Will King Dollar Reign Amidst Global Deflation?

``Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works”.- John Stuart Mill (1806-1873) British philosopher, political economist, civil servant and Member of Parliament, was an influential liberal thinker of the 19th century.

Deflation proponents have been confidently increasing their pitch of a global depression or “severe and prolonged” recession cheering about the US dollar’s recent gains as signs of such manifestation.

Since the US credit system has turned disorderly and dysfunctional, it is true that an alternative major flux for global “liquidity” stems from the US current account deficit. And an improving US current account deficit suggests of a further drain of liquidity AWAY from the global financial system, thus amplifying risk towards the financial markets.

Deflation proponents emphatically argue that the strength of the US dollar stems from (factually) the US dollar’s role as the de facto world currency reserve and secondarily from its sophisticated, deep and advanced state of the markets that are likely to attract “limited” capital flows away from the hinges and back to the center or the origin. Hence a global meltdown extrapolates to KING dollar reasserting its hegemonic role in the international monetary sphere.

Global Liquidity Story Isn’t Exclusively A US Dollar Issue

The US dollar’s role as the nonpareil currency reserve of the world is yet incontrovertible, meaning the US still maintains its lead position among the other currencies as the elected currency benchmark (or reserves) for central banks.

BUT its leadership isn’t at all the monopoly it once used to be. And this is the important difference: the Euro has incrementally been expanding a material foothold in the share of the composition of the currency reserve market especially in the context of developing countries or emerging markets.

From the IMF’s September 2007 survey (emphasis mine),

``Data reported to the IMF by industrial and developing (nonindustrial) countries, compiled on an aggregate basis in the IMF's Currency Composition of Official Foreign Exchange Reserves (COFER) database, reveal that more developing countries than industrial countries have switched holdings into euros. Nonindustrial countries hold some 30 percent of their reserve assets in euros and 60 percent in dollars (as of December 2006), compared with 19 percent and 70 percent, respectively, six years earlier.

``Industrial countries' use of the euro has risen to 21 percent from 17 percent in December 2000, while their dollar holdings have remained fairly steady at 72 percent compared with nearly 73 percent six years earlier. Their remaining holdings are in such currencies as the Japanese yen and the pound sterling.”

Figure 1: Brad Setser: Central Banks Still Buying Dollars

Figure 1 from our favorite fund flow analyst Brad Setser of the Council of Foreign Relations shows how the composition of global currency reserves have been growing over the past decade.

So even as currency reserves of global central banks have steadily grown in absolute terms, which also translates to growth in other major currencies aside from the US dollar, the Euro seems to have outpaced the growth in the US dollar. Hence, the growing share of the Euro relative to the US dollar in the universe of currency reserves.

Why is this important? Because if the premise for a severe recession comes from financial links in terms of a liquidity crunch (aside from the trade linkage), then from the angle of asymmetries in the current account distribution-the Euro zone against the emerging markets-also matters.

If hypothetically 65% of global currency reserves are in the US dollars, and 25% comes from the Euro then the trade imbalances also project liquidity flows not only from the US (although it signifies the main channel) but also from the secondary reserve currency in the Euro and also (but insignificantly) in others. Hence the Euro is also a contributor to global liquidity!

In other words, global liquidity flows from the premise of the trade-current account is not solely a US perspective and can’t be the only basis to reckon for liquidity flows, see figure 2.

Figure 2:tradingeconomics.com: China Trade Balance

Figure 2 from tradingeconomics.com illustrates China’s growing surplus from its trade balance with the world despite the present economic growth slowdown, which implies a shift of the weight of its trade from the US to the Eurozone. Thus, these surpluses have “partially” contributed to the amazing $1.81 trillion surge in their forex reserves last July in spite of the sagging global economy.

And this shouldn’t be seen in the context of China alone as much as it should apply to other emerging countries such as the oil exporting nations most especially the Gulf Cooperation Council (GCC).

While it may be true that the Eurozone may now be feeling the pinch of a US led dramatic growth economic slowdown as we pointed out in our recent weekday post Global Recession watch: Japan and Euroland Economic Growth Turns Negative!, this will also translate to a second round leash effect on the US, which means it isn’t clear whether the US current account deficit would improve at all (since both exports and imports are likely to deteriorate in the face of a slowing global economy!).

One thing seems clear is that regardless of the state of the US current account, the case for the taxpayer funded government intervention to ameliorate the woes from the deleveraging plagued stricken Wall Street plus the spillover effects on the Main street are likely to more than offset any improvements in the current account, which means more financing needs by the US public-by either of the following options borrowing abroad, selling assets or printing money-and private sector.

