Currencies After the Crash

by Sara Eisen

  In any event, further attempts to devalue the greenback, either unilaterally by the United States or in concert with other nations, seem highly unlikely, unless it strengthens fantastically. Furthermore, attempts to debase the buck by deliberately promoting inflation to reduce its purchasing power against other currencies is something I’ve never heard even mentioned, much less seriously discussed, in Washington. And with my forecast of deflation, they probably couldn’t pull off the desired effect of inflation and growth if they tried.

  In The Age of Deleveraging, I identified seven forms of inflation/deflation, and in the October 2011 edition of my monthly newsletter, “Insight,” I noted that five forms of deflation are underway.

  1. Financial asset deflation started with the nosedive in subprime mortgages in early 2007. Now it’s rampant in the collapsed prices of Greek sovereign debt and European bank stocks, and in the balance sheets of European and U.S. banks as they dump assets. U.S. private and public pension funds have been deflated by falling Treasury yields. Stocks are deflating universally in response to global economic weakness, eurozone woes, and the prospective hard landing in China.

  2. Tangible asset deflation is proceeding, and U.S. house prices are likely to fall another 20 percent (Figure 1-35). Commercial real estate prices are down 43 percent. Housing bubbles are bursting or at risk in Spain and China.

  3. Commodity deflation is in full flower as industrial commodities, led by copper, grains, and even gold, nosedive (Figure 1-36). A hard landing in China and collapsed commodity demand will crumble the foundation of the commodity bubble.

  4. U.S. wages and incomes are deflating, with real median household income declining (Figure 1-37) as high unemployment and weak labor demand persist. Household net worth is down 23 percent from its fourth-quarter 2006 peak and, relative to disposable personal income, is lower than in the 1950s. Income polarization persists, and the middle class is being deflated to low-income status.

  5. Foreign currencies are deflating against the dollar, the only global reserve currency and the ultimate safe haven. Also, the euro is mired in sovereign debt crises, commodity-based currencies are dropping, and even the Chinese yuan is problematic.

  6. Inflation by fiat still reigns as government laws and regulations hype costs and wages. This includes increasing minimum wages, requiring higher gas mileage for vehicles, protectionist measures, agricultural price supports, the Dodd-Frank regulations, and all the other ways in which the government, with the stroke of a pen, raises prices by interrupting free markets. The 2012 election, however, may spawn genuine tax simplification and other forms of deflation by fiat.

  7. Goods and services deflation, the seventh variety and the one that most people think of in terms of consumer or producer prices when then they refer to deflation, has not yet arrived. But with deflation in financial and tangible assets, commodities, real wages, and currencies underway, it can’t be far behind. As global deleveraging persists, goods and services prices will be marked down to reestablish equilibrium. With house prices, stocks, commodity prices, and household purchasing power all falling, how can wholesale and consumer prices resist the onslaught when consumers are trying to save and cut debt, not spend freely? The Fed, in its September 21, 2011 policy statement, in effect expressed renewed concern over goods and services deflation.

  Figure 1-35 Case-Shiller 10-City House Price Index

  Source: Standard & Poor’s

  Figure 1-36 Reuters/Jefferies Commodity Research Bureau Index

  Source: Jefferies & Co.

  Figure 1-37 Real Median Household Income

  (2010 $)

  Source: Census Bureau

  Current Account Deficit

  Until the recent rally, the dollar had declined for 25 years, and many people consider this a deliberate debasement of the currency. They also see the chronic foreign trade and current account deficits (Figure 1-1) as a major reason. Note, however, that the rest of the world depends on the United States to buy its excess goods and services, and the American trade deficit of $720 billion over the last 12 months is the counterpart to surpluses elsewhere. The effects of the recently sluggish U.S. economy as well as recession-bound Europe on emerging economies and their securities markets show the export dependence of Asian and other lands on developed country importers, especially America.

