset prices and inflation in emerging markets as argued by two star managers at the well known hedge GLG in the FT last week. To summarise:
- The undue focus on global currency misalignments is misplaced and the heated debates surrounding this issue are more political than anything else.
- The Chinese trade surplus is a mirror image of its domestic savings/investment imbalance arising out of a savings rate in excess of 50% of GDP.
- The reasons underlying the high savings rates range from mass urban migration, a lack of a social security net and the longstanding one child policy – and this cannot be addressed by a simple revaluation of the Renminbi unless (perhaps) it is on the order of magnitude of 40 – 60% which is not tenable.
- There is a implicit understanding between US and Chinese policy makers – the Chinese keep their currency weak in order to import growth from the rest of the world, while the US stimulates itself out of the contractionary impact of this policy by having large deficits which are funded by printing dollars bought by the Chinese.
- In effect, the US is producing inflation in the emerging world resulting in appreciations in the real value of emerging currencies but not necessarily their nominal values.
- The emerging world is being flooded with these dollars (and will continue to be so) despite attempts to stall this flow through various types of capital controls.
- The main impact of this will be asset price inflation, followed by inflation in goods and services in the emerging world.
- This will imply lower real interest rates, higher stock and real estate prices and real appreciation of emerging market currencies.
- For example, if China re-values its currency by 5% a year, and has 5% higher inflation than the global average, in 5 years time it will have cumulated a real exchange rate appreciation of 50%.
- This is likely to eventually create another emerging market crisis down the road - as it historically always has.
A fascinating view-point, and one with which I am increasingly sympathetic to. QE2, rather than being a misguided policy, is actually a masterstroke by the US in terms of forcing upon a real appreciation of emerging market currencies via higher inflation. This could be the most effective method of addressing global imbalances which have plagued the world economy for several years. However, the end game of this approach is likely to be another emerging markets crisis in 5 years (give or take a couple of years) time – on a global scale and with a weakened and highly leveraged US economy being unable to provide the necessary support, as it always has in past crises. This implies an eventual write-down of excess capacity and debt in China and other emerging markets through one-off currency devaluation, and a wide-scale restructuring of domestic economies which should put them on a more sustainable long-term growth trajectory.
Meanwhile, we can expect liquidity inflows to result in continued appreciation in asset prices (see chart below of impact of QE2 on a variety of asset classes since the Bernanke speech in late August) – particularly stock markets as emerging market governments are likely to put a lid on real estate prices (and basic food prices) through a variety of controls and subsidies, so as not to make them more unaffordable for their citizens. Governments finally realise that the bursting of real estate bubbles are more pernicious and widespread than the bursting of stock bubbles. As I noted in last week’s newsletter, relatively undervalued markets like China, Brazil, Russia and some underperforming peripheral markets are likely to receive the brunt of these money inflows. I expect to soon start accumulating positions in equity mutual funds focussed on these countries (together with US high quality stocks with global franchises), while continuing a substantial allocation to high quality US and developed world bonds, some gold and 25% in cash! A barbell strategy for what is increasingly looking like a hot EM and cold developed world!
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