As appeared in the Business Line Hindu.
The US dollar is bearing the brunt of the blame as critics reemerge to vilify its position as the world’s reserve currency. Concerns about many aspects of the US economy have resurfaced following the unprecedented financial commitments made by the Obama Administration to pull the economy out of a deep recession. US debtholders are becoming increasingly apprehensive about this and the trillions of dollars in long-term liabilities that the US government is saddled with .
Although this is nothing new, the momentum to give the world an option of another global reserve currency is picking up as more economists and central bankers come to this consensus, as the Chinese realise the $2 trillion quandary they’re entangled in, and as the US continues to print its way out of this recession simultaneously devaluing the dollar.
STEEP STRENGTHENINGAs the crisis was unfolding at lightning speed, the dollar did strengthen considerably. This was primarily due to two reasons: The lack of another option as a safe haven currency and the forced asset sales all over the world to meet rising capital requirements in the US. So the quick and steep strengthening of the dollar immediately after the crisis should not be mistaken as a sign of long-term resilience. There are several other issues that have plagued the currency which will contribute to its steady decline.
Short-term liabilities skyrocketed to inconceivable heights as the US government committed $3.5-4 trillion in bailouts, guarantees and assurances to various institutions since September last year. Although a lot of this was required to prevent financial Armageddon, the numbers are mind-boggling as you realise that the total amount committed was 30-35 per cent of its GDP.
What’s more alarming are the long-term liabilities that the government is burdened with in the next few decades. Tens of trillions of dollars in entitlement spending towards social security and medicare are not only unavoidable but are rising steadily as average life expectancy rises, healthcare costs surge and inefficiencies in the system persist. There are some signs of hope as this Administration strives to modernise healthcare, and tackle long-term entitlement spending.
But here’s how the situation stacks up currently: China holds close to $2 trillion in US debt and has expressed concerns about the US government putting the printing presses on overtime. In some way this subtly implies that China will not purchase US treasuries at a rapid pace. This is where the dilemma arises, as the US issues treasuries at an unprecedented rate to finance its ever-expanding liabilities. If China either sells current treasuries it holds, or slows the pace of gobbling up newly issued treasuries, interest rates in the US will rise significantly; only to prolong the recession.
CHINA'S DILEMMA In an efficient marketplace, all artificially priced assets eventually get valued at the appropriate levels. This is where China’s dilemma arises. The primary reason its currency is artificially undervalued is because of its unabated appetite for US treasuries. In a way, the Chinese don’t have a choice but to aggressively continue purchasing US treasuries if they want to keep their currency undervalued. So the consequences for the Chinese if they sell US treasuries or slow down their purchases will be paramount as their currency will surge to choke export growth.
The Chinese government and central bank face an uphill task as they confront this complex challenge. With the limited amount of funds they posses, they have to simultaneously perform three critical activities:
They need to keep their currency undervalued to support their massive export industry;
Continued support for their internal growth through their ambitious stimulus plan is critical in assuaging any social uprisings in the rural and semi-urban areas; and
They need to continue purchasing US treasuries to prevent any drastic fall in the dollar’s value.
Clearly, the Chinese are in a multi-trillion dollar quandary as they appear stuck with US treasuries which are depreciating steadily. The US was able to finance its liabilities for years, and successfully bought cheap goods from the Chinese with cheap credit via US treasuries (which it sold to the Chinese), and is now actively pursuing to devalue the dollar as the Federal Reserve and US Treasury realise that’s the only way out. It increasingly looks like the US might have its cake and eat it too.
IF NOT THE DOLLAR...But a few larger questions arise here: How can the dollar be a universally accepted global reserve currency when two countries, the US and China could potentially derail the currency? If the US was analysed as US Inc., would any banker lend it money after glancing through its balance-sheet?
The counterargument for all these questions is often the same: If not the dollar, then what else? It’s not a legitimate question, because, true there is no other currency that is as powerful as the dollar, but if an alternative is presented to the world, if a choice is given to nations, then the true resilience of the dollar will be discovered, because then there will be a choice.
This might not be an appropriate time as nations recover from this historic meltdown, but a clear roadmap must be drawn out in the next one year so that countries can finally choose in which form they want to keep their reserve funds.
The Stone Age did not end due to a lack of stones, similarly the petroleum age will end long before the world runs out of oil and the dollar’s status as the world’s reserve currency will end not due to a lack of dollars but because individuals, central banks, governments and nations will realise the increasingly perilous state of the dollar as the country’s liabilities get compounded with the passage of time.
(The author is a professional trader and asset manager in the US and India.)
