Cited: Reuters
Continued from “Is US Dollar Doomed? Part 1“
THE KINDNESS OF STRANGERS
The reserve currency status is conferred upon the United States that so-called “the exorbitant privilege”, as it was called by the former French president Valery Giscard d’Estaing when he was finance minister, the past 60 years.
Because the dollar is in high demand, U.S. borrowing costs remain low. That makes it easier for the government to fund domestic priorities and military commitments and the average citizen to buy a home or start a business.
It also means the United States need not borrow or repay debts in foreign currencies, making the value of its currency a less urgent concern than it would be for other borrowers who borrow and pay for imports with dollars.
But such easy access to capital has led to huge deficits. With Americans spending more than they save, the money to finance the shortfalls has to come from abroad.
“We are plainly overextended in our budgetary terms and in our dependence on foreign capital; we resort to the kindness of strangers to meet our deficits,” said former Federal Reserve Chairman Paul Volcker at an Economic Club of New York speech last month. Volcker is now head of President Barack Obama’s Economic Recovery Advisory Board. That kindness probably has a limit.
China and Russia have both talked publicly about long-term alternatives to the dollar. Some central banks, including Russia’s, have said they intend to hold a greater amount of their foreign exchange reserves in other currencies.
Chinese central bank governor Zhou Xiaochuan also made waves last year when he said the dollar should one day be replaced, perhaps by a “super-sovereign” reserve currency based on Special Drawing Rights, the IMF’s in-house unit of account.
Economists have interpreted the comments as an attempt to give the Yuan, China’s currency, a more prominent role in global finance, in keeping with the nation’s growing clout on the world stage. Of course, that won’t happen overnight.
“There might be some progress toward multi-polarization of the international monetary regime, but there will be no immediate change to the dollar’s role as the main international currency,” said Zhang Zhigang, chief economist with the China Center for International Economics Exchanges.
But over the last year, China has voted with its pocketbook. It quietly struck currency swap accords worth some 650 billion Yuan ($95 billion) with central banks in Asia, Latin America and Eastern Europe that allow importers to pay for Chinese goods in Yuan instead of dollars.
That could set the stage for greater use of the Yuan for offshore financial and investment purposes. And that is a precondition if the currency is to achieve greater international status.
For now, however, central bank reserve managers have few options beyond the dollar. No country is close to outranking the United States — economically, militarily or politically. The euro, which many see as the dollar’s most immediate rival, is tied to an economic area with no common political or fiscal policy. That’s part of what makes solving Greece’s debt woes so difficult.
It also lacks a common bond market. Veteran Brown Brothers Harriman currency strategist Marc Chandler likens Europe’s sovereign bond markets to those for U.S. municipal debt — lots of issuers of varying size and credit quality, but none that on its own can rival the deep, liquid U.S. Treasury market.
The U.S. Treasury, in an addendum to its October 2009 currency report, cited the disparate sovereign debt markets as the key reason the euro doesn’t take an equal share of global reserves, even though the eurozone approximates the United States in economic power.
But other rivals will likely continue to gain strength. Ten years ago, China “was hardly even on the radar screen” in Washington, said Jeffrey Garten, a professor at the Yale School of Management and a former undersecretary of commerce during the Clinton administration.
“So people who say their currency is nowhere near an international currency and that it’s going take at least 20 or 30 years — I think they’re living in a dreamworld,” Garten said.
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TOWERING DEBT
As they open up and develop their capital markets, emerging economies such as China, Brazil or India could see their currencies occupy a larger portion of central bank reserves in coming decades, according to the October U.S. Treasury report.
It also asserts that as long as the United States maintains sound macroeconomic policies and open, deep and liquid financial markets, the dollar will remain “the major reserve currency.”
Some worry, however, that the parlous state of U.S. public finances makes betting on long-term dollar dominance dicey. The White House this month said the 2010 budget deficit would reach $1.565 trillion — at nearly 11% of output, the largest shortfall since World War II.
But America was running large trade and budget deficits before the financial crisis. “We went into the crisis in a weak fiscal position,” said C. Fred Bergsten, a former assistant Treasury secretary and current director of the Washington-based Peterson Institute for International Economics.
Dean Baker, co-director of the Center for Economic Policy Research in Washington, said U.S. finances are still manageable and a weaker dollar is necessary to boost exports, cut the trade deficit and end a multi-decade spending binge.
Provided America invests in education and infrastructure, maintains high output and productivity and keeps people employed, he said it can overcome the challenges it faces.
“We are moving to a world that’s going to be multi-polar, a world where the dollar is not going to be as dominant as today,” he said. “But if we do things to keep the U.S. economy strong, we will be able to finance ourselves going forward.”
