"last orders for the us dollar?" - auerback art.

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    International Perspective, by Marshall Auerback

    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… it’s 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 party’s 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 Korea’s 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, wouldn’t they?

    But first impressions are often very telling and probably more indicative of the BOK’s true feelings, coming as they did on the heels of warnings by the IMF’s 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 today’s 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 dollar’s 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 hasty retreat.

    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 Reserve’s 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 week’s uproar), have in all probability followed China’s 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. Englander’s 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 Korea’s 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 process.

    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 country’s growing current account deficit, so the dollar’s 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 will plunge.

    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 Asia’s central bankers must continue to increase their purchases of dollars simply to stabilize the dollar’s 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 dollar’s 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 Stelzer’s 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 Asia’s 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 Greenspan’s protestations to the contrary. If anything, the problems today may be even more severe.

    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 Bush’s protestations to the contrary last week in Germany), America’s “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 Information Act:

    “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 lion’s share in safeguarding the world’s 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 Asia’s central banks continue to proclaim publicly their unwillingness to hold vast sums of US dollars indefinitely, as the BOK did last week. America’s position is also not helped by the well publicized dissemination of a recent meeting in Bangkok, in which Asia’s 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 Asia’s central bankers may well have that role reluctantly forced on them, which explains the initial reaction to the Bank of Korea’s 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 Asia’s 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 Asia’s perspective, the Bank of Korea’s 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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