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March 24, 2005 |
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“The decline in [the dollar’s] value has already been substantial, but is nevertheless likely to continue. Without policy changes, currency markets could even become disorderly and generate spillover effects, both political and financial.” Warren Buffett, March 5, 2005.
Is The ‘Tipping Point’ Near? “In my view, March 16, 2005 could end up in the running as a possible tipping point for America. …the message from overseas is that this game is just about over. One by one, Asian central banks -- America’s financiers at the margin -- have dropped the not-so-subtle hint that they are saturated with dollar-denominated assets. From Korea and Japan to China and India -- not to dismiss Malaysia, Hong Kong, and Singapore -- there is a growing protest to massive dollar overweights in official reserve portfolios.” Roach, March 18, 2005. In the grand scheme of things the most notable reserve switch to date - Russia raising its Euro holdings as a percentage of reserves - is only marginally more important than Cuba outlawing US dollars (which is not important at all). As for the South Korea experience on February 23, 2005 – a day when the threat of Korean currency reserve diversification sent the US dollar and stock markets plummeting – it did not take long for the Asian central banks to do damage control. Indeed, immediately following news that South Korea was looking to diversify reserves monetary policy makers of South Korea, Japan, China and the 10-member Association of Southeast Asian Nations held a secret meeting in Bangkok to discuss the US dollars decline. Following this meeting – which resulted in the formation of the ‘Asian Bellagio Group’ – rhetoric from participating members was that no one was losing their cool; that South Korea was not going to sell dollars; that the US dollar was still the currency of choice. That Asian central banks are suggesting they will diversify reserves one day and touting how dedicated they are to their US dollar holdings the next does not necessarily mean that a ‘tipping point’ is near. Rather, financial market jawboning from Asian policy makers could be simply that. Alternatively, you could argue that Roach’s speculations are warranted. After all, as the FX markets become more volatile the possibility of rash decisions being made by one or more major dollar holders increases. Moreover, while Japan and China have been talking a good game 2, they have not been adding to their Treasury positions in recent months. Instead, OPEC has stepped up the plate to help fund the US current account deficit and hedge fund trading has been largely responsible for sending the US dollar/interest rates on a wild ride.
The Unsustainable Trends “This force-feeding of American wealth to the rest of the world is now proceeding at the rate of $1.8 billion daily, an increase of 20% since I wrote you last year. Consequently, other countries and their citizens now own a net of about $3 trillion of the U.S. A decade ago their net ownership was negligible…In effect, the rest of the world enjoys an ever-growing royalty on American output.” Warren Buffett, March 5, 2005. In fact, the latest numbers suggest that American wealth is currently being ‘force-fed’ to the rest of the world at nearly $3 billion a day, and the NIIP in America is probably well north of $3 trillion. Nevertheless, Buffett’s statement that ‘the rest of the world enjoys an ever-growing royalty on American output’ is the point worth remembering. It is the growth of this royalty that threatens to make funding the US current account deficit prohibitively expensive if current trends continue. As for the popular current account deficit/GDP ratio, it has already risen to a level that would spell disaster for most countries. The story goes that the US is the largest and one of the strongest economies in the world and the US dollar is world’s currency. Thus, the US is not ‘most countries’. “In data from the 1980s and 1990s for 10 industrial countries, we can pick out 17 episodes in which a trend widening of a current account deficit was reversed….the average CA/GDP ratio was –4.2 percent when the current account started to narrow.” Mann, 1999. The Clock Is Ticking Given the unprecedented size and scope of the US current account deficit – it is estimated that more 75% of the world’s savings are currently being invested in America – and the fact that US policy makers have done little to remedy the situation, it is logical to conclude that the ‘clock’ in question is a ticking time bomb instead of a wake up call. Granted, slower economic growth in America and/or stronger growth abroad would help narrow the US current account deficit (as would an increase in domestic