Tuesday, March 30, 2010

Currencies - Watch Out for the Race to the Bottom



Friends often ask, where do I put my money now? This is a tough one, because it’s hard to get enthusiastic about the major asset classes, as I’ve mentioned of late. I do like hedge funds, generally, and non-financial assets, particularly timberland. But these asset classes are esoteric by the standards of most individual investors. Let’s look at something simpler, like where around the world, as an equity investor, should I cast my net? The U.S. markets might give me vertigo, but surely there are places in the world worthy of our capital, no?
Investing abroad there are, of course, two components of return, stock prices and currency prices. Most people don’t ponder currency risk (or opportunity), but it matters a great deal. And right now, because of the debt crisis many countries are facing, I think it has to be the first variable to consider.
Here’s why. When countries go bankrupt, they don’t do it the same way that people or businesses do, where you just stop paying your creditors. This is because countries can get more money by taxing their citizens. But this eventually becomes like squeezing blood from a stone. Indeed, one of the more remarkable economic discoveries of the past twenty years is something called Hauser’s Law, which demonstrates that no matter where the U.S. government sets tax rates, they collect only about 19-20% of national income:
(Note: I first wrote about Hauser's Law in "Some Musings About Taxation" which was posted in July 2009.)

So taxation only takes us so far, which is to say nowhere. But governments can do something else that the rest of us can’t: print money. Easy enough, right? You owe, say, China, a hundred billion, just rev up the printing presses! The price paid for this, of course, is inflation, which is how government bankruptcies look in practice. From the borrowing government’s point of view, though, it's an optimal strategy, because it means future debt payments are devalued. One always prefers to be a borrower when inflation accelerates. Pay money back later when it's not worth as much.
Right now, though, the U.S. dollar is rallying, despite the 24-hour hum of our printing presses. Here it is against the Euro:
 Source: Bloomberg
How can this be, when the U.S. is spending so much money it doesn’t have? It's because almost every other EU country is in worse shape than we are, debt wise. What we will see in coming years is a race to the bottom as countries compete to inflate their debts away. Perhaps I’m lacking in imagination, but it’s hard to see how else this could play out.
So, which countries around the world have the biggest problem, and which countries have managed to live within their means? Here is a list of countries ranked by their net debt as a percentage of GDP (net debt is total debt less foreign debt held, less sovereign wealth fund assets (if any), less foreign currency reserves):
RANK
COUNTRY
Net Debt % of GDP
1
Japan
156%
2
Italy
108%
3
Greece
107%
4
Belgium
91%
5
France
72%
6
Germany
70%
7
Canada
63%
8
Netherlands
55%
9
United States
52%
10
United Kingdom
51%
11
Spain
48%
12
Egypt
44%
13
Israel
40%
14
India
35%
15
Argentina
34%
16
Turkey
32%
17
Ireland
32%
18
Columbia
29%
19
Sweden
26%
20
Philippines
25%
21
Mexico
23%
22
Brazil
19%
23
Denmark
16%
24
Indonesia
11%
25
New Zealand
7%
26
Australia
7%
27
Switzerland
2%
28
Malaysia
-12%
29
South Korea
-14%
30
Thailand
-19%
31
Chile
-27%
32
Russia
-52%
33
Norway
-58%
34
China
-62%
35
Taiwan
-77%
36
Hong Kong
-172%
37
Luxembourg
-176%
38
Singapore
-188%
 Sources: IMF, CIA
A few things jump out. Japan – whoa! They’ve been using Keynesian stimulus (i.e. borrowing money to stimulate the economy) for years, to no avail. Most of their debt has been happily financed by their own citizens, which has kept their currency from collapsing, but that won’t – can’t – last forever. Eventually, any creditor will stop the party.
Greece – easy to see why it has pulled the EU into a swamp.
Italy, Belgium, France, UK, Germany, – see Swamp, Greece.
Luxembourg – the one EU country that has lived within its means. I imagine they are quite pissed that they’re being forced to bail out their irresponsible neighbors.
United States - #9 and gaining fast! Not a race you want to win.
On the other hand...
Singapore, China, Taiwan, Thailand, Indonesia  -Asia really has its act together.
Australia and New Zealand - once hopelessly socialist countries that have also gotten their acts together.
Chile - see my post from earlier this month, "How Milton Friedman Saved Chile."
Let's take this one step further.
Countries with a lot of debt got that way primarily because of bloated entitlement programs (see: Socialism). The biggest factor here is retirement benefits. Therefore, having an aging population is an issue that will make bad situations worse.
Here are the median population ages of the most and least indebted countries:

Most Indebted                      Least Indebted
Japan                  44         Singapore           39
Italy                    43         Luxembourg       39
Greece               42         Hong Kong           42
Belgium             42          Taiwan                37
France                39         China                  34
Germany            44          Norway               39
Canada               40          Russia               38
Netherlands       40          Chile                  31
United States     37          Thailand             33
U.K.                    40          South Korea       37

You get the picture. The average age of the most indebted countries is 41, which compares to 37 for the least indebted, and world average of 28. In other words, the countries above on the left have a bad debt situation getting worse. China is sitting pretty.
What we now have is a simple framework to determine where in the world currencies might be at our backs over a medium to long horizon. The "least indebted" group should prosper because they can watch while everyone else competes to debase their currencies the fastest.
I will add one more variable. My colleague Dan Grasman and I believe that resource-based economies will have an added advantage because commodities are one of the few economic beneficiaries of inflation. As money gets printed, it becomes plentiful relative to commodities and therefore commodity prices rise. On the "least indebted" list, Norway, Russia, and Chile stand out.
On the "most indebted" side, only the U.S. and Canada have abundant natural resources.

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