China and other countries possibly shifting away from US assets towards European assets, may temporarily weaken the US dollar against the euro
According to scholar Frank Shostak, of the Mises Institution, the US rumors that China' s central bank has reduced its holdings of US treasuries in favor of European assets. This means putting more pressure on the already battered US dollar.
On the other hand, according to the Shanghai-based China Business News, China has cut the size of its US treasury bonds holdings to $180 billion. This decision, according to the newspaper, was taken by government officials in order to avoid losses from a weakening US dollar. The latest data shows that China' s holdings of US treasuries stood at $174.4 billion in September, the second largest foreign holder of US treasuries after Japan, which holds $720 billion. Both Japan and China hold about 48% of US treasuries held by foreigners.
The possibility that the Chinese authorities may lower their holdings of US assets and substitute them for European assets is seen as a major threat to the US dollar and seems to support the view of most experts. For instance, in his speech on November 9th, the Chairman of the Federal Reserve, Alan Greenspan, suggested that foreigners might get tired of financing the ever-growing US current account deficit, which stood at a record $166.2 billion in Q2.
At same stage, Greenspan maintains, foreigners will start shifting their money away from US assets, thereby depressing the US dollar and lifting the interest rate structure. This in turn will undermine the pace of the US economic activity, so it is argued. According to this way of thinking, as long as the US continues to run a massive current account deficit, the pressure on the dollar and on the US economy will stay intact. Hence, the only solution to this predicament is to devise policies that can tackle the problem of the growing deficit.
Americans are importing more than they are exporting to the tune of 6% of gross domestic product (GDP). So long as that is the case, the US currency will remain stable only as long as foreigners are willing to lend the United States money. This results in steady downward pressure on the dollar, with the risk that the dollar could crash should foreign investors be spooked. Second is the federal budget deficit, pushing 5% of GDP. As the government spends more than it takes in, it must issue bonds in order to raise funds. Those government bonds compete in the marketplace with all the other financial instruments, such as stocks and corporate bonds. More competitors mean higher premiums for people who hold cash. The result is higher interest rates across the board, which will hand the US economy slower growth.
Between these two deficits, the United States is dependent on foreign investors to supply around $3 billion a day in investment. Should that end, the dollar would simply crash.
But that is not all.
Perhaps the biggest reason the dollar is so weak is that the US President' s administration likes it that way. The big dive in the US currency began in the run-up to the Iraq war when, diplomatically, events were not going as well as Washington has expected. The resulting diplomatic chaos proved so destabilizing that global growth came under threat.
For the Bush administration, unofficially driving down the dollar was a neat fix. A weak dollar also simultaneously served the administration' s domestic economic and political agendas. Economically, a weak dollar would make US exports more competitive abroad. In addition to stabilizing US growth in a time of global instability, the Bush administration was already thinking ahead to the 2004 elections. A booming export sector plus increased jobs in the manufacturing sector equals re-election.
There also was a certain amount of payback involved. From 1990 to 2003, Asian states regularly intervened in their currency markets in order to export more to the United States. Even the Europeans were guilty of this to a certain degree, preferring promoting exports to enacting politically dicey (if long overdue) economic reforms. For the Bush administration, informally weakening the dollar reminded all these states who they ultimately depended upon economically at a time when he was seeking political submission. It is notable that most Asian states not pegged to the US currency ultimately signed on to the politics of the Iraq war.
It is also something the Federal Reserve thought sound, as a weaker dollar strengthened inflation. Normally that is a bad thing, but the Fed feared in 2003 the US might slip into deflation. The last period of significant deflation the US suffered was the Great Depression. The Fed considered mild inflationary pressure preferable to potentially repeating the darkest chapter in US economic history.
Even under the best of circumstances, these are trends that show little sign of rectifying themselves during the second Bush administration. Americans are not going to stop purchasing foreign products. The federal government, even under its most aggressive plans, will only be halving the deficit in the next four years. The Bush administration sees no reason to not take advantage of the tools it has to promote employment growth.
Nevertheless, according to the Steatfor forecasts, the dollar will rise in 2005. Why? The first reason is the most basic. US interest rates are at 2%, making them equal to European Central Bank rates, and a full 2 percentage points above Japan' s. As the US economy continues to grow –and its federal budget deficit remains stubbornly high– inflationary pressures will build. Far from the deflationary fears of 2003, inflation in the United States is running about 0.2% per month, right about where it should be. However, rates are still near historic lows. Therefore, over the next year, the Fed will continue to hike rates as it has during the past few months to keep inflation under control.
That is not happening, however, in Europe or Japan. Europe remains unwilling to enact the labor reforms needed to unchain its economies and spark growth because such reforms would radically alter –if not dismantle– the social welfare state to which the European electorates have grown accustomed. EU expansion to ten new Central European and Mediterranean states in 2004 ensures that Europe ultimately will indeed move in that direction –western Europeans do not want to see all their jobs move east to the newer, lower-cost-of-production members– but that will take time, as European policy takes years to debate and implement. For now, rates have to be kept low to keep growth going.
A similar situation exists in Japan, where the key considerations are not profitability or growth, but cash flow and market share. The Japanese economic model requires strong social protections and maximum employment regardless of the bottom line. That has led the government to lean on the banks to provide loads of loans to the private sector in order to keep everything running. The government also has spent more than $1 trillion of its own money propping the economy because of slack domestic demand brought about largely by deflation. That has left Japanese corporations and the government with the largest debts in history, and any increase in interest rates would bring the whole unsightly mess tumbling down.
So long as the US rates are higher than their European and Japanese counterparts, money will flow from those economies into the US economy. There is more. The United States is also growing much faster than either Japan or Europe. In part, this is courtesy of the weaker dollar and low interest rates, but it has much more to do with the flexibility of the US financial and labor markets, which enabled the country to fully recover from its 2001 recession a long time ago. Europe and Japan have not fully recovered. In the third quarter of 2004, US growth hit 3.7%, versus 0.3% for Europe and 0.1% for Japan.
In conclusion, China and other countries possibly shifting away from US assets towards European assets may temporarily weaken the US dollar against the euro. It cannot, however, alter the underlying euro/US dollar rate of exchange. What sets a rate of exchange in motion is relative increase in money supply against increases in goods and services. Over time, relative increases in money supply set the purchasing power of US and euro-zone monies and this in turn sets the underlying rate of exchange. On this score, our analysis shows that since the formation of the euro-zone its money printer has been working much faster than its American counterpart.
We suggest this raises the likelihood that the US dollar is not overvalued (not too expensive) against the euro. Consequently, the Chinese factor can only have a short-lived effect on the dollar, all other things being equal. A fall in the US dollar on account of the Chinese factor against the euro will set in motion corrective actions on behalf of buyers and sellers, which will bring the US dollar towards its underlying rate of exchange.
By: N. Peter Kramer