savings). But alas, all indications are that these ‘painful solutions’ are not likely to arrive so long as consumption in America can be easily funded by investment from abroad. The alternative to adopting policies that aim to remedy the structural issues that support the US current account deficit is to allow current trends to persist until foreign appetite for US assets eventually reaches a tipping point. You could argue that the ‘painful solutions’ mentioned above are ‘inevitable’ whether US policy makers choose to adopt new policies or wait for foreign demand for US assets to peak. However, the key difference between adopting new trade and savings policies versus waiting for the tipping point to arrive is that the US current account deficit could grow to even more ominous levels before the tipping point finally arrives. “There are deep-rooted structural problems that will cause America to continue to run a huge current-account deficit unless trade policies either change materially or the dollar declines by a degree that could prove unsettling to financial markets.” Buffett In The Grand Scheme of Things Your investment dreams will be fulfilled so long as you remain on the path to Emerald City Nearly five years ago Mann speculated that the US current account deficit could continue to widen, but perhaps only for a few more years. Last November Setser and company said that the US current account deficit could continue to widen, but perhaps only for a few more years. As years pass and economists continue to throw darts at their calendars the lesson to be learned, as per Volcker, is that ‘nothing in our experience is comparable’… The reason why the US current account deficit has no historical equal has a lot to do with the lack of comparable statistics, but more to do with investor belief that US dollars are produced by a Wizard in Emerald City. To be sure, after many years of economic and financial market success in America a ‘follow the yellow brick road’ mentality has infected central bankers and private investors alike: there is widespread acceptance that he US economy is too big to folly, that the US dollar is too important to fall, and that the US current account deficit is too big to fail (in the case of the US current account deficit to ‘fail’ means a run against the dollar that deeply impacts all currencies, economies, and trade). The yellow brick road theory is convincing. After all, Asian central bankers supposedly do not have the concerted clout to do anything but try and shield their dollar holdings, and Euroland is likely to intervene and try to suppress the Euro (strengthen the dollar) if the Euro continues to strengthen. In other words, there is potentially an endless supply of foreign money that has a vested interest in keeping the US dollar stable and/or historic global imbalances balanced precariously atop US dollar hegemony. Some have picked up on this capital flow dynamic and called it Bretton Woods II 3. This theory argues that a ‘gold-dollar fixed exchange rate regime has been replaced by a new dollar-renminbi fixed exchange rate regime’, and that ‘cheap financing from Asian central banks keeps U.S. interest rates from spiking upwards, and low interest rates keep U.S. asset values high and supports a consumption-led expansion.” It is this flows dynamic that sustains global imbalances, and renders wicked currency moves from Russia as meaningless. Let me be more positive: if I had an agreement with my tailor that whatever money I pay him returns to me the very same day as a loan, I would have no objection at all to ordering more suits from him. Rueff (1965), from An Essay on the Revived Bretton Woods System. Sept, 2003 Ding Dong, Is The US Dollar Dead? The difficulties in trying to forecast when US external funding obligations will become overly burdensome for the US and/or too frightening for foreign dollar purchasers to ignore is readily apparent: oil is traded in US dollars, Asian central banks must continue to hold US dollars to keep their exports strong, and hedge funds - at least according to the January statistics - are willing to bottom feed on dollar weakness in the search of profits. But while a Bretton Woods II type dynamic makes forecasting the US current account deficit tipping point difficult, that doesn’t mean that investors should ignore the issue altogether. Rather, Buffett - who admits that ‘it’s impossible to forecast just when and how the trade problem will be resolved’ - is holding $24.1 billion in foreign exchange contracts because he believes that the trade problem is likely to be resolved in large part by a weaker US dollar. Furthermore, even those that believe in a soft (deficit) landing concur that the US dollar is headed lower: “Economists at the Organization for Economic Cooperation and Development estimate