Reserve Currency

T-bills

In Wanna Buy a T-Bill, Sucker? The foreign fools who are buying American bonds in Slate, Daniel Gross notes large debt purchases (US Treasury bonds) by Asian central banks in recent months. Such purchases have increased more than 12-fold over 3 years ago.

The massive foreign purchases of U.S. government bonds have helped keep interest rates at or near historic lows, even as federal surpluses have turned into massive deficits.

He sees the current approach as being one that ultimately encourages more investment in Asia by US companies:

The Asian central banks aren't buying U.S. government bonds for investment purposes; they're buying for mercantilist purposes. By buying dollars and dollar-denominated assets like Treasury bonds, they help keep their currencies relatively weaker and the dollar relatively stronger. And by providing a ready market for our government's chief product, they've helped keep U.S. interest rates low. That keeps politicians happy and enables American companies and consumers to do what they do best: borrow tons of money at favorable rates and spend it.

If correct, the situation is a virtuous circle of cross-investment, and not, as some seem to say, a sinister plot by which the US takes advantage of the rest of the world.

De facto dollar standard

In a recent study of international business practices regarding currency exchange rate fluctuations, it is a surprise that most businesses engaged in international trade do not in fact take any extraordinary measures to isolate themselves from the negative effects of exchange rate changes. The number one ordinary measure taken? Use of the US dollar to denominate all transactions, whether US firms are involved or not, whether the transactions have any connection to the US or not. This is true of 50% of non-US firms! This widespread practice increases demand for dollars for purely private (and licit) transactional purposes, and may in fact be part of the reason that there could be a strong dollar in the 90s while the US ran a significant trade deficit.

Says the co-author of the study report:

"To the extent that the U.S. dollar becomes the preferred global currency for international transactions, changes in the value of the dollar will have little direct effect on prices," added Fosler. "This result calls into question the conventional wisdom that a decline in the dollar is the solution to the U.S. trade deficit or that the revaluation of another currency like the Chinese RMB will have real effects. Businesses can simply re-denominate their transactions in U.S. dollars."

The dollar dilemma

Detailed opinion editorial by Niall Ferguson in Australian Financial Review quotes De Gaulle's 1965 warning about the use of the US dollar as an international reserve currency and proceeds to describe how current US economic policies are primarily underwritten by central banks (especially in Asia) holding US dollars as reserve. Substantial increases in US interest rates combined with increased use of the euro as a reserve currency could result in significant hardships to un-hedged debtors in the US, primarily the US government and private homeowners. This is not necessarily a calamity, but it would have serious effects, most notably a slowdown in the US economic recovery.

This rapid role reversal - from world's banker to world's biggest debtor - has had two advantages for Americans. First, it has allowed US business to invest substantially (notably in information technology) without requiring Americans to reduce their consumption. Between 10 and 20 per cent of all investment in the US economy in the past decade has been financed out of the savings of foreigners, allowing Americans to spend and spend. The personal savings rate is less than half of what it was in the 1980s.

The second pay-off, however, has taken the form of tax cuts rather than private sector investment. The dramatic shift in the finances of the federal government from surplus to deficit since 2000 - a deterioration unprecedented in peacetime, according to the IMF - has been substantially funded from abroad. Had that not been the case, the combination of tax cuts, increased spending and reduced revenue that has characterised George Bush's fiscal policy would have led to much more severe increases in long-term US interest rates. Veterans of the Nixon and Reagan years can only shake their heads enviously at the way the present Republican administration has escaped punishment for its profligacy. To run deficits on this scale while enjoying long-term bond yields of under 5 per cent looks like the biggest free lunch in modern economic history. The cost of servicing the federal debt has actually fallen under Bush, even as the total debt itself has risen.

The reason is simply that foreigners are willing to buy the new bonds issued by the US treasury at remarkably high prices. In the past 10 years, the share of the privately held federal debt in foreign hands has risen from 20 to nearly 45 per cent. Just who is buying all these dollar-denominated bonds, apparently oblivious to the possibility that, if past performance is any indication, their value could quite suddenly drop?

The answer is that the purchases are being made not by private investors but by public institutions - the central banks of Asia.

Between January 2002 and December 2003, the Bank of Japan's foreign exchange reserves increased by $US266 billion. Those of China, Hong Kong and Malaysia rose by $US224 billion. Taiwan acquired more than $US80 billion. Nearly all of this increase took the form of purchases of US dollars and dollar-denominated bonds. In the first three months of this year alone, the Japanese bought another $US142 billion. The Asian central banks' motivation for doing so is simple: to prevent their own currencies from appreciating relative to the dollar - because a weak dollar would hurt their own exports to the mighty American market. Were it not for these interventions, the dollar would certainly have depreciated relative to the Asian currencies, as it has against the euro. But the Asian authorities are willing to spend whatever it takes of their own currency to keep the dollar exchange rate steady.