Churchouse Letter
February 2013         by Peter Churchouse

Our Currency, Your Problem

Inside This Issue:
Debt and currency devaluations — what impacts do we expect to see here in Asia.
A look at the impact of ‘Abenomics’ on our Japanese REIT story and the outlook for commercial property.
US labour force participation rates and capital inflows into Asia.
Portwood Portfolio: trimming down Asian High Yield, portfolio 16.16% annualised since inception, thoughts going forward.

The now famous remark by John Connally Jr, US Secretary of the Treasury under president Nixon in 1971 - 1972 bears a similar significance today as it did then. In response to criticism from European Finance Ministers that the US was deliberately devaluing its currency and exporting inflation at the expense of its neighbours, Connally responded with the comment that "it is our currency but your problem". He could have made that remark yesterday with similar relevance.

Connally was very much involved in the program to raise the US debt ceiling by $35 - $40 billion at the time - sound familiar? That sum seems like a rounding error in the context of today's horrendous US debt numbers. He was also charged with initiating Nixon's policy of raising the price of gold, and eventually abandoning altogether the monetary disciplines that adherence to the gold standard brought. We are living daily with the lack of national financial discipline that has ensued.

Policy today seems like a re-run of that old movie. Devaluing of its currency and thereby its massive public sector indebtedness over the medium to longer term seems to be deliberate policy. It has been done before. Remember the inflation of Germany post World War I? US policy makers today will be unlikely to admit this strategy, as Connally and Nixon did in the 1970's, but it seems to be very much what is in their minds. At least the Nixon regime came straight out with it!

President Nixon's Government Debt Problems Pale Into Insignificance by Comparison With What Obama is Facing.

Connally's problems in 1971 and 1972 were nothing compared with what is now facing the current encumbent, Timothy Geithner. At that time gross Federal debt was a mere 39% to 40% of nominal GDP (see Figure 1). It is now around 102% of GDP and looking set to rise further in the upcoming negotiations on raising the debt ceiling. The debt ceiling has been on a fairly continuous path of increases (with no increases from 1993 - 1996 - see Figure 2) since 1996, but has launched into orbit since the onset of the global financial crisis. An increase in the Federal debt limit of $1.9 trillion was passed in February 2010, following $1.08 trillion increases in 2009. The Budget Control Act of August 2011 increased the debt ceiling by a further $2.1 trillion representing a huge 45% increase in the ceiling in 2.5 years.

Admittedly not all of the $2.1 trillion increase in 2011 has been authorised with Congress agreeing to increases in installments. The Treasury announced on December 26th, 2012 that the ceiling would be reached by December 31st.

Excess levels of government debt make currency devaluation a tempting option to reduce the burden of servicing it.

Given the scale of the Federal government increase in liabilities it is scarcely any wonder that a path of devaluation of the currency might be considered as a way to reduce the scale of debt as a percentage of GDP.

Yes, the US$ may have been relatively strong in recent months, but this really feels like a head fake in the longer term scheme of things. From the mid 1960's to the early 1980's US public debt barely increased in real terms, but since then has surged by 600% in inflation adjusted terms (see Figure 3). During this time the US dollar trade weighted index has generally been on a downward trajectory declining by more than 50% since its high point in the mid 1980's and by around 37% over the past decade (Figure 4).

Go back 35 years or so. The Japanese Yen stood at 325 to the dollar. In 2011 it was flirting with a level around 75. That means a Japanese investor would have needed 73% fewer Yen to buy a Dollar of US assets (Figure 4). The Japanese are playing the same game again now, with a deliberate effort to weaken the Yen in a desperate attempt to end years of deflation and anemic economic growth.

The US$ has been on a long term trend of depreciation, and current rising debt levels may make this trend a deliberate policy.

Remember also, it was not too long ago that one needed only US$0.90 to buy one Euro. It now requires US$1.31 to buy one Euro, some 45% more. And it has brushed up against the $1.60 level in recent years (Figure 5).

Even with Europe's shambolic financial status and the US bond market being the so-called safe haven investment, the USD is hardly a bastion of strength. In the context of the alternatives, one might have expected the US$ to have been much stronger given its attractions as the place to hide during the European storm of the past year or so. The US administration does not want it to be. Just remember, it was only a year ago that a great many pundits were calling for the demise of the Euro and a trajectory that would take the currency down to parity with the USD in short order. Well, the opposite has occurred. The Euro has rebounded quite convincingly.

34 years ago it took 4 times as many yen to buy US$1 than it does today

One difference between now and the early 1970's is that...

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