What the hell is water?

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Articles by Russell

Russell Napier

2 June 2024

Russell Napier is a financial market strategist and researcher. He co-founded the investment research portal ERIC and is the author of The Solid Ground, a fortnightly newsletter focused on global macro trends. Russell’s 2005 book Anatomy of the Bear: Lessons from Wall Street’s Four Great Bottoms has become an indispensable title to students of financial history. In 2014, he founded the charitable venture The Library of Mistakes – a business and financial history library headquartered in Edinburgh, now with branches in Europe and Asia.

China's decision to devalue its exchange rate in the mid-1990s created a new global monetary system. Over the past three decades, governments and central banks acclimatised to these changed waters. But a new monetary order is emerging to which investors will need to adapt if they are to keep on swimming.

In his commencement speech to the students of Kenyon college in 2005, the novelist David Foster Wallace explained how “The most obvious realities are often the hardest to see and talk about.” He illustrated this observation by relating the story of the old fish who, while swimming along one day, meets two young fish. The old fish says, “Morning, boys. How’s the water?” The two young fish swim on. Then one looks over to the other and asks, “What the hell is water?”

For those seeking to preserve and grow the purchasing power of their savings, the most obvious reality that is not talked about is the structure of the global monetary system. For almost 30 years, all fish – young, old, and those who started that period young but are now old – have been swimming in peculiarly disturbed water. We don’t discuss it, for the same reason Wallace’s young fish don’t discuss it: because we have known nothing else. That is about to change.

For almost 30 years, all fish – young, old, and those who started that period young but are now old – have been swimming in peculiarly disturbed water.

The ‘non-system’

That investors misunderstand the water that is the global monetary system is evident from their focus on the latest emanations from the US Federal Reserve (Fed). The Fed is important, but it has adapted to swim in the water established by decisions made in China and elsewhere in Asia in the 1990s. In 1994, China devalued its exchange rate and then refused to allow it to appreciate. By 1998, most other Asian countries had followed suit. The decisions to prevent the appreciation of these exchange rates created a new global monetary system that Paul Volcker referred to in his 2018 memoir Keeping at it as ‘the non-system’. But it was a ‘non-system’ in name only; it was as important in determining interest rates, inflation, economic growth and asset price returns as previous global monetary systems, such as the gold standard or the Bretton Woods system. What follows is an explanation of how political decisions taken in Asia in the 1990s have distorted economic outcomes and asset price returns and why that system is ending, as well as some thoughts on how the new system will develop and the consequences for investors.

Any central bank that is determined not to permit the appreciation of its exchange rate creates local currency to purchase foreign currency. The central bank pursuing exchange rate targeting is then in possession of foreign currency, which it invariably invests in government bonds. Think of this as a form of quantitative easing but one in which the local currency created by the intervening central bank results in the accumulation of the government debt of other nations. For example, the People’s Bank of China (PBOC) created renminbi (RMB) via commercial bank reserves – the form most central bank money takes – and exchanged these mainly for US dollars, which were invested primarily in US government bonds.

Disturbed water

The PBOC was agnostic as to the price it paid for the government bonds of other nations as it accumulated and invested foreign currency at a rate determined by the condition of its external accounts. This intervention directly distorted exchange rates, the quantity of money in the domestic economy, the level of interest rates and the availability of credit of developed world economies and, as we shall see, indirectly distorted much more. From 1998 to 2014, China’s foreign exchange reserves grew by $3.8 trillion. Over the same period, the foreign exchange reserves of Asia ex-China grew by $3.0 trillion.¹ That is a lot of disturbed ‘water’, and it is a disturbance to which households, corporations, financial institutions, governments and central bankers have all, to differing extents across the globe, had to adapt. We now live in a world which has been built upon the ‘most obvious reality’ that this is the way things will always be, because this is the only way we have known them to be.

Exchange rate management

The external accounts of any country are referred to as ‘the balance of payments’ because, when an exchange rate adjusts freely, these accounts balance. However, when exchange rate management is in place, the balancing item in the balance of payments is the adjustment in the country’s foreign exchange reserves. The greater the external surplus, the larger the rise in a country’s foreign exchange reserves, the more foreign government bonds it acquires, and the more domestic currency bank reserves it creates. In the ‘non-system’, foreign reserves grew particularly quickly as China and other countries managing their exchange rates ran surpluses in both current and capital accounts. China limited the scale of capital outflow by its citizens but welcomed capital inflows, exacerbating the size of its capital account surplus.

