Russian President Medvedev suggests the dollar is on its way out; Russian Finance minister Kudrin says there is no substitute for the dollar. The Chinese see a need to diversify out of the dollar; the Japanese say their trust in the dollar is unshakable. Let’s look at this puzzle and make some sense of it.
It’s usually more productive to look at what policy makers do rather than what they say. Having said that, this time around, the talk also speaks volumes. Notably, world leaders have expressed their concern about the U.S. dollar and a need to diversify, to reduce dependence on the U.S., to build new alliances as well as to strengthen domestic markets. This is the strategic perspective. Conversely, when a finance minister speaks, it is the realistic perspective. There is simply no substitute for the U.S. dollar today; no other market is as deep and liquid, or able to absorb the cash that needs to be deployed by central banks around the world. The eurozone is (a distant) second, with no clear third contender in line. When China announced it sharply increased its gold holdings, their gold holdings actually decreased as a percentage of total reserves. That’s because the gold market is tiny compared to the money markets (or even compared to most other economic sectors) and China has mostly been acquiring domestic gold production, to avoid causing disruptions in the world markets.
Does that mean the dollar is safe and one should forget about gold as some suggest? Before you exchange your hard money for freshly printed Federal Reserve Notes (the U.S. dollar), think about the dynamics: the CEO of a country says we need to change course; the CFO says we don’t have the tools to get from A to B today. Any CEO worth their salt (and arguably some might not be) will tell the CFO not to whine about the obstacles, but come up with a solution. If you don’t have the tools, get the tools! Turning a large ship around may take some time (in the case of General Motors it took too long), but the ship will eventually change course. Circling back to the greenback, its value is set by supply and demand; more importantly, the marginal buyer or seller sets the price of the day. If, on the margin, countries increase their non-dollar holdings, odds are high it may have a negative impact on the dollar. Everybody hopes this adjustment process will be slow and gradual; with due respect, however, hope is not a strategy.
To put substance behind the hope, we believe countries around the world are racing to put the “tools” in place to be less dependent on the U.S. dollar. In Asia, for example, after the 1997/1998 financial crisis, Asian countries realized they needed to bolster their countries’ reserves. In the latest crisis, they realized that holding almost exclusively U.S. dollar reserves was a risky strategy. The solution is all too obvious, namely to develop domestic markets. This isn’t just about developing domestic consumption to create a more “balanced” world economy, this is about creating domestic infrastructures, fixed income markets in particular. Currently, many global investors invest in Asian markets by buying U.S. dollar denominated securities plus derivatives. This makes Asian issuers – governments, supranational and corporate issuers alike highly dependent on the U.S. dollar. This will only change if global investors have confidence in the stability and maturity of the local markets. The message to “CEOs” of countries around the world is to show that they are open and ready for business. Such trust is not earned overnight. In Asia, Singapore is a leader; not surprisingly, Singapore has a healthy domestic fixed income market. China is on its way, but needs to do more to provide access to its domestic markets (also see our recent analysis Geithner & China: Who are You Fooling?).
Global imbalances typically refer to the fact that the U.S. is responsible for much of the world’s consumption and spending; whereas Asia focuses on production and saving; this is quantified in the current account deficit. Historically, when the current account deficit reaches too high a portion of Gross Domestic Product (GDP), the currency serves as a valve to help level the playing field. To understand the dynamics, one has to realize that global imbalances will always be with us – the world is not flat. However, dangerous imbalances can be built up if the valves are disabled. Of the smaller countries, New Zealand has shown that it is willing to keep its valves open – during the boom years, interest rates were raised in an effort to calm an overheating housing market as the current account deficit approached 10% of GDP; New Zealand suffered in the bust, but unlike most countries, allowed market forces to play out. The currency suffered substantially, but the country is now better positioned than most to participate as the world tries to reflate. At the other end of the globe, take Latvia, which has a current account deficit of about 26% of GDP while insisting on pegging its currency to the euro. Not only has the Latvian economy been wrecked, possibly for years to come, it may pull Sweden down with it, because Swedish banks have substantial exposure to the Baltic country. The International Monetary Fund (IMF) and others are rightfully concerned about what may happen to neighboring countries if and when Latvia devalues its currency. Ask anyone in New Zealand and the response is that the roller coaster of its currency has been no fun and painful to many businesses; however, these are rough economic times and New Zealand has swallowed its medicine. When countries resist, far greater harm can be caused.
