Buttonwood of the Economist: The dollar’s demise

The dollar’s demise
Nov 23rd 2004
From The Economist Global Agenda

Is the dollar’s role as the world’s reserve currency drawing to a close?

WHO believes in a strong dollar? Robert Rubin, Bill Clinton’s treasury secretary, most certainly did. John Snow, his successor but two, says he does but nobody believes him—if only because he wants other countries’ currencies, in particular the Chinese yuan, to go up. Mr Snow’s boss, President George Bush, in one of his mercifully rare forays into economics last week, also said he wants a muscular currency: “My nation is committed to a strong dollar.” Again, it would be fair to say that this was not taken as a ringing endorsement. “Bush’s strong-dollar policy is, in practical terms, to maintain a pool of fools to buy it all the way down,” a fund manager was quoted by Bloomberg news agency as saying. It does not help when the chairman of your central bank, Alan Greenspan, whose utterances on the economy are taken rather more seriously than Mr Bush’s, has said the day before that the dollar seems likely to fall: “Given the size of the current-account deficit, a diminished appetite for adding to dollar balances must occur at some point,” were his exact words. The foreign-exchange market immediately decided that it was sated, and the dollar fell to another record low against the euro.

Mr Greenspan’s words were of huge moment, and not just because he spoke clearly, unusual though this was, nor because the Federal Reserve rarely comments on foreign-exchange movements. No, Mr Greenspan’s words were significant because he was tacitly admitting what right-thinking economists the world over have long believed: that the emperor has no clothes.

Mr Greenspan’s previous line had been that America’s ever-expanding current-account deficit was not a problem when capital could flow so freely around the world; and that, in effect, it would continue to flow to America because the country is such a wonderful place in which to invest. Now he is saying that it won’t, or at least that investors will demand a cheaper dollar, or cheaper assets, or both, to carry on financing America’s deficit.

But Buttonwood suspects that the deeper significance of Mr Greenspan’s admission is that the game that has been played since the collapse of the Bretton Woods system in the early 1970s is drawing to a close. The dollar’s status as the world’s reserve currency—its preferred store of value, if you will—is gradually coming to an end. And, ironically, the fact that it has become so popular in recent years will only hasten its demise.

One man who undoubtedly believes in a strong dollar is Japan’s prime minister, Junichiro Koizumi. Unlike America, Japan has been putting its money where its leader’s mouth is. On behalf of the finance ministry, the Bank of Japan has bought more dollars than any other central bank has ever done. At last count, it had the equivalent of $820 billion in foreign-exchange reserves, most of it denominated in the American currency.

As goes Japan, so goes the rest of Asia. In an interview this week with the Financial Times, Li Ruogu, the deputy governor of China’s central bank, the People’s Bank of China, said that his country would not be rushed into revaluing the yuan, and that America should put its own shop in order. Mr Ruogu’s bank, too, has been a huge buyer of dollars in recent years. China and the rest of developing Asia now have $1.4 trillion of reserves, mostly dollars. This is more than the combined reserves of the rest of the world (excluding Japan). Thanks mostly to Asian intervention, foreign-exchange reserves at the world’s central banks have climbed from $2 trillion in 2000 to $3.5 trillion in 2004.

It used to be that countries amassed reserves as a war chest to protect against a run on their currencies of the sort suffered by East Asia in 1997, or Russia in 1998. But Asian countries have snaffled up far more than would be justified to prevent such crises. Their aim in accumulating these reserves is generally different now: to stop their currencies rising against the dollar and so keep their exports competitive. In effect, they are trying to peg their currencies; China’s peg is explicit. Huge foreign-exchange reserves are the result.

Some pundits have dubbed this arrangement the new Bretton Woods. The Bretton Woods arrangement (a post-second world war agreement that tied the dollar to gold and other currencies to the dollar) collapsed in 1971. The present arrangement seems similarly doomed to failure. The big question is whether the world will suffer similarly ill effects when it collapses.

Past saving?

The upward pressure on Asian countries’ currencies stems either from their saving too much and consuming too little, or from America saving too little and spending too much. American politicians, naturally, tend to concentrate on the first interpretation, because it stops them having to recommend unpleasant remedies, such as cutting deficits or encouraging Americans to save more. But Mr Greenspan’s most recent comments show that he recognises the problem is more home-grown. Personal saving in America, as a percentage of household income, slumped to just 0.2% in September, close to a record low. Indeed, the savings rate has been declining remorselessly since 1981, when it reached a high of 12.5%. This lack of saving shows up in the current-account deficit, which is a record near-6% of GDP and rising.

In effect, foreigners are saving on America’s behalf. In a recent study for the New York Fed, two economists, Matthew Higgins and Thomas Klitgaard, point out that the United States now absorbs more than the measured net saving of the rest of the world combined (suggesting someone’s got their figures wrong somewhere). The American economy cannot continue to expand at its current rate without those foreign savings. The question is whether foreigners will be happy to carry on financing this growth with the dollar and asset prices at their present level. The private sector is already voting with its wallet: it has been financing an ever smaller percentage of the deficit, and there has been a net outflow of direct investment. That leaves the public sector—ie, central banks—and those, in particular, of Asia.

At the heart of the central banks’ calculations is a trade-off: intervening to keep your currency down can be costly, but it is good for exports. Though the costs of intervention are hard to quantify, they are potentially big. Because the domestic money supply is expanded—those dollars must be paid for with something—it can cause inflation (though this can be neutralised through “sterilisation”, ie, bond sales). But the big potential cost is in amassing a huge stash of dollars with precious little exit strategy. Quite simply, Asian central banks now own too many of them to exit en masse, for their exit would cause the dollar to crash and American interest rates to soar, which would cause huge losses on their holdings of Treasuries.

Get out while you can

The biggest risk, of course, is that lenders would lose pots of money were the dollar to fall. As the printer of the world’s reserve currency, America can pass on foreign-exchange risk to the lenders because, unlike other indebted countries, it can borrow in its own currency. Messrs Higgins and Klitgaard reckon that for Singapore, the most extreme example, a 10% appreciation against the dollar and other reserve currencies would lead to a currency capital loss of 10% of GDP. Though loading up with even more dollars might of course stop the dollar from falling for a while, it would increase the risk of still larger losses were it eventually to do so. America already needs almost $2 billion a day from abroad to finance its spending habits, and the situation deteriorates by the week because America imports more than it exports, which worsens the current-account deficit.

The incentives to flee the Asian cartel (to give it its proper name) thus increase the bigger the game becomes. Why take the risk that another central bank will leave you carrying the can? Better to get out early. Because the game is thus so unstable it will come to an end, and probably a messy one. And what will then happen to the dollar? It is hard to imagine its hegemony remaining unchallenged when so many will have lost so much. And doubly so given that America has abused the dollar’s reserve-currency role so egregiously that its finances now look more like those of a banana republic than an economic superpower.