Is a strong currency really a sign of our success?

By Gareth Morgan

The economy is in rude health. It must be, our currency has been the strongest in the world this year - surely a sign of economic prowess, right?

In the global race to deliver the cheapest currency in the world, a stampede that has everyone trying to switch to export-led growth to make up for the slump in their debt-fuelled expansions of the past 20 years, there is a whiff of something not quite right.

Whereas economic orthodoxy would say a strong currency is an indicator of prosperity, in this environment it is one of vulnerability, of helplessness in the face of a clash of economic juggernauts.

We know why the world's largest juggernaut - the United States - is undergoing a currency meltdown.

Its household sector, the largest in the world, has led the charge to buying stuff with other people's money; its government has followed suit; and now the foreign creditors are nervous.

The second largest economy - that of Europe - has fallen victim to the delusion that all countries in that geographic locale could thrive in a world where exchange rates were forbidden, where there was one monetary policy and where a gent's agreement not to run budget deficits above 3 per cent of GDP would be enforced by fines for offenders.

The reality has been that many of Europe's new and southern members have maintained an economic trajectory fuelled by mounting indebtedness to the richest, most senior countries in that euro-folly.

The world's export juggernaut is without doubt China. It secures that position not just by having an open door to inward technology transfer upon which it can lever its abundance of labour, but by multiplying that advantage with outlawing the free trade in its currency. The Chinese central bank commandeers all foreign exchange remittances to China and prints and issues renminbi in exchange. There is no limit to how much of its own money a central bank can print, so any upward pressure on its value is easily countered by issuing more. So for the Chinese, keeping pace with the weakness of the US dollar is no sweat.

And that's just dandy, it means its economy can continue to be as export-competitive as ever. So long as the issuance of truckloads of its own currency doesn't lead to inflation of such magnitude that competitive price advantage is lost.

And that's where the state control over its domestic economy is such a powerful tool. With investment spending being over 60 per cent of GDP, a level matched by no other country, the Chinese continue to expand productive capacity at a rate that defies capacity constraint-induced inflation, its wages to employees are kept naturally in check by the sheer supply of workers, the rate of spending by households is kept in check by that wage inertia, helped by state-directed quantitative controls on consumer credit. The chances of an inflation-induced loss of competitiveness are not high. China's reward for its state-controlled capitalism is ever increasing ownership of global assets.

For the rest of the world, the important change that the Chinese economic miracle has spawned, is that its massive cost advantage in manufacturing has stimulated demand for those goods globally.

Two things flow from that. Firstly the share of global manufacturing production of other economies is shrinking big time, and the global overall demand for manufactures is stimulated by the cheaper prices. The explosive demand from China for natural resources to feed its production machine is driven by these two developments. Commodity producers are in the pink - well sort of, as we'll see.

And the scope for the Chinese miracle to continue looks huge. An example will suffice. Apple computers has its stuff made by Foxconn and Inventec in China in factories that employ 200,000 workers working 60-hour weeks and those firms receive roughly 5 per cent of the value of an Apple appliance. For the Chinese folk involved it is truly a wonderful opportunity for work and income. For the world, the ramifications from this nascent miracle will reverberate far more than we have seen thus far.

The rest of Asia is a microcosm of the Chinese cookie-cutting formula, all with varying degrees of success. But the formula is total inward technology transfer, low unit labour costs and central control of the exchange rate. China adds to that central control of consumer spending and massive state-driven investment.

Back to reality. Firstly let's deal with the buyers of Chinese-made products. We know about the debt-driven expansionism of our consumer economies that has been the 'miracle' of the financial liberalisation of the early 1980s. Now the creditors are a bit wary of the largesse they've funded we are in a bit of a lull. In the US and Europe those debt issues have led to a crisis of confidence in the currencies as economic orthodoxy would predict. By not using the credit to invest in income growth the creditors are exposed and the debtors have harsh times ahead. If the growth potential of the economy deteriorates so will the currency, other things equal. They're not quite equal of course, because as we've seen, China and some other US dollar-pegged Asian currencies have mechanisms to ensure the greenback and euro can't depreciate against their currencies.

That leaves fewer currencies against who these depreciating ones can move against - right? Guess who has to take the strain? The commodity producers who have 'free' exchange rates are ideal suckers for this role. Their export income is improving courtesy of Chinese demand so again economic orthodoxy would suggest, other things equal, so should their currency. And as we well know, it is.

Herein lies the huge risk these commodity producers face in our world of neomercantilism. It's called the Dutch disease, originating from the experience of the Netherlands in the 1960s after its discovery of natural gas drove the guilder up and laid to waste the competitiveness of the country's exports and leading to a major surge in imports. Already we see Western Australia and Queensland the only two states able to withstand the pressure from a surging aussie dollar and here the pressure non-agricultural producers are under is manifest in the layoffs we're starting to see.

Can the central bank here cap the NZ dollar rise and join those immune from the Dutch disease? Of course, it can just print money. But without the other policies that the neomercantalists use, such as controlling credit availability to households and channelling all funds to a range of successful investments that improve competitiveness, then that money printing is likely to spill primarily into household spending and inflation.

We've been there plenty of times in our past.

Have you noticed how indecently prices are rising in New Zealand right now? We all think we're going to be billionaires as the World Cup rolls through.

Has anybody looked at the slack number of forward bookings from abroad to visit expensive New Zealand this year?

The most concerning outcome is that New Zealand will swing on the end of an unsustainably high currency until the economic damage wrought warrants a major change. That damage would come via a hollowing out of our non-commodity producing businesses, no correction in our household savings rate and in time, a balance of payments/external debt crisis as those factors conspire.

So a rising currency, symptomatic of an economy in rude health?

Not really.

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Gareth Morgan is a Director of Gareth Morgan Investments
This article was first published in the NZ Herald.