Buying up bonds

The undervaluation of China’s exchange rate also boosted capital inflow as it attracted direct investment by foreign companies seeking to reduce their costs of production. China’s capital account surplus, added to its current account surplus, turbocharged the growth in foreign exchange reserves and foreign currency bond holdings by the PBOC. The ‘non-system’ was thus set up to transform the developed world’s stock of savings flowing into China into more RMB liquidity and even higher holdings by the PBOC of foreign government bonds. In previous global monetary systems, there had been legal or practical limitations to the scale of cross-border capital flows, but the ‘non-system’ had no such fetters. The movement of this stock of savings to China, to the extent that it added to the pace of reserve accumulation by the PBOC and others, further distorted the global supply of money and credit.

At the core of asset price valuation is a discounted cash flow calculation.

Discounting the future

For investors, the most important distortion was that exchange rate intervention by Asian central banks acted to decouple interest rates from growth rates across the developed world. At the core of asset price valuation is a discounted cash flow calculation. Using a current interest rate (often the yield on government bonds), analysts discount the value of all the future cash flows of an investment to establish the net present value of these cash flows. The faster these cash flows grow, the greater their present value. The lower the discount rate, the higher the present value of future cash flows.

But what if there was a buyer for government bonds that paid no attention to the rate of growth in the economy and the likely consequences for higher inflation? In such a situation, the discount rate need have no relation to the growth rate of the economy and expected inflation. A much larger gap between the discount rate and the growth rate of cash flows would be possible, and the net present value of such cash flows would rise. It is no coincidence that, following the devaluation of the RMB in 1994, the valuation of US equities began to rise. The cyclically adjusted price earnings (CAPE) ratio of the S&P 500 – a measure of value relative to earnings that attempts to adjust for the cyclicality of corporate earnings – surpassed its October 1929 level of 33x CAPE by the end of 1997. It continued to rise to a new all-time high of 43x in March 2000. In Q1 2024, the S&P 500 remains elevated at 31x.² While many reasons were given for this rise in valuations, the key was that investors had come to believe the growth rate of cash flows could remain high, perhaps permanently, while the discount rate could remain low. That reality was a consequence of decisions taken by Asian central banks, not the Fed or other developed world central banks.

The ability of businesses and households to adjust to the new ‘water’ depended very much upon the socio-political environment in which they operated.

Financial engeneering

US corporations, which operated with relatively few restrictions, responded to this new system by adding ever higher levels of debt and outsourcing their manufacturing capabilities to countries, such as China, undervaluing their exchange rates. The US non-financial corporate debt-to-GDP ratio jumped from 55% in 1994 to 73% in 2008 and is at 77% today.³ An increasing amount of the new debt was used to gear up existing income streams from assets rather than create assets with new income streams, and this so-called financial engineering was well rewarded when the discount rate decoupled from the growth rate. Blue collar America was left to adapt to the exodus of jobs to countries acting to undervalue their exchange rates. The wealth gap between asset owners with white collar jobs and blue collar workers with no assets grew and grew. The ‘water’ of the global monetary system had huge real-world impacts, particularly in the US. In other societies, corporations were not as free to move their manufacturing capabilities, fire people or engage in financial engineering. The freedom of US corporations to adapt to the realities of this global monetary system produced high levels of corporate profitability in the US which, when combined with rising equity valuations, produced very good returns for the S&P 500.

Credit cushioning

The other side of this price agnostic flow of newly created capital into the developed world bond markets is what happened to the newly created money in China and elsewhere in Asia. Those schooled in the operation of the gold standard or the Bretton Woods system would expect this excess money to ultimately produce high levels of inflation which would, over time, undermine competitiveness. This decline in competitiveness would have produced a deterioration in the external accounts of these countries and, eventually, a tightening of liquidity that would create an economic slowdown. However, inflation in Asia also remained low in the ‘non-system’. The excess money created by the PBOC funded a major expansion in bank credit, but China’s state-owned banks ensured this credit was focused on funding increased production rather than increased consumption. With the state-owned banks funding Chinese capacity expansion with cheap credit, China’s investment boom went on, keeping prices low both in China and across the globe. Elsewhere in Asia, households and corporates lived in the shadow of the Asian financial crisis of 1997 and did not respond to the availability of cheap credit by borrowing. The creation of ample liquidity in China and elsewhere in Asia thus did not produce the higher inflation that would have led to a rebalancing of external accounts, higher interest rates and slower growth.

Rational exuberance?

