Asia is stuck with the Dollar
Despite this, the dollar remains deeply embedded in Asia’s economic and political architectures. This gives regional investors little room for short-term change, while developing a long-term alternative to the dollar remains a very distant prospect, IPA found after canvassing opinion from around Asia and the U.S.
According to Judah Grunstein, editor-in-chief of World Politics Review, “The political causes to this crisis begin with TARP and the 2009 stimulus package, both of which involved hair-raising amounts of government deployment of essentially borrowed and subsequently printed money.
“I’m convinced the shock of those measures created the kind of exaggerated fear of the accumulated debt,” Grunstein told IPA. “The debt is actually manageable in the short term and, in any case should be reduced in a countercyclical fashion, as opposed to at the outset of a still-fragile recovery. But the polarising effect of health care reform and the popular sense that the U.S. is facing a debt crisis helped create a backlash that allowed the Tea Party to win enough seats in the 2010 mid-terms. That had a major impact on the terms of the debate.”
The Tea Party, a movement borne out of disparate elements of the American political right, has seen their popularity grow rapidly among ordinary voters since it emerged only three years ago. Americans voters are increasingly concerned by the size of their country’s national debt. There is a sense that the political system favours Big Business and Wall Street, not ordinary citizens. Central to the Tea Party’s agenda are plans to roll back the size of the state, impose fiscal discipline and reinstate American jobs.
Despite this new voice in American politics, the recent deficit reduction deal was anything but a comprehensive solution to the problem. If anything, the situation could get worse, according to WPR’s Grunstein. “I think budget issues are going to be increasingly unmanageable and could very well prove to be paralyzing. There is no real way to reconcile the two sides’ positions, and it’s worth noting that the debt ceiling deal does absolutely nothing to address the fundamental causes of U.S. deficits, namely entitlement spending and tax cuts by George W. Bush’s government. Since those are exactly what the two sides are unlikely to agree upon, it’s hard to see where the middle ground is.”
“That raises the very real possibility that the next debt crisis in Washington is not a self-manufactured one, but one imposed by markets looking for some fiscal discipline and responsibility,” he added, “and the political backlash to that kind of wake-up call in the States could make the Tea Party look like a bunch of liberal internationalists.”
Grunstein’s comments reveal the fact that the issue of deficit reduction is only the tip of the iceberg when it comes to the domestic political forces behind recent events. Many of these issues date back to 2009 or beyond and relate to fundamental aspects of the American economy, society and political system and are unlikely to be resolved in the near future.
Bank of Singapore’s Richard Jerram also struck a pessimistic tone when asked whether the situation in Washington could be improved. “The political system in the US is dysfunctional so it is hard to see much that can be done to boost confidence in it. The most immediate issue is going to be the negotiations of the deficit reduction panel that will take place later this year,” he said, referring to twelve-member (six Republicans and six Democrats) Joint Select Committee on Deficit Reduction, which has until November to find $1.5 trillion of savings from the Federal budget.
“Another failure to reach a compromise would confirm the view that the system is broken,” warned Jerram.
China’s Dollar Dilemma
Some of the harshest criticism of Washington’s failure to resolve the debt ceiling negotiations in a smooth and timely fashion came from the Chinese media. Clearly, the prospect of further political volatility in Washington and its negative consequences for the American currency will alarm China, the largest holder of US government debt, and other creditor nations. However, given its existing foreign exchange reserves and a lack of viable alternatives, China cannot simply turn its back on the dollar.
“China has no choice but to keep on buying U.S. dollars. It has an export-oriented economy and huge U.S. dollar-denominated reserves. China does not want to see its dollar assets devalued. And although China has already started to diversify its reserves, there is still a very long way to go before we can reduce our support for the dollar,” a government economist told IPC.
While short term policy change is unlikely, recent events could crystalize support in China to reduce dollar dependency in the future. “The main reason for the S&P downgrade that the US government is unable to reach a long term solution for the debt problem. The recent deficit reduction plan will not fundamentally change the US debt situation and there is still the possibility that US debt will increase over the next decade,” the economist added.
“Therefore, the downgrading is both challenge and opportunity to China. For the foreseeable future, China will carry on buying U.S. debt, perhaps at a slightly slower rate. Most importantly, China will diversify its reserve at a faster pace and make good use of this opportunity to speed up the internationalisation of the RMB,” he said.
Recent events also complicate Beijing’s short term policy calculus as it battles with domestic inflation, the economist pointed out. “China is currently trying to tame inflation partly caused by its own stimulus package. But there are new risks to consider such as QE3, the deepening of the European debt crisis and a possible global economic downturn. Whether the tightening policy will continue as previously is now open to question. Another consideration is that the government is not in a position to launch stimulus measures on the same scale as 2009, when Chinese growth helped avert recession for several other nations.”
