Blight of capital protectionism will give rise to dollar crisis

By David Roche Published: January 30 2009 02:00 Last updated: January 30 2009 02:00 So much taxpayers money is being spent on bailing out the banks that many of them, once significant global players, will be forced to focus on domestic lending to give taxpayers a bang for their buck. Banks that accept state aid are under a lot of political pressure to expand their domestic loan books. Complying with the instructions of their new political masters will mean only one thing: even faster destruction of foreign credit and capital flows. The result will be tantamount to protectionism against the globalisation and free flow of capital. Capital protectionism is the worst form of protectionism. It hits the efficient allocation of investment on a global scale, as well as trade financing and trade in every type of good and service. In contrast to trade protectionism, which normally takes a sniper shot at specific goods, capital protectionism affects every ingredient of globalisation. The outcome is anti-growth from a global perspective because it lowers the productivity of all economies by limiting market forces. But the most immediate impact of capital protectionism is likely to be to magnify the damage being wrought on emerging markets by the credit crisis. Over the last ten years, asset bubbles have been engendered in emerging markets by locals borrowing 'cheap' foreign credit compared to that available locally, and by misplaced confidence in the solidity of local currencies versus the borrowed currency. Ironically, cheap credit borrowed in a weak foreign currency did boost local currencies and then, by setting off asset bubbles, the illusion of fundamentally sound superior economic growth became the common currency in emerging economies. Now the sudden withdrawal of foreign credit makes the rollover of such debts almost impossible. Living standards, growth, currencies and credit ratings will pay the price. The most dangerously affected area by the squeeze on international funding will not be Eastern Europe: though its banks, corporations and consumers will suffer greatly from the aftermath of a foreign currency credit binge. It is China and the other Asian factory economies that will suffer most, because they are about to get hit by the double whammy of plummeting trade and a drought in foreign capital inflows. China boomed on the huge demand for its exports created by the high tide of credit-financed spending and illusory wealth in rich countries. And investment benefited from capital inflows that swelled domestic credit and created China's very own asset bubbles. But now many of these asset bubbles have burst (real estate and the stock market). That is why China's economy began to sink well before exports did - to the chagrin of the 'decoupling' school of illusory economic thought. In 2009, China's exports could fall 20 per cent or so and every 1 per cent fall causes a contraction of 0.6 per cent in domestic GDP because the Chinese economy is structurally way over-exposed to exports and manufacturing and way under- resourced as a consumer and service economy. Investment into China will also fall (who needs new factories today?). Capital inflows will dry up as banks globally shrink their loan books and rich countries' credit allocation turns nationalist. What China is about to suffer is our credit crisis, not theirs, though that might indeed come. All this will have two consequences globally. First, China won't turn outwards towards its international peers to look for common engines of growth that could lift the global economy. Instead, it will turn inwards and focus on using all resources, including its massive stock of international assets, to boost domestic demand. Second, Chinese demand for US Treasuries and financial assets will wither. Part of that will be down to prioritisation of domestic issues and distrust of investing international resources in bailing out the US, whose model Chinese officials feel has failed them. But it will also be down to shrinking external surpluses on both capital and trade accounts. There will be fewer dollars to recycle. The ultimate result of the global credit crisis is a dollar crisis transmitted through the factory economies of Asia. It will begin once the current scramble for dollars to repay corporate debt in emerging markets subsides. The writer is president of Independent Strategy, a global investment consultancy