Starkers

Buttonwood

Mar 16th 2005
From The Economist Global Agenda

The dollar may get another short-lived respite but it is heading inexorably down. The question is how much it takes with it

ALL you need to get into Harvard Law School these days, it seems, is a pair of fuchsia-pink high-heeled shoes. Or so say Buttonwood’s daughters, reliably informed by an early-teen cult film, “Legally Blonde”. On the basis that they can probably manage the shoes, if not the grades, Buttonwood is paying close attention these days to exchange rates. Her hope is that in seven years’ time, if the dollar continues to slide against other currencies (and British universities continue to raise their fees), it might cost little more to send the thuglets to study in Cambridge, Massachusetts than it would to pay their way in Cambridge, England.

What gives with the greenback? In two of the past three weeks, the dollar took a pasting on reports that various Asian central banks, whose purchases of America’s debt help it to go on borrowing and consuming, were planning to diversify their foreign-exchange reserves away from dollars. Bond yields spiked up (ie, prices fell) and shares looked glum too.

Then, on Tuesday March 15th, keenly-awaited figures from America’s Treasury showed a big increase in net purchases by foreigners of American long-term securities. The net flow in January ($91.5 billion) was 50% up on December’s figure ($60.7 billion), way over January’s trade deficit of $58.3 billion. Hidden in the figures were some interesting trends: purchases of American shares picked up, for example—which suggests a genuine fondness for the dollar unlikely to be unwound soon. But so too did purchases from the Caribbean—home to even more hedge funds than The Economist’s own St James’s Street—which could be liquidated tomorrow. Mark Austin, chief of foreign-exchange research at HSBC, a British bank, points out that central banks bought about the same amount as before, while private-sector purchases increased sharply. Is that positive for the dollar or negative? The currency rallied, though questions persisted.

The Treasury data tend to be volatile and in any event show only a portion of real flows. And one month does not a summer make. But taken together with other figures from the Federal Reserve showing an increase in February and early March in the securities it holds in custody for foreign owners, they do suggest two things. The first is that the full shock-horror scenario, in which Asian central banks dump the dollar and America promptly collapses, is way overdone. The second is that although Bretton Woods II is still in business, it is likely to change fundamentally.

The fact is that the markets are hyper-sensitive to these figures, and analysts pore over them like Kremlinologists. The fear that central banks are contemplating industrial action against the dollar—and the collective sigh of relief when it seems they are not—is part of a broader unease about the nature and solidity of America’s economic growth. Based, as it is, on mammoth consumption by both the private and public sectors—ie, on big trade and fiscal deficits—it needs foreigners willing to suspend disbelief and buy shiploads of securities denominated in a currency that has steadily lost value for about 40 years.

So far, the foreigners—mainly Asians plus a few outliers, including Russia and Brazil—have obliged, permitting America to scoop up 75% of the world's surplus savings. Together, Asian central banks have accumulated about $2.5 trillion in foreign-exchange reserves, up almost a quarter in little more than a year, most of it in dollars; Japan and China alone have reserves of nearly $1.5 trillion between them.

Central banks have more reason to purchase dollar assets than to dump them. Buying American securities keeps their own currencies low, their exports competitive and their workers free to move from fields to factories. America’s economy is still growing strongly, despite higher oil prices: this week’s retail-sales figures confirmed that. There is money to be made there: like investors everywhere, foreign buyers are chasing yield by moving up the risk-reward curve these days into bigger purchases of agency debt (the stuff put out by Fannie Mae and other government-sponsored agencies) and corporate bonds. And the biggest dollar holders—especially China and Japan—cannot really afford to start talking down the currency for they would see the value of their own holdings diminished at a stroke.

But the Faustian deal into which Bretton Woods II has turned—whereby America gets to spend beyond its means and Asia gets to invest in export-led growth, at the cost of recycling much of its earnings in America’s securities markets—turns out to have a shorter horizon than most people reckoned. It could turn sour at any time now. And confirmation of that came from another set of economic data, released on Wednesday: America’s fourth-quarter current-account deficit widened to $187.9 billion, a record.

The dollar’s role as the reserve currency of discriminating central bankers everywhere has already lost ground. On figures from the Bank for International Settlements (BIS), the world held 76% of its reserves in dollars in 2000; by 2003, the proportion had slipped to 68%. Part of that reflects the dollar’s slide in value. But part reflects growing diversification, which is as it should be. Asian countries are trading more with each other these days, as well as with Europe. The euro now offers a liquid alternative to the dollar, and Europe shows no signs of wanting to flood the world with its paper.

Russia, Indonesia, South Korea, India and Japan have all murmured significantly, if guardedly, about diversifying of late. Though figures are elusive, the best guess is that most are doing so already. At the end of February, officials and academics from all around Asia met in Bangkok to discuss the sliding dollar and concluded that they should move more definitively to their own advantage. There are repeated suggestions that regional payments systems should be set up, such as the gold dinar standard proposed for the Islamic world in 2002 by Malaysia’s prime minister.

It is possible that, this time around, OPEC and other oil exporters will channel their windfall profits through the Treasury’s books. But what will happen if a significant portion of countries decided not to add to their dollar holdings? More than the dollar would weaken. Big foreign buyers of bonds have been keeping interest rates down, perhaps by one percentage point, as Alan Greenspan suggests. That would change, for a start. Without this support, the yield on the ten-year benchmark Treasury bond could rise to more than 5%, pushing up interest rates on mortgages. That, in turn, could prick America’s house-price bubble and prompt a general deleveraging, with implications for economic growth both in America and elsewhere. Standard & Poor’s, a rating agency, warned on Monday that a weak dollar would substantially increase concerns about credit quality.

This is perhaps not the week to air such apocalyptic concerns, though they are much on Buttonwood’s mind. In the end, what foreign central bankers have it in their power to do is to reveal before all the world that the mighty American economic empire has no clothes—not even a pair of little fuchsia-coloured shoes.

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