This past weekend, finance ministers gave a pep talk for the dollar. They also assured the world that the focus is shifting from saving the world’s financial system from collapse to the “exit” strategy; German chancellor Merkel has been a leading voice in warning central banks that the current policies may lead to substantial inflation. Let us discuss the dynamics here briefly: a key driver of inflation is inflationary expectations – when inflation is a fear, employees will ask for higher wages; businesses will try to push for higher prices, amongst others. As a result, central banks seem to believe that printing money is no problem as long as the markets believe that central banks have an exit strategy; that central banks will mop up all the liquidity in time. To recap, why do central banks say they are working on an exit strategy? That’s what the market wants to hear. How likely is it that they are indeed going to get tough? In our assessment, it’s about as likely as a balanced budget from the U.S. administration.
We have had a lot of talk of “green shoots”, but once one looks deeper, most negative news one hears are facts, whereas most positive news appears to be subjective forecasts and expectations of policy makers. Dark clouds on the horizon include sharply rising mortgage rates (in progress); major trouble in the commercial real estate sector; a continued dislocation in the housing market where home prices cannot be sustained by income; a big wave of foreclosures yet to come as many of those who bought their houses at the peak of the market in 2007 are likely to see big challenges in the summer of 2010 as their mortgages begin to reset. In the banking sector, problems have been brushed away by easing accounting rules. In Europe, a catastrophe in Baltic countries may only be a matter of time; while the IMF and central banks around the world may ride to the rescue, does this sound like the beginning of the exit strategy? Not to us.
Add to that the amount of debt that needs to be raised by the U.S. government. According to our calculations, at least US$15 billion may need to be issued every single business day until the end of the year. This will require a substantial ramp up from the pace seen in recent weeks, a pace that saw bond prices plunge (long term interest rates rise) due to the increased supply of government bonds in the market. When considering that summer months tend to be slower months for governments to issue debt (it’s vacation time around the world), we believe long-term interest rates may have to rise substantially later this year to attract buyers. The U.S. government will be able to finance its deficits, the question will be at what cost. Interest rates are one issue; the other is whether government activities will crowd out private sector borrowers. Corporate America also needs to finance its operations, not just the government, and where is that money going to come from? What about all the other countries that are issuing record amounts of debt? Just ask Latvia – a recent government bond auction yielded zero bidders. But even established countries, say Ireland, have seen the cost of its borrowing surge.
That’s when the bad may turn to ugly: how will central banks, notably the Federal Reserve (Fed) in the U.S. react should interest rates soar? Will they allow it to happen as they currently posture? It looks to us that we risk a collapse of economic growth if the cost of financing soars. There is still too much leverage in the U.S. economy, at the consumer level in particular. At this stage, a broken system has been propped up; the housing market is seen as key to an economic recovery – and all that money printing will have been in vain if market forces overwhelm the Fed by pushing interest rates higher. Naturally, the Fed puts up a brave face. Ultimately, this may be a game of chicken where Fed talk aims to keep interest rates low. However, we believe the Fed may blink first, and increase its financing activities of the U.S. deficit; by printing the money to finance government debt, the Fed may jeopardize the U.S. dollar, in particular if the Fed, as we believe, will be “more efficient” at printing money than other central banks around the world.
Will events unfold as described here? We don’t know, but we believe the risk is real; and if investors agree this risk is real, they may want to consider doing something about it in their portfolio allocation. We have not exchanged our gold for Federal Reserves Notes.
– Axel Merk, Manager of the Merk Hard and Asian Currency Funds