By Karthik Sankaran
Safe as houses! Well, that didn’t work out too well.
With the cautionary experience of the last decade in mind, perhaps it is time to rethink our notions of safe and risky assets. This is particularly true in the currency markets, where we are now told that the US Dollar is the ultimate “safe haven.” This comes only two years after being assured by the ECB, Gisele and Jay-Z that the Euro had supplanted it. However, we would suggest a much simpler criterion for determining whether or not a particular currency is safe. To qualify as a genuine safe haven, the issuer of a currency needs to be able to grow faster than its debts. If not, the entity that issues the currency has two eventual choices—inflation or default. On this count, the currencies of the world’s emerging and developed commodity exporting countries—the likes of Australia, Canada, Norway, Brazil, Malaysia, South Africa, and so on--are vastly superior to the currencies that have traditionally jostled for safe haven or reserve status--Sterling, the Dollar, the Euro (at least as currently configured) and the Yen.
What the commodity currencies have going for them is obviously the potential to benefit from the most important secular change in the world—the rising wealth of three billion people in China, India and Southeast Asia and their increased demand for cars, meat, modern plumbing and all the other things that we take for granted. The potential scale of such demand is truly immense—for example, according to UN statistics, the average Indian household annually uses about 1/20 the electricity used by a US household. Over time, that gap is going to close, and as it does, we will see a secular increase in demand for copper, cement, oil, fertilizer and just about everything else that forms the building blocks of what we consider a good life.
But the story of the commodity currencies is not just about exports. To an even greater degree, it is a story of how well most commodity exporters ran their economies over the last decade. They provide a striking contrast to how the major economies of the developed world behaved. In the case of the US, we embraced ever higher levels of leverage to finance our transition from formica to granite countertops. Meanwhile, the promotion of realtors to the commanding heights of our economy was a notion that originated in the UK, a country that bet all its chips on finance remaining the dominant sector of the global economy. Even as they plotted their assault on the Dollar’s throne, the architects of the Euro confused the size of the currency area with the quality of a currency. Thus, the Euro-area became a congeries of incompatible countries, riven by mutual mistrust and disagreements over economic policy. And Japan continues to suffer from the hangover of a bubble that burst 20 years ago, in what could be a harbinger for other developed countries.
The 2000s have been good to the commodity exporters, on the other hand. And this is not just because they found themselves on the right side of a positive terms-of-trade shock as the price of their exports increased. It is more because many (but not all as the examples of Venezuela or Ecuador suggest), were prudent in how they managed the after-effects. Many of them were schooled to believe that windfalls need to be tucked away in structures like Norway’s petroleum fund, which has analogues in places like Chile. Contrast this with the UK, which finds itself at the tail-end of a 25 year finance “supercycle” with a deteriorated balance sheet and nothing put away for a leaner future.
Regulators in many of these countries tried to restrain their financial institutions from excessive leverage. It is not an accident that countries like Canada and Norway have come through this cycle with banking systems that are healthier than those in neighboring countries. A history of dealing with commodity-related boom-bust cycles has left a legacy of prudence with regulators and bankers. Contrast this to the self-congratulation of the “great moderation” hypothesis, which justified increased private leverage as a rational response to central banks’ success in taming macroeconomic volatility. Today, central banks in the commodity exporting countries can focus on fighting inflation rather than fretting about deflation and hoping for just enough inflation to bail out troubled banking systems.
These factors have not gone unnoticed among the large holders of sovereign reserve assets. They have an intrinsic interest in locking up commodity resources for growth, and meanwhile, they find themselves stuffed to the gills with the nominal liabilities of governments in the US, the Eurozone, the UK and Japan. To make matters even worse, there are serious political ructions afoot that suggest that the two major currency blocs in the world, the US-China Dollar zone and the Eurozone, are both unraveling. Against this backdrop, these Asian sovereigns are starting to diversify into hard assets and into the government bond markets of the commodity exporting countries. These markets might not be as liquid as the truly large bond markets of the G4, but then again, G4 debt profiles are a reminder that liquidity is but a euphemism for supply. Indeed, IMF data suggests that the allocation of reserve assets into currencies other than the dollar, the euro, sterling, the yen and the Swiss franc has picked up quite sharply in recent quarters. Anecdotal evidence suggests that these allocations are finding their way into Australian and Canadian assets among others. This is a development that private investors looking for genuine safe havens would be very wise to follow.
Karthik Sankaran is Director of Investment Allocations for the Covepoint Commodity Currency Fund.