DIRECTOR'S PERSPECTIVE

by Saruhan Hatipoglu sshatipoglu@beri.com

AMERICA’S GREATEST EXPORT: THE US$

The US$ Tsunami.   The world is awash in US$s.  In 2004 the current account (goods, services, income, and transfers) deficit increased to US$665.94 billion from US$530.67 billion in 2003.  One result of this growing imbalance is the enormous foreign exchange reserves held by such countries as China, India, Japan, Russia, and some others.  Another result is the plunge in the value of the US$.  Trading in many commodities, including crude oil and natural gas, is denominated in US$s and, therefore, price increases have been less severe in importing countries with strong currencies relative to the US$.  In a way, policies in Washington, D.C. have permitted the importers to purchase key items and pay for them in US$s earned from Americans.  This description pertains to legal transactions, but when US$s accumulated in recent years from drug trafficking, organized crime transactions, and other illegal activities are considered, the dollar tsunami is in potentially massive levels.

Financing the U.S. Current Account Deficit.   In the Clinton years before the Bush administration, the shortfall was managed easily by foreign purchases of American securities.  The federal budget had been converted to surpluses, the US$ was stable and risks about loss of capital were low.  A financial and fiscal environment had been created that permitted the US$ to be recycled, flowing out through the current account and returning through the capital account.

The question is: if you are an investor from another country today, would you buy American securities in 2005?  Many people are concerned about converting their currencies to US$s at the current exchange rates because the probability of a €1.00=US$1.50 rate in the future is high.  Capital gains in local currency are unlikely during the next four years.  This means that the risk premium on yields has to be substantial.  On 1 April 2005, the prime interest rate was 5.75%, up 44% from 4.00% a year earlier.  The average one-year CD rate was 3.25%, 90% higher than 1.71% twelve months before.  The higher interest rates are currently sufficient to attract some foreign investors to US$ securities but not enough. And, the relative attractiveness is declining steadily.

Managing Foreign Exchange Reserves.   Central banks have traditionally held a large proportion of these reserves in US$s.  However, policies and priorities in the second Bush administration term have caused concern about the future value of the US$.  Rumors have begun about central bankers selling the American currency and buying euros.  If the portfolio switch becomes a proven fact in 2-3 cases, the possibility of a run on the US$ becomes a real threat.  This would be a serious challenge to the global financial system, which is currently not able to absorb such a serious blow.  The possibility of such a catastrophe has acted as a restraint in central bank decision making.

                                                                                               US$ Billion                        

Foreign Exchange Reserves Held By:            End-2003                              End-2004

China                                                                403.251                                640.857           

India                                                                  87.213                                 129.009           

Japan                                                                652.790                                821.203

Korea                                                                154.509                                198.822

Russia                                                                73.172                                 121.166

These five countries are an indication of the gains during 2004.  Total global foreign exchange reserves topped US$3.5 trillion last year, and almost 60% of this amount is held by top seven Asian central banks.  This catapults the region and its central bank policies to the forefront.  Central banks do not engage in speculation, but if the funds remain in US$s, the losses in euros and other strong currencies could be substantial.  Trading patterns will guide some of the decisions, and the volume of purchases denominated in US$s will also be a factor.   It is probable that a shift to euros will take place slowly in 2005 to prevent a run on the US$.  After all, a sudden shift will hurt government investment in U.S. Treasuries for many of these countries, particularly China and Japan (the two countries have over 40% of total global reserves).  Both China and Japan are concerned about their currencies, and a sudden shift away from the US$ will put upward pressure on the renminbi and the yen.  This is the main reason BERI forecasts a gradual shift in composition of reserves.

Interest Rates, Inflation, and the Current Account Deficit.   Americans are predicting higher interest rates because of inflationary pressures created by US$55/barrel crude oil and demand-pull factors.  This is a narrow viewpoint.  The Federal Reserve and the Bush administration should be aggressively defending the US$ by raising interest rates more rapidly, rendering American securities more attractive, and making the cost of goods and services, domestic and foreign, less attractive.  It is not overheating of the economy, or even signs of inflation, that makes significantly higher interest rates necessary.  What requires deliberate action is the weak US$ and the threat to the global economy caused by the dollar tsunami.  It is this combination that is likely to create a much-feared recession for the U.S.

Washington, D.C., is currently resisting calls to put a brake on demand, especially with sharply higher interest rates.  The impact of sharp hikes on the federal budget deficit would be sufficient to force the politicians to make spending cuts, an option not attractive to the Bush administration and his loyal Republican Congress, some of whom will face elections next year.  Slower growth is painful for politics, but a recession is lethal.  The disequilibrium caused by large current account and budget deficits and a depreciating currency could cause severe economic deceleration.  Fix it now.  Do not tease it with measured interest rate hikes. If not addressed appropriately, the outcome will be a chaotic global financial environment.

DIRECTOR'S PERSPECTIVE Last Updated May 7