China, Asia: Last Orders for the US Dollar?
- "Steve" posted:
Date: Wed, 2 Mar 2005 12:42:44 -0500
Subject: Last Orders for the US Dollar?
March 1, 2005
"Below the favourable surface [of the economy], there are as dangerous and
intractable circumstances as I can remember.... Nothing in our experience is
comparable But no one is willing to understand [this] and do anything about it
We are consuming about six per cent more than we are producing. What holds the
world together is a massive flow of capital from abroad its what feeds our
consumption binge... the United States economy is growing on the savings of the
poor A big adjustment will inevitably become necessary, long before the social
security surpluses disappear and the deficit explodes We are skating on
increasingly thin ice." Former Federal Reserve Chairman, Paul Volcker
Last orders is the cry one usually hears at closing time in an English pub.
The beer spigots are turned off and the partys over. One had a similar sense
of finality for the US dollar last week following the announcement that the
Korean central bank, which has some $200 billion in reserves, would diversify
the currencies in which it invests, according to Reuters, citing a Bank of
Korea (BOK) spokesman in a parliamentary report. The dollar fell sharply and
the US market (although subsequently recovering) recorded its largest one-day
fall in almost 2 years.
No doubt under considerable pressure from Washington, the Bank of Koreas
position was clarified within 24 hours. A BOK spokesman iterated that its
desire to diversify its foreign exchange reserves was not new and did not mean
it would sell the US currency. The ever accommodating Tokyo mandarins were also
wheeled in: We have no plan to change the composition of currency holdings in
the foreign reserves and we are not thinking about expanding our euro
holdings," Masatsugu Asakawa, director of the foreign exchange market division
at the Ministry of Finance (MOF), told Reuters the same day. Given the size of
their respective dollar holdings, both countries would say that, wouldnt they?
But first impressions are often very telling and probably more indicative of
the BOKs true feelings, coming as they did on the heels of warnings by the
IMFs Managing Director, Rodrigo Rato, who urged the US to implement a credible
set of policies to reduce its need for external financing before it exhausts
the world's central banks' willingness to keep adding to their dollar reserves:
Record levels of debt are now financed by foreign investors and it is highly
unlikely that such easy credit will continue to be available to the U.S. on the
basis of the existing policy path. One has a sense that the Koreans were
echoing this message: No mas.
That the mere threat of an Asian central bank diversifying its reserves out of
US dollars temporarily sent both the US currency and stock market tumbling last
week is truly indicative of the fragile state of the current financial system.
In fact, even the use of the term financial system ought to be used guardedly
here, since it implies that there is something orderly underlying todays
speculative wildcat finance. In spite of the coordinated damage control by the
Koreans and Japanese, it is very telling that the dollar did not swiftly regain
its previous losses. The actions in the foreign exchange markets suggest that
its participants (central bankers included) are coming to a belated recognition
that something is truly amiss. It is certainly not a happy state of affairs
when the dollars well-being is largely dependent on a handful of Asian central
banks, which between them control almost $2.5 trillion in reserves and are
beginning to become more public in their desire to hold fewer greenbacks.
The Bank of Korea, like every other major Asian central bank, faces the awful
dilemma that confronts any large holder of an asset that is declining in value.
They would like to diversify their reserves into other assets. To do so they,
have to sell dollars and buy, for example, more euros. But if they do that (and
telegraph their intentions in advance), they risk pushing the dollar over the
cliff, causing a huge loss in value of their remaining dollar reserves.
Financial instability would likely ensue, which explains why the Koreans beat a
In spite of the spin doctoring, there is mounting evidence to suggest that the
Asian central banks have already begun to lose confidence in the Federal
Reserves ability to rein in U.S. financial and economic excess and are quietly
acting accordingly. The Bank of China, for example, has given ample indications
of its long-term intentions on this matter: Roughly 50% of China's growth in
foreign exchange since 2001 has been placed into dollars. Last year, however,
while China saw its reserves grow by $112 billion, the dollar portion of that
was only 25% or $25 billion, according to the always well-informed
Montreal-based financial consultancy firm, Bank Credit Analyst. The Deputy
Governor of the Bank of China has also signaled that to ward off foreign
exchange risks, China needs to readjust the current structure, increasing the
proportion of the euro in its foreign exchange reserves.
