Monday, 9 November 2009

Funding dollar deficits

With mounting budget deficits and a fresh fall in the private sector savings rate, quite a number of US commentators have become worried about whether the rest of the world will continue to provide credit for what is apparently an endless overconsumption. In Europe, there has been no shortage of dire predictions that at some point in time, the chronic external imbalances of the US ultimately would lead to higher bond yields in the US and that it would even have an effect on European bond yields. And that the way for the USD to go would be down, down, down.

Yet, there seems to be no drama in the bond market and that the dollar weakening (against the EUR) progresses orderly and not in a collapse.

The factor that most commentators appear to overlook entirely is that half of the world  (or at least half of the world's GDP) has been running on a spontaneous dollar peg for quite a while. With such a mechanism in place, there is no particular reason why there should be no funding of dollar deficits.

10 years ago, in the period between the Asian currency crisis in 1997 and the introduction of the Euro, tons of ink were spilled in arguing the pros and cons of the European currency union. All the right buzzwords were used, and the debate was utterly inconsequential. In that very same period, a number of the Asian countries (and quite a number of Latin American ones as well) quietly established a peg towards the USD. At that period it was a logical choice, as USD was the unrivalled trading and reserve currency as well as the currency of the world's largest single market, the USA.

Typically, a peg to the dollar was a unilateral decision taken by the country pegging its currency to the USD. It is the country itself that assumes all responsibility for maintaining the peg. Given the traditional US attitude: "our currency, your problem", nobody would expect the US monetary authorities to lend a hand to, say, Argentina if her currency were about to weaken or strengthen.

Using the most fundamental of theories about exchange rates, a country that happens to run a current account surplus with the USA can chose two actions. A) to accept that the USD falls against the currency of the country in question or B) to purchase assets denominated USD in order to prevent the exchange rate from moving.

According to US government data through august 2009, the three countries with the largest trading surplus against the US are China, Japan, and Mexico. Canada comes in on 6th place, while Venezuela is 7th.

All of these countries have to a varying degree pegged their currencies towards the US. Japan and Canada have no official peg but are known to manage the float of JPY/CAD, whereas the other countries have rather strong pegging mechanisms.

For the USA it has the huge advantage that the largest surplus countries are forced to re-invest their surplus in USD denominated assets. For the surplus countries, maintaining the peg means that they have only a small currency risk towards their largest export market, and they have only a small risk of seeing their dollar assets devalue.

Against this background it seems almost foolhardy when US lawmakers rattle their sabres and call for a Chinese revaluation or a free float of the currency. It appears that those using such arguments only see the exchange rate as a measure of competitiveness. They fail to see the other side, the dependence of the US on a continued funding from abroad, and that this funding is secured as long as the main surplus countries peg their currencies.

Meanwhile, in a parallel universe, the big losers are the Europeans, who at every turn see their currency appreciate against the dollar bloc. European politicians may enjoy the warm glow of having the manliest of currencies. But in a slightly longer perspective, the fact that the EUR has been the only currency to systematically appreciate is a serious danger for the nascent economic recovery in Europe.

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