  Furthermore, as Belgian-American economist Robert Triffin pointed out in the 1960s, the country whose currency is the global reserve currency must be willing to run current account deficits to supply the reserve currency demanded by other countries. This is known as the Triffin dilemma because of the conflicting goals of a current account surplus to promote a strong currency and the need to run a deficit to meet the needs of foreign holders of that reserve currency. In the case of the dollar, many of those foreign reserves are held in the form of Treasuries.

  The Triffin dilemma also explains, at least in part, why the U.S. trade and current account deficits have not been self-correcting, despite the declining dollar. A falling greenback is supposed to boost U.S. exports and economic activity while weakening imports and therefore economic activity in foreign countries. That, the theory goes, should induce interest-rate cuts abroad to rejuvenate those economies while interest rates rise in America, and the shift in interest-rate spreads in America’s favor should make U.S. investments more attractive. Also, faster growth here than overseas is expected to attract foreign money. The net effect is to strengthen the dollar as money moves from abroad to the United States and reestablish equilibrium.

  Recycled Dollars

  By definition, the U.S. current account deficit must be recycled back into dollar investments, which can range from currency to Treasuries to U.S. corporate stocks and bonds to Iowa farmland. The only alternative is to convert it to paper dollar bills, cut them up with scissors, and flush them down the toilet. If the Taiwanese don’t want to invest their dollar current account surplus in greenback-denominated assets, they could trade their dollars for Swiss francs, but then the seller of those Swiss francs would have the responsibility for recycling the dollars. Of course, in the recycling process, foreign dollar holders can determine the buck’s relative value, but that doesn’t change the necessity of keeping their dollar current account surpluses in dollar assets.

  Many people worry that big foreign holders of dollars, especially the Chinese, will dump their Treasuries and other dollar assets for political reasons. Accidents can and do happen, but such attempts could be suicidal. If foreigners refused to recycle their ongoing trade surpluses with the United States into American investments and tried to dump their existing holdings of Treasuries and other American assets as well, the dollar would collapse, and so would global financial markets and the global economy. The export-led developing countries, first and foremost China, would be the biggest losers, while the United States and other developed lands would fare better.

  But no one wants that, and—short of panic, which is always a risk—no one will precipitate it. Foreigners now hold almost half of U.S. Treasury bonds, about 10 percent of American stocks, and better than a third of corporate bonds. Also, where would they go if they vacated the dollar? The Swiss franc and gold are much too small markets to accommodate the holders of foreign dollars.

  It’s ironic that the United States, with its chronic trade and current account deficits and the resulting big holdings of American assets by foreigners, has more power in the international trade game than the foreign holders of these assets. But in a world of surplus goods and services, the buyer, not the seller, has the upper hand. Just ask any successful salesperson.

  The U.S. current account and trade deficits are likely to fall in future years. Consumer retrenchment will retard imports, and therefore these deficits will fall, assuming that foreigners continue to buy U.S. exports. For every 1 percent decline in consumer spending, U.S. imports fall 2.8 percent on average. Furthermore, while globalization has eliminated labor-intensive U.S. manufacturing, the manufacturing that remains is highly p
roductive. The Boston Consulting Group believes that seven industries may see production for U.S. consumers move from China back to the United States: furniture, transportation equipment, computers and electronics, electrical equipment and appliances, plastics and rubber products, machinery, and fabricated metal products. Rising labor costs in China will work to the advantage of American competitors, as will transportation costs, closer proximity to U.S. markets, and other such factors.

  Furthermore, net physical barrels of crude oil and petroleum products imports have fallen 41 percent since August 2006 as a result of the weak U.S. economy, more conservation, and rising domestic production. Petroleum imports dropped from 60 percent of total supply in 2005 to 49 percent in 2010. As these trends persist, the petroleum trade deficit, which was $27.6 billion in November 2011 and 58 percent of the $47.7 billion total, will decline, assuming that oil prices don’t spike, thereby reducing U.S. trade red ink.