The point is improving current account imbalances should reflect both sides of the ledger and doesn’t automatically translate to a complete or outright drain of liquidity as deflation proponents suggest.

Strength of US Dollar Depends On The Reliability Of US Markets?

Yet if the argument will directed to the premise that the inherent advantage of the US markets due to its depth, sophistication and advance conditions signify as main reasons why the perceived “trust” as a safehaven status, this quote from the Bank of the International Settlements over the fate of the Euro as an alternative foreign currency reserves should serve as an eye opener (highlight mine) `` The euro comes closest to challenging the dollar in its role as a store of value. As a unit of account and medium of exchange, the dollar’s role is not as secure as it once was, but the dollar is still preeminent.”

So what defines a store of value for the BIS?

Again the BIS ``In the strictest sense, this will be a currency whose value is reliable in terms of future purchasing power. This in turn is linked to the maintenance of sustainable macroeconomic policies. Moreover, the store of value function can also depend on the anchoring role of a currency to the extent that the central bank tries to align the currency composition of its country’s assets and liabilities. More generally, the store of value function of an international currency is linked to the breadth and depth of financial markets, in particular to the availability of investments which meet wealth holders’ risk-return objectives.”

So if the Euro’s best chance to compete with the US dollar is seen in the role of a store of value, it implies that the Euro’s “breadth and depth of the financial markets” appears to have nearly assimilated the US markets in order for the BIS to issue such qualifying statement.

Besides, in today’s functioning monetary platform in the fiat “paper” money standard whose system is backed by nothing but promises based on “Full Faith and Credit” of governments then the US dollar as the alleged beneficiary via the “safehaven” asset status from a global meltdown overlooks where the epicenter or source of today’s crisis emanates from.

This comment from Yu Yongding, a former adviser to China's central bank on the cataclysmic repercussions for the global financial system on a failure of U.S. mortgage finance companies Fannie Mae and Freddie Mac as quoted by Bloomberg (HT: Craig McCarty)

``If the U.S. government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic, if it is not the end of the world, it is the end of the current international financial system.''

If we go by Mr. Yongding’s statement; the end of the current international financial system is tantamount to the end of the US dollar as the global currency reserve!

So how does one consider the US dollar as today’s “safehaven” when it has been a major source (US housing bust, subprime, Fannie and Freddie Mac) for most of the troubles scourging the financial markets today?

True, global central banks continue to accumulate US dollars have been responsible for their policy decisions, but this is done to maintain the status quo or because of the Nash Equilibrium-(wikipedia.org - a game of two or more players wherein “each player is assumed to know the equilibrium strategies of the other players, and no player has anything to gain by changing only his or her own strategy (i.e., by changing unilaterally). If each player has chosen a strategy and no player can benefit by changing his or her strategy while the other players keep theirs unchanged, then the current set of strategy choices and the corresponding payoffs constitute a Nash equilibrium.”)

- or its military doctrine equivalent of the Mutually Assured Destruction (MAD) scenario where once such an event unfolds could prove to be devastating to all involved (once deeply exposed trading partners of the US suddenly decide to quit the game)! So for example, if China decides to quit from the US dollar accumulating game, hell would probably break lose (via a US dollar crisis or hyperinflation on a global scale)!

So it isn’t clear that global central banks will continue supporting the US economy or its financial markets, which will likely to be reflected in the state of the US dollar, if economic or political conditions degenerate further.

Besides, US officials seem very much aware of these conditions, hence quickly signed into a new law to provide for a temporary fix to the ailing GSEs; aside from previous bridge liquidity “alphabet soup” of Fed-US treasury programs, widening the scope of collateral acceptance and direct stimulus to the public.

Another, the seeming “resiliency” of the US economy in the face of a housing and financial sector meltdown has been predicated on mainly its “net” exports and global central bank financing. Thus we read into US Federal Reserve Chair Ben Bernanke’s current policy actions as an indirect stimulus meant for global economies especially for countries tied to the US dollar via currency pegs as previously discussed Global Financial Markets: US Sneezes, World Catches Cold!. The US seems banking on “inflating” on global growth to sustain its economy and keep it out from the clutches of recession.

Thus inflation as a US monetary policy is being transmitted globally and the world has been reciprocating.

Proof?