Bank of Singapore’s Jerram agrees that Beijing’s options are extremely limited when it comes to moving away from the dollar. “Beijing is trapped, whatever the path for QE3 or a debt deal. If it wants to pursue a currency that is undervalued and tied to the dollar then it has no choice but to continue to accumulate dollar assets.”
“This is an expensive policy for three reasons. First, the interest rate on the domestic instruments that are the counterpart to dollar accumulation is higher than on the dollar assets it is buying. Second, because the RMB is undervalued against the dollar, it will rise over time and those dollar assets will be worth less in RMB terms. Third - and this is not discussed enough - it makes no sense for a developing country with foreign reserves at 50% of GDP to continue to build reserves. Domestic returns are higher than those on US debt so China should not be exporting capital to the US.”
“China is also trapped because it cannot diversify away from the dollar because it would have exactly the exchange rate effect that it has been trying to avoid. Moreover, the sums involved are so huge that it is not practical - no other market is large enough,” he added, rounding off a bleak picture.
Dollar Retains Regional Support
While policy momentum within China may gather behind reforms to reduce overall dollar dependence (be it foreign exchange reserve diversification, the use of CNH for international trade settlements or non-dollar pricing of international commodities), devising a long term alternative would require extensive multilateral discussion and debate. As last month’s rush to US Treasuries demonstrated, investors still see the risk of a US default as marginal, and there is little sign of genuine desire to fundamentally reform the dollar or its place in the regional economy.
“There won’t be any radical change to US debt because major sovereign nations and institutions still regard US debt as the safest asset to hold,” said the government economist. And according to BoS’ Jerram, there is no need for investors to make radical changes and “the market still views US debt as being very low risk.”
In Japan, the largest holder of US debt after China, “there is some concern over Washington’s economic credibility but I wouldn’t say US credibility has been damaged so far” Chie Nishiyama, an analyst at Lipper’s Tokyo office, told IPA. “Currently, the downgrade only S&P have decided to downgrade. Moody’s and Fitch have retained the AAA rating. So for asset managers using benchmarks, the effects will be limited,” Nishiyama said.
“Japanese purchases of US Treasuries may not change drastically, since other than Japanese Government Debt (JGD), Japanese investors will have a difficulty finding a safer asset with large liquidity and better credibility. Furthermore, adjusting Japanese Government and related institutions’ portfolio exposure may take some time due to bureaucratic procedures and the traditional political alliance with the U.S.”
Given Japan and other major creditor nations in Asia remain attached to the dollar for both political and economic reasons, it will require the development of a viable alternative by China followed by a sustained diplomatic effort to persuade regional partners to walk away from the dollar - both extremely long-term projects.
US Down but Not Out
For global investors, events of the last few weeks confirm the relative attraction of emerging markets as a source of returns, according to BoS’ Jerram. “The policy focus in the US (and Europe) is on deficit reduction rather than growth. This means that emerging markets will remain the focus of global growth. It also means that G7 central banks will have to maintain very low interest rates for years to come, to balance the fiscal tightening, so the global search for yield will continue.”
But despite downbeat growth sentiment in developed economies, the dollar looks set to retain its preeminence as a reserve currency for some time to come. “The US dollar remains the major global currency. Developing nations may support their own currencies or Special Drawing Rights, but these are long-term issues which haven’t yet been properly discussed,” Nishiyama concluded, while the Chinese government economist conceded that “in the long-run, US treasuries are still the safest US asset China has access to.”
Moreover, the US can still avoid worst-case economic scenarios, according to Bank of Singapore’s Jerram. “QE3 still looks unlikely to us, in part because we think the US can avoid a double-dip recession, and in part because the Fed seems to be looking for other mechanisms to ease policy if necessary rather than adopting QE3,” he said.
While China is “trapped,” the US has a range of policy options to explore. Despite being the largest creditor, China only holds around 8% of total US debt - a significant amount, but less than, for example, the UK (2.5%) and Japan (6.5%) combined. This means Washington is still able to leverage its geopolitical allies to maintain the dollar’s ascendency.
Washington also holds several trump cards. “Remember that one of the more creative (radical) suggestions from the US side on pushing China to allow faster RMB appreciation is to prevent them from buying any more dollar debt,” BoS’ Jerram pointed out. Until there is a genuine alternative for the dollar for use in trade settlement - be it the fledgling Offshore RMB or SDR, Washington will have the upper hand in all dollar-related negotiations.