Current account deficits start to matter

Currencies, Economic growth, Leverage

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The US Fed’s decision to keep cutting interest rates is causing a major change in Asian investment behaviour. This will slow world economic growth quite significantly, and is bad news for chemical industry sales. It also means that the informal Bretton Woods II system of currency management has broken down.
Under this, Asian investors operated in accordance with mercantilist principles. In order to grow their economies, they lent money to Western countries. These loans allowed the West to increase its purchases from Asia, in turn increasing employment in Asia. These loans were funded by the earnings from the exports, so the circle was self-supporting. But as the US economy slows, so it becomes less able to import from Asia.

Now, the Financial Times is reporting that Asian central banks have decided to move some of their current $1000bn of official reserves away from US Treasuries. Similarly, the world’s 5th largest pension fund (S Korea’s National Pension Service) has decided to rebalance its $220bn portfolio away from US government debt.

A spokesman for the Korean fund told the FT that their decision was due to the fact that “The Fed continues to cut interest rates. We are still making profits from the Treasuries that we bought in the past, but we think we’d better dispose of them and had better buy higher-yielding European-government debt.”

In turn, another article in the FT explains that current account deficits are now beginning to matter again to investors. Until a year ago, investors simply chased high yield, wherever they could find it. In particular, Japanese investors poured money into small countries with high interest rates, such as Iceland, and into the major Western countries, where it supported the development of massive leverage in asset markets.

Now, in what is becoming a general theme, investors are becoming more worried about ‘return of capital’ than ‘return on capital’. They worry that heavily indebted countries such as the US and UK may choose to depreciate the value of their masive foreign debts via inflation and a falling currency. So, suddenly, current account deficits matter again. And currencies such as the Swiss franc, Japanese yen, the euro, Malaysian ringgit and the Taiwanese and Singapore dollars are all in favour.

Equally, currencies such as the US dollar, the UK pound, the South African rand, Turkish lira, Icelandic krona, as well as the Australian and NZ dollars are out of favour. This means these countries will find it more difficult to borrow abroad, and so their growth will suffer. The effects can already be seen in the UK, where the availability of mortgage loans for house purchase has dropped by over a third in the past 6 months. And rates on those loans that are available have risen.

Housing makes a major contribution to chemical industry sales and profits. It looks as though this engine of growth has begun to go into reverse in several key countries, where demand has been strongest during the boom period.

Trends in currency markets tend to run for several years, once they start. Unless traders rediscover their appretite for risk, this could signal difficult times ahead for countries with major current account deficits.

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