From generating inflation to war of currencies.. From competitive devaluation to real war?

R.NapierThe world is facing a complex crisis which looks like it can’t be solved: the leading governments and central banks are trying to minimize the base rate, to reduce the debts by generating inflation and weaken their currencies with the leading example of the Japanese and Brits. All of these will affect others negatively, taking in consideration the current economic and demographic situation, where the population is aging, the economy is rather stagnant and this will lead to a deeper problem – said in his interview for the Russell Napier, one of the leaders of CLSA, a British financial consulting company based in Hong-Kong.

Péter Zentai: You are a historian and consultant and nowadays your knowledge is highly important, because even the most knowledgeable people concerning the markets do not really know what is coming in the short run both economically and financially. Do you agree with that?

Russell Napier: Yes, I agree with all of that. We went through a period when we believed that finance is understandable through numbers and equations, and now it is a major political and social shift on the way. There is a huge shift in the relationship of capital labor and government. Financial history has better answers than equations, so people are starting to realize that finance is more than numbers, it is sociology, psychology, even philosophy.

Does this time remind you of similar patterns or relatively similar periods?

It does not remind me one specific period, but what is happening now, happened before, but not one time. We are moving to the financial system, we had post World War II.

Do you agree that the western part, the leading part of the global economy, is in a social and political decadence?

The term decadence carries more overtones, but it is clear that the western part is living beyond its’ means, so I would not use the word decadence. This excess use of debt happened before, and it happens all over the world, in the private sector and also in the public sector. This happens over and over again, because people believe that they can extend the quality of life with debt, even the industrial revolution was financed with debts.

Many popular political leaders claim that the western world should return to production and building factories. Do you agree with this point of view?

We do not necessarily have to go back to production, because there are many other parts of economy then making stuff and finance. For example technology, retail proves to be successful when we are talking about expanding businesses. Although I agree that finance has become a too large proportion of GDP in most developed countries. We should return to the level of ‘60s and ‘70s regarding the proportion of finance present in GDP, when the economy was performing pretty well.

This over-extending financial sector has or has not contributed to the present crisis?

Yes, it has contributed. A large part of the financial sector is doing debt, not equity. The GDP ratio is going back to the level of World War II. When one is using too much debt, its’ economy becomes too fragile to shocks. Today the financial sector is dealing with too much debt which raises the fragility of the whole system.

What is your opinion about how the United States, the European Union, Japan and their central banks are handling this kind of crisis?

What they are trying to do is called repression model. This basically means trying to hold down industry below level of inflation. If you can grow nominal GDP faster than the level of interest rates over a long period of time it will reduce the debt-to-GDP ratio, which makes the economy less fragile, at least that is the plan. However they are trying to control interest rates, both short and long term rates. You have to have inflation above those long term interest rates. My view is that the major changes in emerging markets are bringing down global inflation and the developed world will feel to get inflation and keep inflation above these long term interest rates. As a result, their chosen solution is not working this time, because in a world where you are facing with deflation and nominal GDP is growing lower than these interest rates it looks like a “Japan scenario”.

According to some articles quoting you, they all say that you think the Japanese model is dangerous to a certain extent. Can you specify why?

Yes, it is dangerous on the short run for Japan’s competitors, and dangerous on the long run even for Japan itself. We are facing currency wars, which has the goal for everyone to become more competitive. The easy way to grow your way out of the problem is to depreciate your exchange rate. For example Italy in the end of the World War II found the solution to most of its problems through depreciation, and that is what the currency war is. Japan just won the currency war, it succeeded in depreciating its exchange rate, which means it cuts the dollar selling price of its products, and through this it takes market share from elsewhere of the world. If the global economy was blooming this would not be so negative. But with today’s economy this is harmful, because it is taking market share from elsewhere, from the major competitors, such as Korea, China and Germany at some stage also. The Japanese central bank is printing money to fund its government, and my opinion is that there is no plan b, as it is in Great-Britain with the repression model. They just force the savers to buy the government debt at very low interest rates, but the problem is in Japan the saving system is already full of government debt and is shrinking due to the aging population, so all of this will lead to a very high level of inflation. This is positive for the equity market for a few years, but not for Japan’s competitors nor for Japan itself on long run.

Strengthening of the US dollar versus the euro because of the major market players think the quantitative easing will be ending. What is your comment on that?

I don’t think the QE will end or that the US growth is as robust as people think it is. I think the underlying strength of the economy remains weak. I think the dollar is partially going up for that reason, the bigger reason is that we have severe problems in some emerging markets, and they scrambling to pay back their dollar loans. That is the key reason why is the dollar going up.

Are we at the start of the dollar strengthening of this period or already in the middle? What is your personal suggestion?

The strengthening has been on the way for 18 months, so it is not the beginning of the period, but it is not the end either. It will strengthen significantly further, until the end of the “emerging markets crisis”.

Has the US government or the FED the power to stop the strengthening?

When the demand for the dollar raised (the foreigners have borrowed dollars) and the dollar went up the FED always responded by slashing interest rates, trying to keep the dollar down, but it cannot do it anymore.

Talking about the euro zone, some of the experts say the problems revolving it have passed, others say it is the start of a big trouble. What is your opinion about the euro zone?

The euro zone is not starting to have a big trouble; its problems have not begun yet. The euro zone can’t exist, unless it makes major steps towards a federal system, federation of states or a banking union. I don’t think they can do that. The second thing is that all over Europe people are voting for nationalists, because they don’t want to move in to federal states of Europe. Some stage it will happen that people will vote for such a nationalist party which will satisfy the euro.

What kind of role is the UK playing today and what kind of role will be playing in the next few years?

The UK cannot be in the federal states of Europe, it cannot join the euro, so it has to play a different role, being outside the euro. Many other countries will come to be in the same position as the United Kingdom. This has the benefits of being in a “club”, but not the benefits of being in a federal system. These countries will be forced to have a similar opinion as the United Kingdom to be elected.

What you have just said suggests that USA will regain power, because it doesn’t have such political problems.

US has the major problems of its own, particularly in relation with the size of its debt, size of its deficit and the size of its retiring baby boom generation. However Europe has its problems, like the failure to create the political conditions necessary to have a single currency. If Europe would try this it would find itself in a slightly better situation than the US.

Do you think that China is facing big trouble or are these problems solvable and if China is profiting of these other problems?

I think there is a solution for China to take care its problems, and that solution means devaluing its exchange rate. Behind the barriers of its exchange controls China does not have a robust economic and financial system, but because it was running with large external surpluses it could run this system. The problem is their large external surpluses basically evaporated, and therefore to run a system like this they cannot do that with an overvalued exchange rate. Many people say China is on the verge of a banking crisis, I disagree with that. I think they are devaluing their exchange rate to avoid banking crisis, but that puts them in the middle of an international political crisis. The world lures a country which undervalues its exchange rate for 25 years, and when it’s overvalued for 20 weeks devalues it, so the China’s relationship with the world is the center of the problem here. There is a huge challenge for diplomacy to work on a global financial system, which works, because now we don’t have one.