The United States found ready buyers for roughly $1.7 trillion in new debt issued in fiscal year 2009, which brought total debt held by the public to $7.89 trillion, some 55% of output.
There are, however, some early signs that buyers may be growing sated. Treasury plans to issue another $1.5 trillion to $2 trillion this year — a record $126 billion this week alone. Yet auctions for $41 billion in long-dated debt earlier this month attracted only modest interest. The yield demanded by buyers of fresh 30-year debt was the highest in more than two years.
The United States still pays less than 4% on its 10-year Treasury notes — well below an average of 7- 9% in the 1980s and 1990s. But economists also worry about the government’s unfunded pension and health care liabilities. Last year, Dallas Fed President Richard Fisher estimated that the United States may be on the hook for as much as $99 trillion, much of it tied to Medicare. That’s about seven times the size of the entire U.S. economy.
“The bottom line is that we can’t keep borrowing at this pace forever,” said Kenneth Rogoff, Harvard University economist and former chief economist at the IMF. “That only works if the Chinese are willing to lend us unlimited amounts of money at near-zero interest rates, and that just isn’t going to last forever.”
When it ends, Rogoff said the U.S. will have to deal with higher interest rates, higher taxes and slower growth, all of which will further undermine its economic might.
WHEN LEVERAGE ISN’T LEVERAGE
Of course, much as the United States depends on Chinese savings to finance its deficit, China depends on U.S. consumers to keep buying its exports.
Few think this mutual dependence can last indefinitely. U.S. authorities and a number of economists claim the problem is China’s inflexible exchange rate that pegs the Yuan to the dollar, thus keeping it undervalued to support exports.
Analysts at the Washington-based Peterson Institute say that given China’s massive growth, the Yuan may be undervalued against the dollar by as much as 40%.
Since President Barack Obama assumed office, the U.S. has twice declined to label China a currency manipulator, a move that could trigger trade sanctions. But the administration has repeatedly complained of China’s unfair trade advantage.
Recently, the White House even pledged to double U.S. exports in five years, a goal that economists say would require a significantly weaker dollar. It’s not clear how much other nations, particularly China, will go along.
In the post-Cold War era, currency talks are the rough equivalent of nuclear arms reduction negotiations. In language evocative of the U.S.-Soviet face-off, Chinese military officers have proposed punishing Washington with “a strategic package of counter-punches” that includes dumping U.S. government bonds.
While the military plays no role in setting China’s foreign exchange holdings, the comments underscored the rising level of tension and mistrust between the two powers.
Nicholas Lardy, a senior Peterson Institute fellow, dismisses such threats, noting that China’s vast dollar wealth would start to evaporate and its currency to rise if it started unloading Treasuries.
“The Chinese are in the classic dollar trap. They have so many dollars that they can’t diversify,” he said.
Marc Leland, head of Leland & Associates and deputy undersecretary of the Treasury during the first Reagan administration, said: “It’s only leverage if one thinks they can pull the trigger. I don’t think they can.”
Morgan Stanley Asia chairman Stephen Roach isn’t so sure. He said that if the U.S. eventually resorts to trade sanctions against China — not unthinkable in a U.S. election year, with the unemployment rate near 10 percent — Beijing would likely retaliate.
China might boycott a Treasury auction, he said, which could cause the dollar to plummet and interest rates to spike.
“I spend a lot of my time talking to the Chinese about that, and if it happened, I think they would feel compelled to stand up and take strong retaliatory actions, even though, yes, there would be consequences for them as holders of Treasuries and other dollar-denominated assets,” Roach said.
“Once you believe that you are better and greater than everyone else, you have a problem,” he said, “because today, the competition is right around the corner.” That may be especially true for any winner of a reverse beauty context.
The dollar’s future may depend on Washington assuming a more humble attitude according to Merk, the investor who is betting against the U.S. currency.
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My Take: It seems that China just might have the US government by the short hairs! Somebody once said when you control the money you control the country. I don’t know who said that, but I think they may have been right. While we worry about Halloween costumes and Njoy products, they buy our debt.
I wonder if anybody in the government has actually considered that. It will be interesting if they call the debt due because we are delinquent. I have seen people who junk a car to pay a debt. What will the government junk to pay its debt? Then again, some of these experts could be right and China could be between a rock and hard place and the people who buy junk cars will not be making any money.
I think I will sit back with my E cig and wait and see. Maybe by the time it’s time for people to start buying their adult costumes for Halloween we will know more. I truly believe in this country and believe we will survive this recession.
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If Federal Reserve Chairman Ben Bernanke gives a reassuring assessment of the recovery and retail earnings that shows an improvement, Wall Street could keep going up after its best week this year. The chairman seems to believe that the retailers hold the keys for stocks.
