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Stephanie Pomboy Presents: Please Recycle


Developing economies have always had a propensity to spend rather than 'recycle' their dollars...


For those of us whose investment time horizon extends beyond one day, the present environment is -- in a word -- exasperating. Somehow, we just can't seem to advance the debate. While there is some discussion about whether the housing bubble's deflation will be orderly or not, the larger issues remain unexplored. Eventually, we console ourselves, the markets will be forced to acknowledge (as they did in 2001) that the bubble's bust has derivative consequences (e.g., it's not just homebuilders that are exposed). But will we still be sane and/or solvent when that happens? Only time will tell.

From a less self-interested standpoint: When it does become apparent to all that we are in deep you-know–what, how will the rest of the world respond? Will they, as they did last time 'round, rush to our rescue, plugging our asset dike with their capital? Or are they about to pull the ripcord on US consumers and this whole vendor-financing gig once and for all?? This is, arguably, the most important question of all. If the rest of the world is willing to 'go again,' extending more credit to massively over-extended US consumers, then we just delay the inevitable reckoning another day. If not, the dollar will at last decline unanswered.

While this week's headline TIC stats suggest no cause for alarm, these aren't exactly stable flows. We long since lost the stickiest of all capital flows-direct investment. Today, the bulk of our capital inflows come courtesy of foreign speculators stretching for yield (with private sector purchases of non-government paper accounting for 70% of the inflows over the past year) rather than policymakers trying to keep the US flush. One need look no further than China, our chief vendor financier, for proof. The chart above suggests they're not exactly tripping over themselves to send bucks back to Hank Paulsen & the gang.

The conspicuous gap between the dollars China is taking in and those it is sending back to us, as we all know by now, reflects its purchase of stuff. From investments in infrastructure to spending on welfare programs to filling their SPR, China is using its bucks to buy economic independence rather than US paper. Can you imagine?!

The key, though, is that China is not unique. Developing economies have always had a propensity to spend rather than 'recycle' their dollars, holding only 32% of their allocated reserves in dollars versus 74% in the industrial world. And, importantly, dollars are now flowing from industrial to developing nations in record fashion. This would be bad for the dollar (and good for commodities) in normal times, but is bound to be particularly so today. After all, we are in the middle of a Cold War for Resources.

Which brings us to the other potentially-pivotal difference between today and post-bubble 2001. In the formation of the legendary global imbalances over the last 5 years, the world has been flooded with dollars. The result is that, unlike 2001, the world is now desperately SHORT on resources and massively LONG the dollars required to purchase them. Essentially, we have stocked the rest of the world the dollar ammunition it needs to fight the war for resources. Might the U.S., like Stonewall Jackson, inadvertently be done in by its own dollar troops? The idea that a commodity boom could be sustained, much less accelerate, at a time when the US economy is slowing is not one that's bound to be widely embraced. But given the surplus of dollars … and lack of compelling paper opportunities… it may be a mistake to rule it out.

Of course, dollar bulls will argue that the point is moot. Ya know, the great Petro-dollar recycling story. According to them, the fact that roughly $300 bln a year is being transferred from the hands of our friends (like Japan, Europe, UK, etc) to our enemies (Venezuela, Russia, etc) is actually good news!? Call me crazy. But for folks like Putin and Chavez, buying U.S. financial assets would seem to rank pretty low on the list of things 'To Do' with forex reserves. The chart below confirms our suspicions. In fact, one gets the distinct impression that Russia has a cutoff of, say, $10 bln it will 'recycle' each year, regardless of how much forex reserves might swell.

To be sure, these dollars will eventually find their way back to the U.S. But, by the time they do they'll have been man-handled so much they'll scarcely be recognizable, much less desirable.

In this regard, the current market discourse misses the point. While talking heads engage in a lively debate as to whether the housing bubble deflation will be orderly or dis (orderly), they all share a smug confidence that the answer simply determines how frantically the rest of the world rushes to our rescue. With the cold war for resources underway and the world well-munitioned with the dollars required to fight it, this may prove a rather dangerous assumption.
No positions in stocks mentioned.
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