Saturday, December 04, 2004

Dollar meltdown

The New York Times says that the falling dollar tests nerves of Asia's central bankers [subscription required].

There is a gigantic money circulation pattern that has made East Asia prosperous. In this cycle, Americans spend to the hilt, in the process, absorbing an enormous quantity of goods manufactured in Asia. The Asians get a flood of dollars, which presumably should drive up the value of their currencies relative to the dollar, making their goods more expensive, and exerting a brake on this cycle. Instead, the Asians buy US securities, making going into debt cheaper for the Americans, and spurring further consumption. The Asians get rapid economic growth, driven by exports, and the Americans get to live the good life with plenty of goods. There are some unfortunate effects, such as the distress of American workers who lose jobs in manufacturing industries that are no longer competitive, but statistically, the world is overall better off. And who can deny the evidence of the sparkling new skylines of the burgeoning cities of China?

The question is, can this cycle continue indefinitely? If not, can the world wean itself off of this cycle in a gradual fashion, avoiding major economic disruptions, and moving smoothly into a new pattern? The answer to both questions is, seemingly, no. As US deficits and debt climb to record levels as a percentage of the US economy, the limits to the cycle are becoming evident. And it seems that getting off this cycle is not going to be easy.

Japan now has around $820 billion, China around $600 billion, Taiwan $235 billion, South Korea around $193 billion of foreign currency holdings. The bulk of these holdings is in dollars, and are thus vulnerable to a fall in the value of the dollar. Ideally, these countries would gradually diversify their holdings, and also let their currencies rise gradually against the dollar. Gradually domestic spending would take the place of exports in driving their economies. They would also buy more from the Americans. This would enable the Americans to gradually get their economic house in order.

But as the NYT puts it : "The problem for Japan is that it is in so deep that to a large degree it is chained to its American debtor....anything Japan might do to slow its dollar purchases would only create a self-inflicted wound". The economist Richard Koo is quoted "If they could move it all out of dollars in one day, I am sure they would do it in an instant. But if they move 10 percent, and the dollar goes down by 20 percent, they are stuck with 90 percent of the portfolio worth 20 percent less." NYT reiterates: "Japan and China hold too much American debt to be able to diversify discreetly".

What could happen is that the dollar drops rapidly. American interest rates will have to rise to finance the ongoing deficits. American consumption will slow. Asian export-driven growth will vanish. The global economy might shrink.

We are living in interesting times.


Anonymous said...

Glad to see you're back. There for a minute I thought you might pack it in. Just wanted to let you know that I appreciate your insights and perspective.

Arun said...

India's rupee is not pegged to the US dollar, while, the Chinese yuan is so pegged. In this regard, India is more market-oriented than the Chinese. India is earning more dollars than it is consuming and so the value of the rupee goes up relative the dollar. China is earning more dollars by far than India is, and has a bigger surplus of dollars, but the central bank intervenes and keeps the exchange rate fixed.

If the market is efficient, then intervening in the market should come at a cost. That cost to China is not yet apparent.

In the meantime, The Economist weighs in.


America's challenge is not just to reduce its current-account deficit to a level which foreigners are happy to finance by buying more dollar assets, but also to persuade existing foreign creditors to hang on to their vast stock of dollar assets, estimated at almost $11 trillion. A fall in the dollar sufficient to close the current-account deficit might destroy its safe-haven status. If the dollar falls by another 30%, as some predict, it would amount to the biggest default in history: not a conventional default on debt service, but default by stealth, wiping trillions off the value of foreigners' dollar assets.

The dollar's loss of reserve-currency status would lead America's creditors to start cashing those cheques—and what an awful lot of cheques there are to cash. As that process gathered pace, the dollar could tumble further and further. American bond yields (long-term interest rates) would soar, quite likely causing a deep recession. Americans who favour a weak dollar should be careful what they wish for. Cutting the budget deficit looks cheap at the price.

Anonymous said...

The longer the Asian Central banks delay, the worse it will be for them. So they will have to unload them. It is going to be a rough ride.

As far as China is concerned, they are more interested in getting technology from US, and so keep propping up the US dollar. Note that 95% of their economic growth (similarly for India) is internal. Sure, they will lose some amount from dollar devaluation, but it won't be "devastating", and they will recover. The loss to US will be a lot more, and definitely end to dollar dominance. China has safeguards in place (like capital controls) so foreign investors would flee in panic, as for E Asia in E Asia crisis. Note Asia crises did not affect two countries with capital controls: China and India.

The China doomsayers have been wrong so many times; they do not understand that, unlike the Tiger economies, they are not as vulnerable to shocks, thanks to sensible government control. After all, what did the dreaded SARS do? reduced growth by less than a percent for a little while...