Napier: «I don’t believe the Fed will raise rates even though the economy is adding jobs and producing a little bit of wage growth.»
Mr. Napier, you have been arguing for quite some time that China needs to devalue its currency. Did you expect such a step this year?
It is very hard to guess the timing of such a political decision. However, the probability of this happening increased pretty much this year because Chinese currency reserves were declining and domestic interest rates were not coming down, despite the liquidity measures by the central bank. We have seen Chinas reserves falling before, in 2012. But back then, Beijing managed to turn it around by pushing up capital imports. The last straw was the collapse of the stock market. The Chinese authorities realized that the chances of pulling in more capital were limited and that therefore, the decline of the reserves would likely continue if they did not adjust the exchange rate.
You do not believe that the devaluation was motivated by the aim to make the RMB an accepted reserve currency, as officially stated?
The main motivation behind the move was to create easier monetary conditions. You cannot combine an exchange rate target, an external deficit and easy money at the same time. We know that China wants easy money. Given it has an external deficit which it could not turn around this time, it had to move the exchange rate. China devalued the RMB simply to bring interest rates down.
But interest rates went up after the move?
Domestic interest rates are not coming down. Until they do and credit starts flowing into the economy again, the exchange rate will have to adjust further. I can’t think of a single country that managed to inflate monetary policy with such a small movement in the exchange rate.
How much further has the RMB to weaken?
I have argued for long that the RMB will have to depreciate more than 20%. This is not a forecast based on any calculation of a level to make Chinese products highly competitive on global markets. It is a «guesstimate» based upon just how much Chinese money and credit have to grow to sustain economic growth at a level acceptable to the Communist Party.
What are the implications of the devaluation?
The implications are much bigger for the rest of the world than for China. A more aggressive devaluation to reflate the economy is positive for China.
And for the rest of the world?
China will be selling things cheaper in Dollar terms, which is bad for the competitors. It adds to global deflation, and that is exactly what central banks in developed markets are trying to defeat. Even more important is that the China’s devaluation tends to shift people’s perception of what the risks in emerging markets are. And that is what makes it a global problem.
How do emerging markets cause a global problem?
Some of the emerging markets borrowed massively in foreign currency in the past. The rapid depreciation of their currency creates solvency issues. If there is a significant default in the emerging markets, we are a facing a global crisis. The last thing the world needs in times of slow global growth is a credit crunch. But such a credit crunch somewhere in the emerging markets is very likely.
Do we face a remake of the Asian crisis 1997/98?
Asia is the wrong focus. One big issue that led to the Asian crisis was the high level of foreign currency debt in relation to GDP. Most of Asia today doesn’t have as high levels of foreign currency debt to GDP as in 1997/98. The exception is Malaysia, probably because of its large oil company Petronas. The country faces similarities to 1997/98. But the rest of Asia is fine, they can let their currency devalue without having solvency problems.
If Asia is not the problem, what emerging markets are at risk?
The focus should be on Eastern Europe, less on Latin America and Asia. Eastern Europe is completely different. Some countries there will default. It is just a matter of time. They borrowed too many Euros or Dollars. Turkey for example owes 400 Bio. $ to the rest of the world.
What could be the trigger for a credit crunch in emerging markets?
I have learnt from history that it is very hard working out what the trigger is. In 2008, it was the collapse of Lehman Brothers that triggered a credit crunch. Now it could be a major event in Turkey or a default of the Brazilian oil company Petrobras or some event in Malaysia. But if I have to pick one I would say it is Turkey introducing capital controls. Such controls will mean that Turkey will not pay back principals amounting to 400 Bio. $ and the interests on it.
Couldn’t the damage of a major default in Turkey be contained?
We saw in the past that when credit stops to flow to one big emerging market, it tends to stop flowing to all of them. In Eastern Europe, there are lots of countries with large current account deficits and currency links to the Euro. They need to be importing capital, but I fear it will stop flowing there.
You worked in Hong Kong, when Malaysia imposed exchange controls back in 1998. What are the lessons?
When Malaysia imposed capital controls, capital flows instantly stopped everywhere in the region as people reassessed the risks associated with investments in emerging markets. The banks had been pricing the risks far too low. It also showed that politicians can completely change the default risks with one single decision. When a country borrows foreign currency and gets into troubles it has two options: Either paying it back to the expense of the local people or not paying the foreign creditors for the benefit of the local people. Most politicians chose not to pay.
The US central bank is preparing for a rate hike. Don’t you think the Fed-officials will have to change their mind given the external headwinds?
I don’t believe the Fed will raise rates even though the economy is adding jobs and producing a little bit of wage growth. But a lot of the income growth goes into savings. I think this is driven by demographics. At the same time, the US economy faces a lot of external challenges including a dramatic decline in the oil price and a stronger dollar. The markets will soon realize that the economy is not turning up to a high level of consumption like the one we associate with the past 40 years of US economic history. Therefore, the Fed will not raise rates. If we find ourselves in the scenario with solvency issues in emerging markets, the Fed could even go back to quantitative easing or at least to opening swap lines to emerging markets.
Zero interest rates for longer or even a bond-buying program sound like good news for equities. Could developed market equities go up and shrug off the possible problems in emerging markets?
No, absolutely not. Another asset purchase program by the Fed will not help this time. It’s like if you are lying in the hospital and the doctor says «The good news is you are getting more medicine. The bad news is it does not work.»
But so far, quantitative easing, known as QE, has helped to push stock prices up.
Yes, it did, but the goal of QE is to push up nominal GDP growth. That should eventually reduce the debt to GDP ratio. What we are observing now across the world is the failure of that kind of policy. Once people realize that failure, equity markets will come down because so much money has been bet on the functioning of that policy. People are going to realize that boosting nominal GDP is not the way we bring down the debt ratios. It leaves us with much more painful ways to to reduce debt, such as austerity, allowing for defaults or massive political manipulation of various prices in the market places.
The almightiness of central banks will gradually be challenged?
Exactly. The recent move of the People’s Bank of China and the decision by the Swiss National Bank to scrap the floor back in January have something in common. They are evidence that the central banks are not succeeding.
Where should investors put their money in that environment?
I recommend only cash and high quality bonds.
What about gold?
It is too early for gold. A deflationary environment and a strong dollar are not good for precious metals. Once governments are getting more active because of central bank failure, the gold price will rise again. Until we see governments implementing administrative policies under the guise of macroprudential regulation in order to influenc the flow of capital, you have to wait to invest in gold.