Even the Koreans, hitherto circumspect about their intentions (and likely to be
even more so after last weeks uproar), have in all probability followed
Chinas lead. A study by Stephen Englander of Barclays Capital Research
indicates that unlike Japan, where the dollar share of reserves has risen over
the past year, it appears as if Korean foreign exchange reserves were
approximately 80 per cent US-dollar denominated before 2003, around 70 per cent
in 2003, and 60 per cent or less by the end of last year. Englanders judgment
is based on estimates of how much the dollar value of Korean reserves moves up
or down against other currencies. He deduces that the comparative lack of
one-to-one correlation in the value of the reserves with the won-dollar
exchange rate movements implies that as much as 45 per cent of Koreas
substantial reserves may now be in non-dollar holdings. So the only real
question remaining is the extent to which the Koreans intend to continue this
Even if the Bank of Korea or the Bank of China were to desist from further
selling their existing stock of dollars, this may only give the dollar a
temporary reprieve, as it experienced in the first month of this year. US
private savings are clearly insufficient to fund the countrys growing current
account deficit, so the dollars external value (and by extension, the bid in
the bond market) is highly dependent on continued purchases by other central
banks. If, as the Korean and Chinese actions suggest, begins to diminish
further, in the absence of renewed foreign private sector inflows, the dollar
It is not enough to argue, as economist Irwin Stelzer did recently in the
London Sunday Times (Falling Dollar and Rising Oil are a Dangerous Mix
Sunday, February 27, 2005), that the dangers of a falling dollar can be
alleviated by the Asian central banks continuing to buy dollar assets,
although at a slower pace and shifting to non-government bonds. Such is the
US position today that Asias central bankers must continue to increase their
purchases of dollars simply to stabilize the dollars current value. Purchasing
power parity does not come into play here. Debt trap dynamics do. That is to
say, even we make the generous assumption that the dollars recent depreciation
in trade weighted terms has ensured that the price of US goods are now cheap
relative to its trading partners, it may well be irrelevant because as the
compounding effect of its overseas liabilities rise, the US faces a growing
deficit on its net overseas income which will further add to size of the
underlying current account deficit.
This is the essence of a recent piece of research by Stephen King of HSBC ("The
Ticking Time Bomb", HSBC, January 2005), who argues that as US imports are so
much larger than exports, exports must grow 5 per cent faster than imports just
in order for the trade deficit to stabilize. The basic math suggests that the
problem of a rising US current account deficit will be with us for many years.
On current trends, the US will have net foreign liabilities equivalent to 90
per cent of GDP and payments on overseas debt will reach 1.5 per cent of GDP.
In order to finance this deficit, King contends that Asian central banks would
have to double the size of their dollar foreign exchange reserves. Despite
Stelzers attempt to reassure, reduced purchases will be insufficient to
restore a modicum of equilibrium to the dollar and financial markets.
But how many more dollars can Asias central banks buy? Current strains come
against a backdrop when in the 15 months to the end of March 2004, the Bank of
Japan acquired some $320bn worth of US liabilities - a sum equivalent to $2,500
per head of the population or more than three quarters of the US federal
deficit, according to Nouriel Roubini and Brad Setser, (Source: "Will Bretton
Woods 2 Regime Unravel Soon? The Risk of a Hard Landing in 2005-2006", draft
paper, February 2005).
This is why we raised the possibility two weeks ago of a potential US
repudiation of some of its debt, as it did in the 1930s (when FDR declared it
illegal to own circulating gold coins, gold bullion, and gold certificates,
thereby repudiating the government's obligation to repay the country's bond
holders in gold coin of the present standard of value) or the during the
1970s (when President Nixon slammed shut the gold window and went off the last
vestiges of the gold standard in 1971, in effect repudiating the remnants of
the Bretton Woods system, which had governed the global economy throughout the
entire post-war period).
One could make the case that the dire economic circumstances of the Great
Depression or the stagflationary 1970s made these exceptional actions one-off
generational events unlikely to be repeated in more normalized times today.
But as Paul Volcker recognized at the top of these pages, there is nothing
normal about the current economic environment, in spite of Mr Greenspans
protestations to the contrary. If anything, the problems today may be even more
At the time of the 1929 stock market crash, total US credit was 176 percent of
Gross Domestic Product. In 1933 with GDP imploding and the real value of debt
rising even faster, total credit rose to 287 percent of what was left of GDP.
