Walter Molano | Size matters
Let's cut to the chase. Devaluations are nothing more than wage cuts.
We can easily be distracted with Mundell-Fleming models, exchange rate parities, employment assumptions, competitiveness/productivity factors, pass-through inflation parameters and other fancy terms that lead to empty stares and glazed looks.
The real objective of a devaluation is a reduction in pay.
Since the onset of globalisation, workers in the developing world began to earn more than those in the developed world. Two decades ago, the fantasy kingdoms of Orlando, Florida, were a playground for families from the Midwest and the Northeast. Today, they are choked with Brazilians and Argentines. Likewise, the alpine resorts of Banff, British Columbia, were holiday destinations for Californians and Europeans. Today, they are brimming with mainlanders.
Since 2000, Chinese wages have tripled. In dollar terms, per capita income increased sevenfold. Similar increases have been registered throughout the developing world. Less than 18 months ago, restaurants in S„o Paulo were more expensive than London. Brazilian investment bankers were paid more than their counterparts on Wall Street, and a trip to the supermarket in Bogot· was costlier than going to Publix in Miami.
As compensation increased, competitiveness declined. In 2007, Latin America posted a current account surplus of US$24 billion. This year, the shortfall will approach US$200 billion.
In May 2010, Chinese exports jumped 50 per cent y/y. In July of this year, they sank 8.3 per cent y/y and fell another 5.5 per cent y/y in August.
For a long time, the developing world could sustain its bloated lifestyle by borrowing cheaply in the international capital markets. Zero interest rates in the United States and Europe encouraged investors to look elsewhere for yield, but the party came to an end when it became apparent that interest rates in the US would rise.
So, how do you cut the wages of an entire country. As John Maynard Keynes pointed out almost a century ago, prices are sticky on the way down. What he meant was that everyone is happy to raise prices - that is, wages - but no one wants to lower them.
On a micro-level, managers attend to this problem by firing their overpaid workers. However, on a macro-level, a country does it by devaluing its currency. The recent devaluation of the BRL was nothing more than a 45 per cent pay cut for 200 million Brazilians.
Unfortunately, the same will happen in China. Last month's three per cent devaluation of the CNY was just a sliver of the adjustment that needs to happen. The Peoples Bank of China lost 12.5 per cent of its reserves during the last 12 months, and it is expected to lose a fifth of its holdings by December. No one seems to notice because the numbers are so big.
A little over a year ago, the country had about US$4 trillion in international holdings. However, the rate of loss is staggering. It is the equivalent of Brazil and Russia losing all of their reserves over a period of 12 months.
History tells us that incremental devaluations are rarely sustainable. The history books are full of small devaluations that never worked. The breakup of the ERM in 1992, the Tequila Crisis of 1995, the Russian devaluation of 1998, the Samba Crisis of 1999 and the collapse of the Convertibility Plan in 2001, started with minor currency adjustments and valiant central bank defences. However, they all failed.
The imbalances were too big for a tweak. The disparity in wages was too much for small movements. Moreover, the market needs to overshoot. It needs to create bargains, where assets look so cheap and workers appear to be so underpaid that foreign investors will dive back in.
Fortunately, the adjustment in China does not have to be of the same magnitude as in the rest of the developing world. In contrast to Latin America, China used the boom years to improve productivity. Highways were built, power plants were expanded and high-speed trains were introduced. As in the past, Latin America used the boom years to have a roaring fiesta, but it did nothing to improve the quality of its workers or the competitiveness of its products.
While Latin America and parts of Southeast Asia suffered devaluations of more than 50 per cent, China's adjustment will need to be half as much - or even less. Nevertheless, it is only a matter of time until it does so.
Of course, that will trigger a tsunami across the financial markets, leading to further declines in commodity prices and deeper devaluations of emerging market currencies. Still, it will be an essential step in restoring a sense of equilibrium to the global economy.
Dr Walter T. Molano is a managing partner and the head of research at BCP Securities LLC.