Thursday, January 29, 2015

Read.

This article is the best I've ever seen explaining why we are in the middle of a deflationary avalanche. I never quote so much of an article, but most people also don't follow links. So, I've outlined a pretty important segment of the article describing why the dollar becomes strong in deflation. This in turn hurts US companies. Please read the whole article. It's really good at describing the ripple effect. EME stands for emerging market economies.


"The initial transmission mechanism by which global oil deflation negatively impacts EMEs is falling currency exchange rates. Oil price deflation is generally associated with a corresponding rise in value of the US dollar relative to other currencies. A rising dollar in turn means falling currency values for other countries.

Since the collapse of global oil prices began in earnest last June, the Russian Ruble has fallen approximately 38 percent.  The Venezuelan currency, the Bolivar, by around 45 percent. Nigeria’s currency, the Naira, has declined 12 percent just since mid-October. Even the currency of developed oil exporting countries, like Norway’s Krone, has fallen 17 percent.  After having remained stable for several years, the US dollar clearly began to rise last June, as global oil prices commenced their freefall that same month. So falling oil prices drive the dollar up and in turn depress EME currencies, and especially depress the currency of oil exporting economies. And the more dependent the economy is on oil exports, the greater the EME currency decline.

In other words, it’s not sanctions on Russia by the west that are responsible for the lion’s share of the ruble’s recent decline. Nor is it Venezuelan domestic economic policies that are contributing most to the decline in the value of the Venezuelan Bolivar.  It is the collapse of global oil prices that is the main culprit.

All commodities, not just oil, take a major hit when sustained oil deflation sets in.  A sharp and sustained decline in oil is generally associated with declining sales and prices of other commodities. The entire global commodities sector may be impacted negatively. That has already begun to happen with commodities like copper, gold, and other industrial metals, that have begun to fall as well in the wake of the current oil price decline. The Bloomberg Index of 22 basic commodities, for example, has recently fallen to its lowest level since 2009.

Even non-oil, but commodity heavy, exporting EMEs have experienced significant currency declines relative to the US dollar since global oil prices began to fall more rapidly last June.  In recent months Brazil’s Real has fallen 15.5 percent and Australia’s dollar by 12 percent–and in both cases despite their central banks’ interventions in currency markets to prevent even further currency declines.

Declining EME currency values sets in motion a number of critical economic developments that cause EME economic growth to slow sharply, and even precipitate recessions.

For example, sharp declines in currency values lead to capital flight from the EME. Both domestic and foreign investors dump those currencies, buy dollars, and send capital out of the country to buy US assets — typically US bonds and stocks and other assets that may be attractive as well, like real estate. The EME capital flight is then reflected in EME stock market declines and a rise in EME government bond interest rates. Former flows of foreign direct investment into the EME also slow. Money capital in general dries up. Credit becomes scarce. Falling currency values also lead to higher cost of imported goods for consumers and consequent decline in consumer real incomes and spending. Business exports also decline.  All the above translate into slowing real economic growth in the EME, and even recession.  And all because of rising dollar — the global trading and reserve currency — and the decline in the EME’s currency exchange rate that sets the process in motion."

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