My recap of the past week

Oil stayed high -- but not high enough to worry Peter Fritsch and Kelly Evans of the Wall Street Journal.

The dollar fell against the euro and loonie -- but probably not by enough for the dollar to displace the RMB on the G-7’s agenda.   Alas, the value of the RMB -- at least against the dollar -- is determined almost entirely by the policy choices of a country that isn’t a part of the G-7.   That is part of the G-7's current problem: the key  G-7 countries tend to agree far more on things that they don't control than on those things where they might have an impact.

And the GCC countries – led by the Saudis -- reaffirmed their commitment to their dollar pegs and in all probability their commitment to high domestic inflation and negative real rates as well.  

Pegging to the depreciating dollar is producing a significant nominal depreciation of the Gulf countries’ currencies at a time when commodity price appreciation calls for a real appreciation of all commodity currencies (not just the Canadian dollar).   But unless the Gulf states are willing to save the entire commodity windfall, the pressure for real appreciation won’t go away.   Higher spending and more domestic investment will lead to higher inflation.   High inflation together with falling nominal rates will push real rates down – and they are already quite negative in some parts of the Gulf.   The excesses fueled by negative rates, in turn, are likely the biggest future risk to Gulf – not excessive government spending. 

Yet even though nothing changed on the surface – the Gulf still insists on pegging to the dollar, Chinese economic policy is on hold prior to the Party Congress – it still seems that the dollar zone is beginning to fray around the edges.    In an interesting post on the dollar, Knzn notes that: 

“there are obvious cracks developing in the structure that has supported the overvalued dollar”

My friend from our Treasury days and the blogosphere's leading Fed Watcher Tim Duy notes:

The Fed is dumping additional liquidity into the system at a time when most central banks are attempting to turn off the faucet. The Fed is implicitly, if not explicitly, relying on countries with fixed exchange rates to absorb that additional liquidity at the cost of inflation in those economies  .... In my darker moments, I fear that the Fed is forcing their foreign counterparts down one of two paths - either central banks with appreciating currencies throw in the towel and match Fed rate cuts, thereby unleashing a fresh wave of global liquidity, or central banks with fixed exchange rate finally decide that they can no longer bear the inflationary cost of supporting the US current account deficit.

Even long-time defenders of the dollar zone do not seem quite as convinced as they used to be. 

Stephen Jen highlighted the Gulf’s difficulties holding inflation down so long as it pegs to the dollar.  This week’s Economist story on China didn’t try to argue that China’s currency is fairly valued even with China’s large and growing current account surplus.   Indeed, it makes the opposite case – the main current risks to China’s economy stem directly from its reluctance to allow RMB appreciation and the resulting need to run to an expansionary monetary policy.   The Economist writes:

Many in China have concluded that the blame for Japan's economic malaise in the 1990s lay largely with the appreciation of the yen. Beijing has therefore allowed the yuan to rise by only 10% since July 2005. But Japan's real mistake was its loose monetary policy to offset the impact of the rising yen—which further inflated the bubble—and then its failure to ease policy once the bust had happened. By holding down the value of the yuan and allowing a consequent build-up of excess liquidity, China risks repeating the same error.

Well said. 

The graph highlighting how Chinese wage growth hasn’t kept up with the increase in labor productivity is stunning.   Unit labor costs are falling in RMB terms.   Try looking at the evolution of Chinese unit labor costs in euro terms.  It isn’t that hard to figure out why Chinese exports to Europe are growing so fast (they are up 40% y/y according to the Chinese data, while exports to the US are up only 15%) .  

The Economist still argues that the roughly 3% contribution of net exports to overall growth is small relative to the 9% contribution from domestic demand.   I by contrast would hesitate to downplay the close-to-record contribution net exports are making to China’s growth, even if (as is almost always the case) domestic demand contributes more.   

So long as net exports continue to stimulate China’s economy, China’s ability to grow solely on the back of domestic demand hasn’t been tested.  Indeed, there is a decent argument that the recent strong growth in domestic demand is linked to a surge in investment in the tradables sector and the financial boom generated by very low real interest rates – both of which stem from the same factor (the peg) that has supported net exports.    So long as China has been able to substitute offset slower growth in its exports to the US with more rapid growth in its exports to Europe and the Middle East, the extent of the correlation between domestic demand growth and export growth hasn’t really been tested.

Finally the IMF released its COFER data on global reserve growth.   The financial press, alas, was far more interested in a few relatively small investments by sovereign wealth funds – purchases that struggle to add up to China’s likely average monthly purchases of dollar bonds -- than taking a fresh look at the backward looking data on reserve growth.   The limited coverage of the IMF’s new data of the size of world’s reserves -- and the currency composition of a fraction of those reserves --  focused on an insignificant 0.1% fall in the dollar’s share of total reserves rather than the much more important increase in total reserves.  

Indeed, if you make a few reasonable assumptions about the currency composition of the reserves of the countries that don’t report data to the IMF (I have a pretty good of who they are by now), emerging market dollar reserve growth likely matched the US current account deficit over the past two quarters.  

That is new as well as big and important. 

More wonky details later.    I wouldn’t want to disappoint Felix.

But first a big thanks to Michael Pettis for filling in over the past week.