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James Turk: After three years, oil is starting to rise in euros too
By Marshall Auerback
PrudentBear.com
Tuesday, March 1, 2005
http://www.prudentbear.com/internationalperspective.asp
"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 6 percent 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 percent 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 percent 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
tructure, 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 percent US-
dollar denominated before 2003, around 70 percent in 2003, and 60
percent 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 percent 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 give the
dollar only 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 those
of 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 percent of GDP and payments on overseas debt will reach 1.5
percent 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 $320 billion 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, ("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 $500 billion (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 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 most 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 that
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. So it may well be the case that "last orders" are truly in
for the US dollar.
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