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Soros Could Be Wrong

Date: Friday, July 25, 2008
Author: Emma Trincal, HedgeWorld

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Book Review

A Roadmap For Troubling Times By Louis-Vincent Gave and the GaveKal Team, GaveKal-Dragonomics, Hong Kong, 2008, 260 pp., $12 (paperback).

HONG KONG (HedgeWorld.com)—The United States is rather efficient at dealing with its credit crunch problems, according to Hong Kong-based hedge fund manager and research firm GaveKal Holdings Ltd. In GaveKal's latest book, this thesis serves as the foundation for a continued exploration of a theme dear to the firm's team of macroeconomists, including Chief Executive Louis-Vincent Gave, his father and GaveKal Chairman Charles Gave and Anatole Kaletsky, chief economist. They discuss the notion that the dollar's status as the world reserve currency so far remains unchallenged and offer a positive take on the U.S. and Asian economies, though the same cannot be said about Europe.

Three Currency Functions, Three Dollar Exchange Rates

GaveKal is not bearish on the dollar despite the currency's accelerated depreciation this year. But instead of offering a blanket statement on the dollar, the authors break down the dollar exchange rate into three components. First they look at the U.S. dollar versus what they call the "savings currencies" such as the euro or the British pound. Europe indeed has an aging demography and tends to save more than the United States. Second, GaveKal compares the dollar to what it calls the "commodity currencies," or those used by commodity producing and exporting countries such as Australia, Canada and New Zealand. Finally, they examine exchange rates with Asia or the Middle East, where "trading currencies" are in place, for instance the Chinese renminbi and the Japanese yen.

According to GaveKal, from 1933 to 2001, "We had the mother of all revaluations of the U.S. dollar against all three currency functions." That would be a blanket statement but it did not last. Given the commodity rally, the dollar has experienced a "massive devaluation" against the commodity currencies, according to the book. Looking at the trading currencies, though, the picture is more subtle. In theory, the United States should be undervalued against the trading currencies due to the current high U.S. account deficit. To be sure, the dollar has depreciated against those Asian currencies but not that much, the authors write, adding, "In good logic, the trading currencies should have moved higher."

GaveKal's economists write that Asian currencies did not appreciate against the dollar because they were manipulated by the central banks of these countries that wanted to boost exports and did so. But now, the arrangement is about to change. If the Asian central banks stop preventing their currencies from rising, the consequence could be immediate for commodities. The vast amounts of domestic excess liquidity may stop flowing into commodities as it has done in recent years, the authors warn.

The authors are convinced that Asian countries will put an end to their pegged currency system because the peg has led to imported inflation given the dollar's weakness. Because inflationary pressures are now so high, central banks in the "trading countries" will be forced to raise interest rates, reversing an old system, which will lead to an appreciation of their domestic currencies.

Long Asian Currencies and…

As a result of this scenario, one of the trade recommendations the authors give is to buy Asian and Middle Eastern currencies. Another potential recommendation would be to short commodities. The authors do not go that far. In fact, they don't offer any committed trade advice on this asset class, perhaps wisely because it seems difficult to anticipate the timing of a shift from the current bull market to a reverse momentum. But long-term, GaveKal is not bullish on commodities.

"Our take on commodities is a simple one: We fully understand and admire our clients who are willing to make the bet that the Asian demand and the currency supply constraint can only mean higher prices," they write. "Most commodities continue to make new highs. But at some point, capitalism's structural trends will prevail and commodities will return to their marginal cost of production."

They explain in another chapter of the book what they mean by the return to a marginal cost of production: "Thanks to technology, freer trade, lack of full-scale wars, etc. … the marginal cost of production of almost all commodities has spent the past fifty years falling. This point may not happen for years. Though, in the near term, we do fear a potential ‘inventory correction' linked to the Chinese Olympics."

The book was made available for sale on GaveKal's web site in May. Interestingly, crude oil was trading at a seven-week low on Thursday [July 24], though the immediate reason behind the correction was not the Olympics but rather a report published by the U.S. government showing less demand in the U.S. and Japan, two of the three largest oil-consuming countries Previous HedgeWorld Story. It's not impossible though that GaveKal may be correct sooner than later on its commodity outlook.

…Short the Euro

So why would the dollar maintain its current reserve currency status? Part of the answer is because there is not much competition. If one currency could in theory play that role, the euro, it is nowhere near able to fit the bill, according to the book. In fact, GaveKal pushes its proverbial bearish view on the euro even further.

In February, GaveKal Capital Management Ltd. and Corriente Advisors LLC launched the European Divergence Fund, a strategy that shorts the euro on the view that government debt spending is not sustainable in most European countries Previous HedgeWorld Story. It has not been easy. Since Feb. 1, the dollar has lost about 6% against the euro. Yet the dollar has been firming against the euro recently with the decline in oil prices and strong regulatory intervention to bail out U.S. financial institutions as seen last week.

But GaveKal invokes more fundamental and long-term grounded reasons for being bullish on the dollar versus the euro. There are mainly two factors. The first is that the credit crunch is awaiting Europe. "The credit crunch which has thus far mostly only engulfed the U.S. is starting to make its way into Europe. And soon enough, Europe's banks will likely be reporting losses and write downs, and investors will flee to the safety of the highest government bond paper," the authors write.

Sound familiar? Perhaps, but the United States has already done a lot, according to GaveKal. The researchers describe a three-step plan for any banking problems caused by a credit crisis, concluding that the United States has already done most of it. The first step is to devalue the currency to boost exports and attract capital flows from foreigners. Indeed, this administration's policy has been to let the dollar fall, and it has succeeded. The second and third steps are to re-capitalize the banks and put in a steep yield curve to encourage banks to lend again. "When we look at the U.S. today, we have to say that we are impressed by the speed at which this three-step plan is being implemented," the authors wrote.

The natural implication of this theory is that when seriously confronted with a banking crisis, Europe will have to let the euro fall against other currencies, including the dollar because it is part of the bank recapitalization process.

The other factor that explains GaveKal's bearish take on the euro, is the one that led to the launch of its new fund in February. Government debt in Europe is already too high and continues to increase, which will precipitate an exchange rate crisis. In both France and Germany for instance, government debt as a percentage of gross domestic product has, since 1990, jumped from the 35% to 40% range to the 70% to 75% range. Naturally, the governments in Europe will have to finance their public debt. The result will be for the European governments the necessity to devalue the euro, the authors predicted.

Fundamental Faith in Capitalism

The book touches upon countless other themes that would be difficult to summarize. But one common trait of this book with its predecessors, including last year's "The End Is Not Nigh" Previous HedgeWorld Story is its fresh and optimistic outlook on the global economy, with a firm commitment to never fall prey to the influence of the "doomsayers."

Unlike other investors turned authors, such as George Soros, who diagnose today's credit crunch as the worst market crisis in 60 years, GaveKal—perhaps due to its perspective from Asia, the part of the world that is growing the fastest—identifies secular trends in which to find solace, among them the arrival of 3 billion new workers and consumers in the world economy; the global division of labor that results from "almost universal free trade;" and the reduction of transport, communication and data processing to "virtually zero."

At the end, the team of economists has a humanist, almost classic take on life and trusts that human nature will behave "rationally."

"At this stage, the main question for investors should be whether the destabilizing reflexivity stressed by George Soros or the stabilizing rationality in which we broadly believe will turn out to be the main force driving the world economy this year," they wrote.

Needless to say, the reader, if an investor, should hope if not bet that Mr. Soros will be wrong.