(Irving Fisher described the collapse of GDP as a function of price deflation,
which raised the real burden of debts, as firms and households shed assets and
reduce expenditures in order to pay down debt. But these acts of liquidation by
all economic agents pushed prices yet lower, which in turn raised the real debt
burden further and caused further economic implosion.) In 2000 at the top of
the late bull market, total credit was 269 percent of GDP. An extraordinary
statistic to be sure, but dwarfed by today's figure, in which total credit
stands at a whopping 304 percent of GDP, according to a recent study by fund
manager Trey Reik of Clapboard Hill Partners.
The obvious answer in such circumstances would be to restrain US consumption.
But were Americans to begin to significantly pare their debt burdens, aggregate
demand would likely collapse and trigger something not unlike what Fisher
described in the 1930s. A world war was ultimately the means by which the US
economy emerged from the ravages of the Great Depression. But with the country
already overstretched by current military operations (and possibly more to come
in spite of President Bushs protestations to the contrary last week in
Germany), Americas big stick is looking decidedly eviscerated by woodworm.
The Pentagon continues to plead poverty in spite of a budget now in excess of
$500bn (larger than the defence budgets of the next 20 countries combined).
Such is the state of its recruiting shortfalls that a draft is quietly being
considered: Rolling Stone magazine reported in late January that two of Mr.
Rumsfeld's deputies met with the head of the Selective Service Agency in
February of 2003 to debate, discuss and ponder a return to the draft.
According to a memo from that meeting made public under the Freedom of
Defense manpower officials concede there are critical shortages of military
personnel with certain special skills, such as medical personnel, linguists,
computer network engineers, etc. The potentially prohibitive cost of
attracting and retaining such personnel for military service, the memo adds,
has led some officials to conclude that, while a conventional draft may never
be needed, a draft of men and women possessing these critical skills may be
warranted in a future crisis.
Similarly, USA Today reported last week that the US Army and some elite
commando units "have dramatically increased the size and the number of cash
bonuses they are paying to lure recruits and keep experienced troops in
uniform." For some special elite units, the Pentagon is offering up to $150,000
in bonuses, while more than 49 percent of the job categories in the Army can
now receive $15,000 bonuses, and "16 hard-to-fill job categories, including
truck drivers and bomb-disposal specialists" are eligible for $50,000 bonuses.
How much more can America afford to pay out? The US may well try to make the
case that since it is doing the lions share in safeguarding the worlds global
security from the threat of terrorism, the rest of the world could engage in a
form of burden sharing by forgiving a large chunk of its debt (although one
wonders whether the Chinese, amongst others, would agree with this
formulation). That said, proposed negotiations along these lines are invariably
undermined if Asias central banks continue to proclaim publicly their
unwillingness to hold vast sums of US dollars indefinitely, as the BOK did last
week. Americas position is also not helped by the well publicized
dissemination of a recent meeting in Bangkok, in which Asias leading economic
policy makers discussed, among other things, global economic imbalances and
how to deal with the faltering dollar. The whole tenor of the discussions
focused on Asia taking defensive, pre-emptive action to safeguard its own
interests, rather than extending a further helping hand to Uncle Sam.
A former Federal Reserve Chairman, William McChesney Martin, once described the
role of the institution he led in the 1950s and early 1960s as taking away the
punch bowl when the party was really getting going. Clearly, the Greenspan Fed
is no longer willing to play that role (if it ever did). But it is increasingly
dawning on the markets that Asias central bankers may well have that role
reluctantly forced on them, which explains the initial reaction to the Bank of
Koreas announcement. The positions of both the US and Asia are becoming
increasingly untenable. On current trends, America has embarked on a trend
which will exhaust Asias central banks abilities to hold increasing amounts
of US dollars; its recourse to military (as opposed to economic) suasion, may
simply make the problems worse. From Asias perspective, the Bank of Koreas
threat last week to reduce the share of dollars in its portfolio might simply
represent the first of many cries de Coeur from that part of the world that
enough is enough. It may well be the case, therefore, that last orders are
truly in for the US dollar.
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