All Roads Lead To (From?) the Dollar

After four years of the strongest global economic growth since the early 1970s, the consensus forecast is for two more years of the same. The US has led the developed economies in growth while maintaining very low interest rates and inflation – a true “Goldilocks” scenario. While growth has recently slowed, unemployment remains very low, aggregate profit growth remains strong and the equity markets appear reasonably valued by historical price/earnings measures. However, the imbalance between saving and consumption in the US has created a number of policy pitfalls. In particular, three current policy issues – central bank preferences among reserve currencies, growing protectionist sentiment in Washington, and Middle East and other “sovereign wealth” dollar-concentration risk – pose a serious threat to the value of the dollar.

In a global economic system which is open to trade, macroeconomic variables like growth, inflation, interest rates and exchange rates are interrelated. The dollar still remains as strong as it is, relative to other currencies, due to a myriad of factors: central bank demand for the dollar as an interest-paying reserve asset (unlike gold), global demand for US investments and a dollar-denominated asset (like oil), and the combination of relatively high interest rates and low, predictable inflation in the US. The US derives a number of economic and political advantages as the provider of the dominant global reserve currency. The ability to print money and exchange it for real goods and services results in a “seignorage” profit. A strong dollar exerts a downward pressure on US interest rates and makes foreign goods less expensive, thereby reducing domestic inflation pressures. Thus, the impact of an unruly decline in the dollar could be severe: an increase in real long-term US interest rates, a widening of credit spreads among currencies, and a pullback in global equities.

The dollar as reserve

The current composition of monetary reserves held by central banks around the world is about 60 percent dollars, 25 percent euros, and less than 5 percent each in a number of other currencies like the British pound sterling, the Japanese yen, and the Swiss franc. A number of surveys and recent central bank actions suggest that the dollar is losing some of its luster as an international reserve currency. Governments in Asia and the Middle East have publicly discussed further diversifying their holdings away from the dollar. A poll by London-based Central Banking Publications found that many central banks are considering investing more of their growing reserves into higher yielding assets such as stocks and commodities, which might entail further movement away from the dollar. To a large extent, they must: the US Treasury calculates that approximately $1.2 trillion dollars in foreign reserves were created in 2006 while less than $500 billion in new Treasury debt was issued that year.

Rather than courting foreign central banks by reducing the federal budget deficit through fiscal austerity (as the International Monetary Fund might require of a developing country), the US government continues to spend freely, supported by a surprise(?) increase in tax receipts. Any significant reduction in demand for the dollar by central banks around the world would have a direct negative economic effect in the US and might also establish a self-fulfilling expectation of further weakening.

China bashing

Congress has grown protectionist, pinning a decade of wage stagnation on the trade deficit and some vague concept of outsourcing. China, accounting for the largest portion of this deficit (34% in the final quarter of 2006), is an obvious target. On June 13, four Senators introduced a bill aimed at penalizing China over its exchange rate policy, predicting that they would have the votes to pass it in Congress this year even if it was vetoed by President Bush.

Focusing on a single bilateral slice of a much larger multilateral deficit ignores the macroeconomic context of the trade relationship. America’s savings-consumption imbalance has created deficits with many economies — not just with China. Further, contrary to much conventional wisdom, data suggests that China is not so much the world’s factory, itself, as it is the final destination of a pan-Asian supply chain. Intermediate inputs and supplies from the region’s other major economies like Korea, Taiwan, and Japan are sent to China for final assembly and shipment to the US. This helps explain why China is the largest export market for Korea and Taiwan and is rapidly closing in on the US as Japan’s largest export market. A recent academic study estimated that domestic Chinese content (material and labor) accounts for only about 20% of the total value of Chinese exports to the US.

Congressional pressure on China could dampen China’s appetite for dollar-denominated assets. If China succumbs to US pressure and allows the yuan (renminbi) to appreciate more rapidly against the dollar (a “managed peg” system has allowed the renminbi (RMB) to increase by about 7% versus the dollar since July 2005), the need for China to prop up the dollar by purchasing dollar-based assets (mostly Treasury instruments) would decline, likely causing interest rates to rise. On the other hand, if China resists and Washington enacts onerous trade sanctions, the Chinese might understandably direct their investments away from the US. To keep this in context, however, it’s important to understand the relatively small dimension of the current “problem.” China’s Treasury reserves are only about 5% of all the Treasury debt currently outstanding and account for less than one day’s trading volume in Treasuries. Still, we think that imposing economic sanctions on a major foreign lender is hazardous policy.

A fist full of dollars

In the oil-rich economies of the Middle East, dollar-concentration is a critical risk. Their one commodity (oil) is priced in dollars and their currencies are, for the most part, dollar-pegged. Much of their revenue is recycled back into dollar-denominated assets and, as a result, their foreign exchange reserves are dollar-heavy. Policy-makers in the region worry increasingly about the inflationary impact of holding dollars made chronically weak by prolonged current account and federal budget deficits. Kuwait’s recently announced decision to end its dollar-pegged currency regime may well be the first step in a regional diversification strategy to counter the threat of that scenario.

Implications for our clients’ long term investment horizons

Two great investment booms of the last 10 years (first in equities, then in real estate), coupled with (or maybe because of) the increasing maturity of the US capital markets has encouraged US consumers to spend a larger and larger share of their income, funding their “savings” from gains in their capital assets. This shift from income-based saving to wealth-based saving is worthy of its own article in a future Commentary.

In any event, the result is an economy which must attract huge capital flows from the rest of the world to fund excess (relative to income) consumption. Banking on the growth and stability of the US economy, and wanting to perpetuate domestic growth, foreign governments have been willing to play this role without demanding ever greater compensation in the form of higher interest rates. For foreign central banks and sovereign wealth managers, it has been a very low risk/low return investment with unparalleled liquidity. However, at the nexus of these macroeconomic and policy variables is the value of the dollar. Policy shifts at central banks around the world, ill-conceived trade legislation or a decline in the confidence of oil-exporting economies of the Middle East could turn a supportive global economic environment into something a lot less comfortable for American consumers and investors.

We continue to position client portfolios to build wealth over the long run. For example, our new commodities vehicle (see the article below) combines the protective benefits of passive commodities exposure with three sophisticated trading strategies. Global equity market and real estate investments provide exposure to global economic activity and foreign currencies, diversifying the risk of the US economy and the dollar.

Jason Thomas, PhD, CFA
Chief Investment Officer