The Fed often questioned, sometimes out loud, what was happening. As early as December 1996, Fed Chairman Alan Greenspan wondered at the ‘irrational exuberance’ in the US stock market without realising the rationality of high equity valuations when the discount rate and the growth rate decouple. In 2005, Greenspan pondered why US bond yields were falling while he raised short-term interest rates. What he hadn’t assessed was the impact from price insensitive buying of his government bonds by Asian central bankers at a time when undervalued exchange rates continued to send a wave of disinflation to US shores that also supported government bond prices. Ben Bernanke, the man who was to succeed Greenspan, attributed this decoupling of the US growth rate and the discount rate to the ‘Asian savings glut’ without reference to the role Asian exchange rate management had in transforming Asia’s external surpluses into purchases of US treasury securities. Perhaps they really did not realise what was going on, but the bottom line is they ultimately adapted their own monetary policy to ensure deflation was avoided and any collapse in asset prices that would damage financial stability was resisted. The Fed’s actions were crucially important, but they were reactions – the driving force behind monetary policy was Asian exchange rate intervention policies. Developed central banks may have been independent but they independently adjusted their own policy to the new global monetary system established by political decisions in Asia.

For China, the policy of managing its exchange rate no longer delivers positive economic outcomes.

Change to exchange

There is growing evidence of an internal deflation in China at a time when the country’s external accounts are deteriorating markedly. If the PBOC now has to intervene to support the exchange rate, the result will be the selling of foreign government bonds and a contraction in RMB bank reserves – a tighter monetary policy which will exacerbate deflationary pressures. The country’s external accounts seem likely now to force the PBOC to intervene to support the RMB or accept a devaluation. China’s current account surplus is much smaller, relative to GDP, than it has been, and recent contractions in exports may reflect structural problems as foreigners diversify their supply chains. Meanwhile, the country’s capital account has moved into deficit as foreigners have been liquidating both their RMB denominated portfolio assets and even their direct investments. The more these adjustments are driven by structural changes associated with a growing cold war, the more difficult it will become for China to maintain a stable exchange rate and grow the economy. China’s total non-financial debt-to-GDP ratio is at a record high of 308%, well above the US level of 252%. With deflation evident and debt to GDP rising, China cannot accept an exchange rate management policy which finally, due to a deficit in its external accounts, restricts its ability to grow.

If China continues to target its exchange rate, it is likely to have to endure the form of debt deflation associated with economic contractions that turn into depressions. Even the unelected president of China is unlikely to force such a form of economic adjustment upon his people. We cannot know when China will abandon its exchange rate targeting policy and adopt the fully independent monetary policy it needs to escape a debt deflation, but that time is nearing. When that move to a freely floating RMB does come, the cornerstone of the global monetary system will be removed. Suddenly, as they did when the gold standard ended in 1933 or the Bretton Woods system ended in 1971, investors will face the obvious reality that the most obvious reality is no more.

One world, two systems

The period following the collapse of the gold standard and the Bretton Woods system was one of chaos, and it took years rather than months or quarters to establish a new global monetary system. On this occasion, a dichotomy seems highly likely, with China and its allies forming one monetary system and the rest of the world coalescing around the US dollar as the cornerstone of its monetary system. It’s very unlikely that China could simply repeg its currency at a lower level to the US dollar as that would result in an even greater reliance upon cheap Chinese products. It is also unlikely, given the deteriorating geopolitical situation, that China would wish to link its currency in any way to the exchange rate of its cold war enemy. Investors will increasingly have to choose to invest in only one bloc. And, for most, that will be the US bloc, where returns are more likely to be fungible and support spending in retirement. When the time comes to formulate the rules of the new US dollar bloc, the key criterion for almost all countries will be to establish a system that inflates away the excessively high levels of debt which are a legacy of the ‘non-system’. Such a system will have to permit a high degree of domestic autonomy over the creation of money and also likely recognise that local authorities can influence the choices of their domestic savers with a view to forcing investment in government bonds and keeping yields low. This is known as financial repression and, in its consequences for investors, it is almost the polar opposite of the ‘non-system’ which has produced such outsized returns from most developed world asset markets.

In a financial repression, bonds become, as they did from 1945 to 1979, ‘certificates of confiscation’.

The most obvious reality

The equity winners from the ‘non-system’ have a lot of adjusting to do to survive and eventually thrive in a financial repression. They will have to reverse a generation of financial engineering and will lose access to the very cheap manufacturing facilities which helped power their profits. The S&P 500, in particular, is full of the winners of the old regime. In seeking the equities that will produce real returns in the new system, investors should generally avoid equity index constituents which have large market capitalisations – often because they have been the winners of the old regime. Eventually ‘the most obvious realities’ – the ‘water’ of the new monetary system – will form from the chaos. For the active managers who can see how it forms, there is the ability to both preserve and grow the purchasing power of savings. Success in investment need not entail getting the right answers about the future. It entails merely getting better answers than your competitors but, crucially, to the right questions. “What the hell is water?” is now the best, most obvious question.

Articles by Russell

Russell Napier

World Bank
Bloomberg
International Monetary Fund

This article first appeared in The Ruffer Review 2024

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What the hell is water?