Tuesday, July 10, 2012

Currency & Decoupling Myths - Part 1

Two themes are fairly popular in the financial/investment community over the past few years. 1) A waterfall decline in the value of the dollar and 2) The decoupling of emerging markets specially a country like India. Both these statements are based on a very shallow analysis and understanding of the economic dynamics at play. While I don't argue with the fact that all government monopolised paper currencies are undesirable and would ultimately loose their value (including the dollar) and there might be some emerging market that may stand on its own feet in the wake of the global economic tremors which I hope would be India but the reality is that these cases are not that straightforward and a lot of things have to turn before they actually happen. What I mean is that under the current dispensation the dollar might actually strengthen a lot atleast against emerging market currencies and the India might end up submerging under the wave of economic upheaval.

It is critical to understand the key difference that distinguishes a developing/emerging economy from a developed economy and it is certainly not the GDP or per capita. It is technology, capital stock and labour productivity. For US there is an extra dimension of defense & military prowess. I would like to add that though a higher living standard in form of per capita is certainly one of the main aims of economic growth, it is important as to how you achieve it as here means are equally important than the ends. So many middle east nations inspite of having a high per capita incomes don't qualify as developed nations.

The amazing growth and the inflation of the asset prices that we saw in the last decade was certainly jaw dropping but in no way unprecedented. The only difference being that unlikely previously this time the many parts of the world are on fiat standard or should I say more appropriately a proxy dollar fiat standard. The reason for this remarkable period of prosperity on such a global scale was the global liquidity from the developed world. You must have heard this argument many times before but let me explain in a little detail how this thing works by taking a very simple example.

Let us a say that a factory in India produces "hand-made" textiles. It employs 1 labour and so can produce 10 dresses a day. There is a machinery in US which if used can increase the factory output by 100% i.e. 20 textiles a day. That machine costs 1000 dollars and a textile can sell for 10 dollars abroad.

A more traditional way to growth was to develop expertise back home and build that machine using which the production of textile would increase and in the mean time train and recruit more labour if required. This would certainly increase the growth rates albeit quite slowly and pretty much what happened in large parts for the world in 17th and 18th century. However a faster way to grow and  in my opinion the smarter way to grow is to why re-invent the wheel, acquire the technology already created and grow rapidly, pretty much what has been happening in the emerging markets.

Now the machine can be acquired in two ways both happen due to a monetary phenomena and influence both demand and supply.

1) Since one has to pay for the machine in dollars it is but natural India can try to acquire dollars by selling its textile to US. However there has to be a demand in US for these dresses, well the credit binge of the last decade assured that and so many countries ran huge current account surpluses with US and other developed markets to acquire their currencies using which they could then acquire these capital goods and increase their production dramatically.

2) There is another way in which the dollars are acquired and this is again due to the credit binge of the last decade. As I explained in one of my blog posts before (Link) that the savings ultimately is equal to the credit created net off government deficit/surplus. So because of this massive credit expansion the dollars first looked for yields within US and then these savings went abroad. So to return to our example, let us say some one from US would want to invest in the textile mill 1000 dollars, the mill owner would then quickly acquire that machine thus increasing his production thus creating self fulfilling prophecy and justifying that investment.

Since the reported GDP is a spending metrics/measure so as a result there is a consumption led growth in US and an export/investment and consumption led growth in emerging markets. Capital good companies of the US would certainly do well.

So to summarise be it the export led growth of many emerging and commodity based economies or the so called internal consumption and investment growth stories like India, both need the constant supply of dollars and other developed market currencies to keep their growth engine going and to say that because Indian economy is not export dependent and so can decouple is the a shallow understanding or a misrepresentation of the monetary dynamics.

Sure there are also some countries that can decouple and India has a couple of features namely 1) a vibrant entrepreneur class and a 2) a large educated workforce however on the flip-side it also a very large pool of population that in malnourished and underdeveloped and under the current dispensation at the Centre a government that believes in nothing but looting of productive resources and re-directing them in order to fund it's electoral chances as it did the last time.

In any case for India or for that matter any emerging market to decouple it is important that it develops a strong technical and capital foundation or attract highly productive labour to it's shores which only one or two out of a hundred would manage to do. So be careful against this decoupling mis-propaganda.

Let me extend the above argument further to throw some light on the currency myth and almost a consensus in the financial industry of an impending precipitous dollar decline in my Part 2 of this article later......