Currency Devaluations Uncover Economic Myth

by: Carlos X. Alexandre

As of late, headlines have centered on the wild fluctuation of exchange rates and talk of protectionism, leading to the inevitability of currency devaluations, which Merriam-Webster defines as "an official reduction in the exchange value of a currency by a lowering of its gold equivalency or its value relative to another currency." Gold value? Time to update the dictionary definition, for it has been at least 10 years since a currency was backed by gold, although only partially. The Swiss Franc dropped the 40% gold backing requirement in 2000, and on Tuesday, gold holdings by the Swiss National Bank equal about 20% of assets.

But the focus on the currency war that is brewing is misplaced. What the issue highlights is the weakness of the BRICs — Brazil, Russia, India, and China — unlike what we were told by the investment cheerleaders that placed the aforementioned economies on a pedestal, and pointed to their economic strength as a cause for celebration just a few months ago. According to accredited experts, the BRICs would save the world with their consumption and literally obliterate the need for the U.S. economy to feed the global marketplace! Really? So why is everyone so concerned with the value of their currencies vis-a-vis the Dollar? Actually they should rejoice, because domestic consumption will benefit.

The acronym "BRIC," coined by Jim O'Neil at Goldman Sachs, must be correctly changed to "CRIB" because these developing economies, notwithstanding remarkable growth, are still in their infancy when it comes to domestic consumption, and self-sufficiency. Let's get real here and see the economic engine for what it is!

The August 6, 2009, issue of "BRICs Monthly" published by Goldman Sachs, was titled "BRICs as Drivers of Global Consumption." An excerpt states that "In the long run, our projection implies that income per capita in the BRICs will continue to rise. Also, spending power is likely to shift away from the richest countries towards a growing middle-income bloc, comprising emerging countries in general, and the BRICs in particular." Then it adds that "This will lead to higher consumption as BRICs middle-class consumers catch up with their counterparts in richer countries."

This is fascinating stuff, and I will agree that domestic consumption has grown, but the first point is that CRIBs depend on the continued growth of exports and raw materials sales, and are at the mercy of external markets — and as the developed world consumer consumption shrinks, so will the CRIBs. The May 20, 2010, issue reinforced the concept with a graph titled "Millions in the BRICs to Enter Middle Class Income Bracket by 2020, Far Surpassing the G7." And that is the second point. The social, political, and cultural environments are not conducive to the existence of a middle class, much less to an expansion. Furthermore, an expansion of the middle class has an adverse impact on labor costs — and that is the economic advantage currently in place.

For the record, and as large as it appears, China's Trade Balance is running 20% below one year ago. The myth will unravel further as the currency wars take hold in the global financial markets, and India, which escapes the main news channels, is already living with a negative Trade Balance. Russia's declining surplus is tied to the price of raw materials such as oil, and China's gain in the last 6 years became India's loss as indicated by the Trade Balance charts for the two countries.

India Trade Balance 2000-2010

China Trade Balance - 2000-2010

The GDP for the BRICs, U.S., and Eurozone up to 2009 is shown in the chart below. Question is "What will the end of 2010 look like?"

BRIC, US, Eurozone GDP - 1998-2009

Then we have the usual suspects and, according to Reuters, "Washington is floating the idea of specific targets for current account balances. This would build on a G20 pledge a year ago to tilt growth away from exports in fast-growing surplus countries, such as China, and to boost savings in rich deficit economies, including the United States." "We are exploring whether we can agree to commit to keep the external imbalances to levels that are more sustainable, making allowances for different kinds of countries, such as commodity producers," Tim Geithner said in an interview.

Tim, how exactly does one accomplish balanced Current Accounts in a free market where private capital moves across borders on a whim, without regard for Government posturing?

Disclosure: CXA never holds positions until at least 24 hours after publication.