that ongoing deficits of 3 percent of GDP would bring the U.S. NIIP to -40 percent of GDP by 2010, and that it would eventually stabilize at around -63 percent. If the deficit remains at today's level, they foresee the NIIP growing to -50 percent of GDP by 2010 and eventually to -100 percent. These estimates, however, fail to consider that future dollar depreciation and market adjustments in interest rates and asset prices will likely check the increase of the NIIP.” Levey, March 2005. In the The Overstretch Myth (quoted above), Mr. Levey offers one of the most optimistic outlooks on the US trade/current account deficit problem you will ever read. But, and to reiterate, not even Levey can ignore what current trends are yelling: ‘further dollar depreciation’. In 2000 CBO statistics suggested that US government surpluses could grow so strongly that by 2008 the US would be debt free. Hindsight permits us to regard these surplus forecasts as being overly optimistic, if not ridiculous. But remember, times were awfully good in 2000. US interest rates are currently ‘low’, the US economy is strong, foreign appetite for US assets is strong, and no real investment alternative to the US dollar currently exists (save gold). Looking back 5 or 10 years from now will we be recalling how ridiculous it was to think that a 6.3% CA/GDP ratio was sustainable? History tells us that all unbacked (by gold) fiat money eventually suffers extreme decreases in purchasing-power (it is not wizards, but ordinary men who are doing the printing behind the curtain). Despite having no historical equal, the widening US current account deficit is telling us that the US dollar is heading even lower. As for the possibility of a dollar decline turning into a full fledged dollar crash, there are probably too many participants following the yellow brick road for that to happen. But remember, this conclusion is only based upon the current situation. Presently, most foreign investors are sanguine: they may view us as spending junkies, but they know we are rich junkies as well. Our spendthrift behavior won’t, however, be tolerated indefinitely. Buffett 1. Were hedge funds really behind the Caribbean Treasury purchases in January or was it the ‘Wizards and Snowmen, with printing presses, who reside in Washington?’ 2. “financial market jawboning from Asian policy makers” -- As recently Hon Kong warned of the dangerous in accumulating Euros, and Japan threatened currency intervention. Sources have claimed that Japan was trying to prop the dollar up before year end (March 31) before they have to publish a balance sheet of the value of their US holdings. 3. “The Bretton Woods gold-dollar fixed exchange rate regime has been replaced by a new dollar-renminbi fixed exchange rate regime. This new regime is based on structural current account deficits in the U.S. and structural current account surpluses in Asia, with the Asian current account surpluses financing reserve accumulation by Asian central banks. These reserves are lent back to the U.S., the U.S. with cheap external financing. The U.S. gets to consume more than it produces and finance budget deficits cheaply, while East Asia can maintain strong export growth and rapid industrialization…. Proponents of the Bretton Woods hypothesis also argue that this system is in the shortrun interest of the U.S.. Cheap financing from Asian central banks keeps U.S. interest rates from spiking upwards, and low interest rates keep U.S. asset values high and supports a consumption-led expansion.” From The US as a Net Debtor: The Sustainability of the US External Imbalances NYU Original: An Essay on the Revived Bretton Woods System NBER Related Material: Mar 16, 05: Starkers Economist Mar 10, 05: The Global Saving Glut and the U.S. Current Account Deficit Bernanke Feb 05: Will the Bretton Woods 2 Regime Unravel Soon? The Risk of a Hard Landing in 2005-2006 Feb 4, 05: Current account Greenspan Feb 4, 05 The United States as an Indebted Empire AEI Dec 28, 04: Euro Trash: Even drug dealers are giving up on the dollar. Slate Dec 13, 04: The Paradox of Trade Roach Dec 04: The Revived Bretton Woods System is Alive and Well Deutsche Bank Nov 29, 04: The World’s Biggest Excess Roach Nov 10, 04: America’s privilege, the world’s worry Economist Nov, 04: Dollar Adjustment: How Far? Against What? IIE (Online Book) Oct 31, 04: US deficit: It is not only sustainable, it is logical FT (Document) Oct 13, 04: Imbalances, Illusion, Investment Prospects UBS Oct 3, 04: The U.S. Current Account Deficit and the Global Economy Summers May 04: Global Imbalances and the Lessons of Bretton Woods NBER Sept 03: An Essay on the Revived Bretton Woods System NBER Dec, 00: Current Account Adjustment in Industrialized Countries Freund |
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