This from Joachim Fels of Morgan Stanley (emphasis mine),

``In most countries – even in many that have raised interest rates this year – the policy stance is fairly easy. Real short-term interest rates (nominal policy rates minus current CPI inflation) are currently negative in no less than 20 of the 36 countries in our coverage universe. Among others, these include the US, Japan, Canada, Switzerland, Russia, Ukraine, the Czech Republic, Korea, Taiwan, Singapore, Indonesia, the Philippines, Malaysia and Peru. With policy easy to start with, there is thus little scope to cut rates aggressively. By contrast, there are only a few countries that have relatively high real short rates and thus tight monetary polices. Apart from Australia and New Zealand (where real short rates stand at 2.75% and 4%, respectively), these include Brazil and Turkey, where real rates stand at 6.6% and 4.65%, respectively.

``Global real policy rate still negative. Aggregating across all countries in our coverage universe, the weighted global monetary policy rate currently stands at 4.5% in nominal terms. However, current global (weighted) inflation is running at 5.3%, so the global real rate is -0.8%, the lowest in this decade. Thus, global monetary conditions remain very expansionary, limiting the room for a major global monetary easing.

So if global monetary environment remains expansionary how can deflation proponents argue that the world will be engulfed with a meltdown from deflationary forces? The US and the UK, Spain, Ireland, Australia and those suffering a structural “housing bust” does not translate to the same predicament all over the world, especially not in the Philippines.

Besides what is to “deflate” in the Philippines or most of Asia?

Figure 3: BIS: Loan/deposit Ratio of banking systems in Asia and the Pacific

Except for Australia and Korea whose loans are above deposit reserves, loans in most of Asia have not been “leveraged” as shown by the BIS and are below reserves of deposits. In other words, the Asian banking system has more deposits than extended loans.

Yes, a global economic slowdown is in the cards-some will experience recession, some won’t-but definitely not from the garden variety type as seen in the deflation paragon.

Deleveraging Is Not A One Way Street; Short Sales And Market Efficiency

Then there’s the other argument where the whole world will be enveloped by the feedback loop of de-leveraging.

Against the common impression deleveraging isn’t a one way-street though, see figure 4, especially when we deal with advanced or sophisticated markets because of the available facilities to bet on EITHER DIRECTIONS.

Figure 4: stockcharts.com: US-dollar Index-commodity Pair trade

The chart in figure 4 shows how gold (candlestick main window) /oil (lower pane) and the US dollar index (black line behind main window) have had a strong inverse correlation, as demarcated by the blue vertical lines (as US dollar troughs when oil/gold peaks and vice versa). The Dow Jones AIG Grain (lowest pane) seems to have moved ahead of its major commodity bellwether.

The tight correlation suggests of the proliferation of “paired” trades, which means participants who shorted/longed the US dollar also bought/sold oil and gold. Such is why the violent action in one market could have reflected an equally volatile action in the another-but in an opposite direction!

It also means that since every transaction is accounted for by an entity, anyone (represented by an individual or by a company) who is “forced to liquidate or delever” on their market position has to closeout (by taking the opposite position-of either a buy or sell-on the original position taken!). If an entity took up a “short sell” position then one closes by “buying”, and in the same manner if the same entity takes up a “long” position then the consummation of the trade translates to a “sell”.

Thus deleveraging doesn’t automatically mean selling, it can also mean buying!

Proof?

Figure 5: US SEC’s Short Sale curb=Magnified Upside For US Financials!

The US SEC imposed a curb on “naked” (selling without actual possession of borrowed shares) short selling on 19 financial companies last July 16^th. And as we demonstrated above, the huge short position taken by the public was forced to unravel, see figure 5 (see blue arrows). This led to a strong simultaneous upside rebound for the beleaguered Dow US financials (main window), the Broker Dealers (pane below the main window) and Banking indices (lowest pane). Yet this doesn’t account for derivatives.

Maybe one factor why the US equity markets have not entirely collapsed in the face of a prospective or ongoing recession, prompted by the meltdown in the housing and financial domain, is because of the public’s liberal access to “short” the market. To quote Mises.org’s Robert Murphy ``But the basic principle is simple enough: just as a speculator who wants to go long can borrow money to buy stocks, so too a speculator who wants to go short can borrow stocks to "buy money." Short selling is no more mysterious than buying stocks on margin.” Hence, the short selling facilities could have minimized the volatility on the downside by allowing for greater pricing efficiency through expanded liquidity.

Well of course since this isn’t back by any evidence, this is just a guess on my part.

But for the world markets especially in dealing with the deleveraging issue, it could be a different story. Deleveraging means global investors have to sell equity holdings as “short facilities” have not been as deep and widely used as those in the US.