  On Balance

  On balance, the credibility factor is the only one of my six criteria for a primary international trading and reserve currency on which the dollar is at all questionable in the years ahead. Because of the United States’ superior prospective productivity growth, huge economic size, and deep and broad as well as open and free markets, the American currency should persist as the unchallenged winner. And the credibility issue will probably continue to be noncrucial because there will probably be no global alternative to the buck for many years to come.

  CHAPTER 2

  THE WORLD’S HEGEMONIC RESERVE CURRENCY: THE U.S. DOLLAR VERSUS THE CHINESE YUAN

  STEPHEN L. JEN

  “The growing question is whether the exceptional role of the dollar can be maintained.”

  —Paul Volcker, former Federal Reserve Chairman, November 31, 2010

  The global financial crisis of 2008 has made it tempting to discount the long-term prospect of everything American. In addition to the derating of the United States’ economic, political, and military dominance, many people argue that the dollar will soon lose its hegemony, or authoritative dominance, as a reserve and international currency. At the same time, in part because of the powerful rise of China in the past decade, some people believe that the yuan could soon become a major reserve currency, perhaps challenging the dollar in that role within the decade.

  While the rise of China’s economy and the growing international role of the yuan are compelling generational trends, it may be a mistake to underestimate the durability of the dollar as the dominant reserve currency and overestimate the speed with which the yuan could become a dominant reserve currency.

  Here are five thoughts.

  1. It Is a Mistake to Think that the Reserve Currency Dominance Has Much to Do with the Relative Size of the Economy

  In purchasing power parity (PPP) terms, China’s economy is already 70 percent that of the United States, and it is projected to surpass the United States’ by 2016. Some have argued that, simply because of the sheer size of the Chinese economy, the yuan will, almost as a matter of course, become the dominant reserve currency. However, looking at the various reserve currencies in the world, there does not appear to be a tight relationship between the size of the economy and its reserve currency status. For example, in terms of nominal GDP, the United States is slightly smaller than the European Economic and Monetary Union (EMU), yet its share of global reserves is more than twice as large. Switzerland’s economy is 8 percent the size of Japan’s, yet the Swiss franc, as a reserve currency, has almost as big an international market share as the yen. At present, the yuan accounts for zero percent of the world’s reserves; it is much harder to manufacture a reserve currency than it is to manufacture goods.

  Without a stringent application of the rule of law, accounting transparency, and sufficient liquidity in the underlying markets (bond and equity markets), it will be difficult for emerging-market economies in general to make—by mandate or by size—their currencies “reserve” currencies. Fixating on the size of the economy in this discussion is like judging the value of a car based on only its top speed, ignoring other criteria such as handling, reliability, safety, and comfort.

  It is difficult to be the hegemonic reserve currency of the world. Importantly, the issuing country must have (1) liquid capital markets, (2) a relatively stable economic regime, (3) a sustainable political regime, and (4) a mighty military force. Neither the eurozone, China, Japan, nor Russia possesses all four of these criteria. China may have an enviable production-export industrial complex, but it does not yet have a yield curve* that is meaningful or viable. In fact, in many of the emerging-market economies, the development of the capital markets has in general lagged badly behind the developments of the real sector; this is like someone having the upper body of a body builder but the legs of a 12-year-old boy. Why else would China—supposedly the future issuer of the dominant reserve currency in the world—need to have US$3.5 trillion in reserves for self-insurance purposes?† These countries rely on the U.S. dollar as the currency to use in the event of an emergency precisely because it is superior to and more trustworthy than the yuan.

