Crossword

“Men occasionally stumble over the truth, but most of them pick themselves up and hurry off as if nothing ever happened.” ― Winston S. Churchill

US Economy – Key changes and implications

Since July 2017, Brent Oil has been on a tear from $45 to $70 currently. But the new swing producers which is not Saudi Aramco but US shale has gone about improving technology horizontal drilling, hydraulic fracking and incorporating low-cost sensors reducing cost of human intervention and consequently rearing to go in 2018. This has the potential to make America the leading oil producer in the world in 2018 with production in excess of 10 million barrels per day and imports declining from 12 million barrels per day to below 2.5 million barrels per day in a decade. This oil can be sourced from Western Hemisphere. In addition, Trump is looking to allow drilling in hereto before forbidden Alaskan fields. Current, oil prices will not sustain and so will not American dependence on Middle East and the need for protecting those sea lanes of communication.

When the Global Financial Crises struck the Fed fund rate went from 5.25% in June 2006 to 0.25% in December 2008, a full 5% reduction. This began increasing in December 2015 to 0.5%, the December 2016 to 0.75% and then March, June and December of 2017 saw three increases bringing it to 1.5%. The Feb proposes to undertake another three step increases in 2018 taking it to 2.25%. In the meanwhile, the major central banks which are in divergence will have no choice but to follow the Fed upwards although with a lag as it normalizes policy rates and builds adequate buffers for the next slowdown or recession. China especially will face tremendous pressure on forex reserves, despite controls on capital account convertibility. The current difference is 10-year UST and China are 1.3% of which more than half may disappear once the Fed completes its interest rate raising cycle for 2018. It is no position to increase interest rates to the extent required given the ~350% of GDP leverage the economy is currently running at so the likely give will be in exchange rates, which in turn will feed into the pressure on reserves.

10-year	% Rate
US	2.66%
German	0.63%
Japan	0.07%
China	3.95%

The recent Trump tax cuts that not only pushes wages for American workers, it also provides benefits for corporations like Apple to move their massive offshore funds home. These cuts will provide a boost in the short term, while they will enhance the federal deficit in the longer run. In addition, the ongoing trade friction is forcing corporations to evaluate how they place at least a part of their supply chain in the largest consumption market globally which consumes almost equal to Euro Area, Japan and China put together. This is, again, leading to higher investment in the US. The trade friction was a given how the export driven economies were essentially freely accessing the US markets without allowing similar benefits to US exporters with both trade and non-trade policies (http://poleconomyindia.blogspot.in/2017/01/stimulus-and-protectionism.html).

While this has happened, unusually, the dollar index in the last year has declined by 11% putting great pressure on export dependent countries. But as the dollar reverses course and the cost of funds rise coupled with a dollar liquidity decline globally due to higher domestic oil production, tax changes and trade friction, the funding pressure on emerging economies, which have relied heavily on dollar credit over the past decade, will rise leading to declining currencies, rising inflation and rising funding costs.  

Old Empires Rise

The dominant story of the last few centuries has been the rise of Western Europe and US and decline of the age-old empires - Ottomans, Persians, Hans, Poles and Indians. We are now witnessing a rise of China, Turkey, Poland, Iran and India and a revival of Russia and Japan. This is happening at a time when the sole superpower is tired of its quagmires of the last 15 years and facing growing challenges in North Korea and China which are beyond the capacity of any other country to tackle.

The above is not only the consequence of breakdown of balance of power in multiple locations at Eurasia but also a cyclical revival of power. Iraq was holding in place the balance in power against Iran which was destroyed by US war, what resulted is a shite led Iran backed government in Iraq. Turkey which is in the process of emerging from the self-imposed self-protective secular camouflage imposed by Kemal Ataturk post World War 1 as a leading power. It is only these powers which can reconfigure and create a sustainable balance of power in the Middle East and till then US has to engage in its balancing act. Where this and the emergence of renewable energy will leave Saudi Arabia is a fear which dominates their regular actions whether in Yemen or against Qatar.

Russian bear that went into hibernation post the collapse of the Soviet Union rediscovered itself with Putin and post 2008 we have seen a continued power projection by Russia in its neighbourhood – Georgia, Crimea, Ukraine and Syria. It continues to significantly fund subversive activities in the entire eastern European landmass. It recognises that its demography is in decline and so potentially is the future of its oil dependent economy. It has a decade to reinforce at its historical buffers in Eastern Europe. But it shares borders with three strong states – Turkey, China and Poland. Russia for most part is European country and it historically that the Russians, Prussians and Austrians that had divided the Polish empire which reached its height in 1619 when it occupied present-day Ukraine, parts of Russia, Belarus, Estonia, Latvia and Lithuania. We are seeing a revival in Polish economy and political power including their national will to ensure their independence – expanding its army and platform acquisitions. Poland is likely to be the flank of Russian and Turkish power projection westward in the current century.

East Asia is undergoing its own geopolitical dance as China’s rise affects the balance of power with Japan. Japan is already in the process of changing its constitution to change its force configuration to meet the rising challenge of China. China as it faces a more uncertain US presence to protect its energy sea lanes from the Middle East is envisaging oil pipelines running from Pakistan and from Burma to protect itself from the narrow lanes in Malacca straits which India, Japan or the US can significantly constrain and enhancing its naval presence in the Indian Ocean. This in turn is creating threats for India in their near neighbourhood from Pakistan to Nepal to Burma and the Indian Ocean region. India has already become the 5^th largest defence spender globally and may go on to become the 3^rd largest behind China within the next decade. But ultimately China faces the US – in its presence in South Korea, Japan, Taiwan, Vietnam, Philippines and Singapore. This also represents the One Belt One Road geopolitical manifestation besides the desire to stabilise the Xinjiang in its west. China is an economy facing massive leverage, very poor demographics, income imbalance and export dependence. It is erecting significant barriers and internal controls as President Xi tries to manage the contradictions (which I have discussed in detail in earlier articles) and reconfigure the economy. This is where US policies will exercise their maximum force.

Distributed power with multiple balance of power structure was the way the world was before the two superpowers divided it post World War II. We are geopolitically in a pre-World War II world with the material difference that there is still only one superpower.

The crossword of economics and power will work itself out but not without testing the patience of investors and ability and calmness of politicians and generals.

“Nothing whets the intelligence more than a passionate suspicion, nothing develops all the faculties of an immature mind more than a trail running away into the dark.” ― Stefan Zweig, The Burning Secret and other stories