For instance, the Philippines now allows for “borrow and lending”, though I have not read the entire regulation, based on my principal’s opinion, the rules seem quite stringent and rigid as to discourage any actual application because of the costs of compliance. If costs exceeds the benefit who will avail of the trade?

Put differently what good is a facility if it is stifled by suffocating regulations or if it can’t be used?

Finally the penchant of deflation proponents is to compare present occurrence to that of the Great Depression,

This quote from Professor Barry Eichengreen of the University of California, Berkeley in the Financial Times should account for a good retort,

``And since other currencies were linked to the dollar by the fixed exchange rates of the gold standard, US deflation caused foreign deflation. As US demand weakened, other countries saw their currencies become over­valued. They were forced to raise interest rates in the teeth of a deflationary crisis. By raising interest rates, foreign countries transmitted deflation back to the US. Only when they delinked from the dollar and allowed their currencies to depreciate did deflation subside.

``The difference now is that the Fed knows this history. Indeed Ben Bernanke, the Fed chairman, wrote the book on the subject. Seeing the analogy, his Fed has responded to the subprime crisis with aggressive lender-of-last-resort operations. If anything, it may have been too impressed by the analogy. Its mistake was to cut interest rates so dramatically at the same time that it extended its credit facilities. It would have been better to lend freely at a penalty rate. Higher interest rates would have made its emergency credit more costly and led to better-targeted lending and less inflation.

``The Fed’s response has forced other central banks that manage their exchange rates against the dollar, mainly in Asia, to import inflation rather than deflation. Their currencies have become undervalued rather than overvalued. As their real interest rates have fallen, these countries are now exporting inflation back to the US. Where global deflation led to the collapse of commodity prices in the 1930s – devastating those countries dependent on exporting commodities – our current inflation is having the opposite effect. This time, primary producers are the biggest beneficiaries.”

In short, the gold standard of then and today’s paper currency standard aside from the transmission effects of the currency pegs supported by mercantilist policies have been important nuances.

One important thing which was not marked by this observation was that the Great Depression was significantly exacerbated by “Protectionism”.

Summary and Recommendations

A global recession may happen but it isn’t likely to be a depression or alternatively said “severe and prolonged”. Not for most of Asia, especially the Philippines. A global recession may occur because OECD or major developed economies seem to be undergoing recession but is not likely the case for most of the EM economies.

The argument for a US current account improvement as effectively draining the global liquidity picture seems incomplete. The Euro is also a secondary contributor. Although a slowing Eurozone could also mean further test on global liquidity conditions.

Likewise, the second round effect from a global economic slowdown is likely to put a stress on US exports clouding the certainty of the improving path of the US current account balance.

What is clear is that the taxpayer funding of the financial sector and of the main street will offset any improvement in the current account which means more financing requirements through external borrowing, selling of assets to foreigners or monetization.

The argument that the US dollar represents as “safehaven” under a global deflation is unclear if not questionable. First, global deflation seems unlikely; the world’s monetary climate seems still expansionary. Besides most of Asia has less to deflate compared to the overleveraged West. Asia’s “contagion” problems will likely fall on liquidity and not solvency issues.

Second, since the US dollar is the source of the present stress, the argument of its “safehaven” status has been in a test since 2002. Such tests isn’t likely to end soon and may get worst.

Third, the recent rebound by the US dollar and the accompanying fierce selloff in the commodities could be as a result of pair trade deleveraging, aside from a reflection of a global economic growth slowdown. Deleveraging does not equate to outright selling since it can also mean buying especially under markets that are advanced, sophisticated and deep.

Fourth, we don’t buy the argument that the US dollar or the Euro or of any paper currencies as representing any insurance from currency debasement policies by global governments. Inflationary policies assure the loss of purchasing power of paper currencies.

Although the US dollar may rally against the Euro, this may signify an interim or cyclical move instead of a complete turnaround similar to 2005. The US dollar has been in a bear market since 2002 and is likely to remain under pressure given the massive fundamental imbalances it is faced with.

Meanwhile, gold has been on a losing streak. Gold and precious metals represent as our insurance against government’s inflationary actions. The precious metal sector could depart from the performances of its industrial siblings based on the question of health of global economies.

We understand gold to be in a long term bullmarket especially from the fundamental perspective where global governments will work to use their inflationary powers to reduce the impact of any financial or economic dislocation for mostly political ends.

Figure 6: US Global Investors: Gold’s Seasonal Performance

We understand too that added to gold’s present infirmities from delevariging issues is that gold is in a seasonal weakness (see figure 6) and could most likely pick up over the next few months once the deleveraging issues fade.