  Perhaps the critical issue for the yuan and other emerging-market currencies that might aim to challenge the dollar is not the size of their economies or their trade, but the size and li-quidity of their financial markets. The bond markets of the top five reserve currencies (the U.S. dollar [USD], the euro [EUR], the Japanese yen [JPY], the British pound [GBP], and the Swiss franc [CHF]) account for some 90 percent of the world’s sovereign bond liquidity, and more than two-thirds of the equity-market liquidity. While these top five reserve currency issuers account for only 36 percent of the world’s trade, they account for 81 percent of the currency transactions and 96 percent of the world’s foreign reserves. The gap in terms of the level of development and openness of the financial markets is one of the key defining differences between developed and emerging markets. Unless China, India, Brazil, and others can offer the world full access to their financial markets, and actively nurture these markets to make them large and liquid, it will be very difficult for their currencies to become dominant international currencies in the near future.

  2. It Is a Mistake to Underestimate the Incumbency Advantage

  The half-century lag between the milestone of the United States surpassing the United Kingdom (in terms of size of economy and volume of trade) and the dollar finally replacing the pound sterling as the leading reserve currency after World War II is a reminder of the immensely powerful forces of economies of scale. Children around the world—even those in China—are eagerly learning English, not because English is necessarily superior to French or Mandarin Chinese, but because everyone else in the world speaks English. The dollar is “English” in the currency world. Similarly, it makes sense to price commodities in the most widely used currency in the world—the dollar: it would be odd to mandate that oil and gold be priced in Special Drawing Rights (SDRs) of the International Monetary Fund (IMF) just so that we could be politically correct or “democratic.” The U.S. dollar enjoys a tremendous advantage in its use as an international currency because there are so many dollars circulating. Even if the U.S. dollar does lose its hegemonic reserve currency status (a consensus view), I believe that this will be an extremely gradual process (an out-of-consensus view).

  The dollar’s international reserve currency status should be judged on its role as (1) a medium of exchange, (2) a unit of account, and (3) a store of value. On points 1 and 2, I think it will be extremely difficult for the U.S. dollar to cede its lead to any rival currency. It is only on point 3 that the dollar has issues, which are accentuated in an increasingly multipolar world. When the global economy fell into a violent recession in 2008—one caused by the United States itself—the dollar, rather perversely, was bought as the safe haven currency. I doubt that the U.S. dollar’s international reserve currency status (in the private sector, not the official sector) has deteriorated that much since then. In short, the dollar’s role as (1) a medium of exchange
and (2) a unit of account has been well maintained over the last 35 years.

  It may be useful to examine the role of the U.S. dollar as the invoice and settlement currency not just for international trade, but also for cross-border capital flows.

  There has been much angst regarding the dollar-denominated international monetary system. On August 25, 2010, French president Sarkozy announced his agenda for France’s then-forthcoming presidency of the G-20 Group, which would include a discussion on a comprehensive overhaul of this dollar-dominated system. On August 28, 2010, the IMF’s first deputy managing director, John Lipsky, delivered a speech on a similar topic and touched on the international role of the dollar. Furthermore, there have been ample reports of countries promoting the settlement of regional trade in local currencies, not in dollars. For example, in the past two years, China has signed numerous agreements with its contiguous trading partners to settle border trade in local currencies, bypassing the dollar. On July 2, 2009, China and Brazil announced their agreement to settle some of their trade in their own currencies, instead of the dollar.* Moreover, China has also announced important steps toward greater internationalization of the yuan by liberalizing the capital account.†

  The powerful and irreversible trend toward general diversification away from the dollar is clear, except that this consensus view is not supported by data.

  There is perhaps not a sufficient appreciation for the relative size of international trade and international capital flows. It is well known that global trade has surged sharply in the last decade, reflecting in part China’s entry into the World Trade Organization (WTO) in 2001 and its subsequent ascendancy. Global exports grew strongly from US$6.1 trillion a year in 2001 to US$15 trillion a year at the end of 2010—a cumulative 100 percent increase over the decade.* If more and more of global trade is being denominated and settled in currencies other than the dollar, surely the dollar’s hegemonic status is being eroded, or so the argument goes.