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Economic Commentary

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Flying kites

Thu, Jun 18 2009, 07:36 GMT
by John Browne

Euro Pacific Capital, Inc.

This week, the BRIC countries (Brazil, Russia, India, and China) conspicuously gathered in Moscow for their first-ever economic summit. Although these countries are divided by culture and geography, they are united by healthy economic growth and their concern about unprecedented levels of U.S. debt and the safety of their respective reserves. There can be no doubt that these emerging economic powers are trying to chart an economic path that will free them from dependence on the American financial system. And there is ample evidence that the first coordinated steps are being taken.

Although their combined GDP represents only fifteen percent of the global economy, these four countries together hold some 40 percent of the world's currency reserves, more than half of which is denominated in dollars. As they begin to openly question the continued role the U.S. dollar as the world's official ‘reserve,' attention should be paid.

The recent murmurs coming from Moscow were the second public expression of growing dollar concern in less than six months. Only this past April, at the G-20 meetings in London, China suggested that the U.S. dollar be replaced by a gold-backed currency, administered by the International Monetary Fund (IMF). China tactfully allowed its motion to die under a general G-20 display of unity and goodwill. Likewise, at the G-8 meetings in Italy this past weekend, the Russian Finance Minister, Alexei Kudrin, said, “the U.S. dollar's role as the world's main reserve currency is unlikely to change in the near future.”

‘Flying kites' is a well-proven political technique for gaining gradual acceptance of a new idea. In April, it was China alone who raised the first official prospect of replacing the U.S. dollar as the world's ‘reserve' currency. Now, China has been joined by its fellow BRIC members. Both times, the idea was raised and then tactfully dropped. But each time it served to erode confidence in the dollar's role. It is likely that the next time the matter is aired publicly, some OPEC members will also add their names.

It appears, therefore, that although support is continually ebbing, the U.S. dollar will avoid a direct attack from creditor states, at least for now. But investors should be aware of what led the mighty American dollar to be questioned in the first place.

When President Bush entered office, the published U.S. Treasury debt was a massive $5 trillion. He and Greenspan added a further $5 trillion by financing the biggest asset boom in history.

Since then, President Obama has launched a massive socialist-style program of bailouts, quasi-nationalizations, and stimulus measures orientated towards even more entitlements — at a projected additional borrowing cost of around $2 trillion. At the same time, $2.5 trillion of Treasury debt has to be refinanced this year, meaning the government will have to borrow a total of $4.5 trillion in 2009 (even on the most optimistic assumptions). Despite this, the Fed had, until recently, been successful in persuading the Treasury market that all was under control, such that government bond yields held at surprisingly low rates.

Now, however, there is increasing concern as to how the massive projected budget deficits are to be financed without a steep increase in interest rates and a resulting fall in current bond prices. Indeed, last Monday, in an attempt to quell the negative sentiment, a top IMF official publicly professed that the recent spike in longer-dated U.S. Treasury yields was not a sign of inappropriate monetary policy.

In reality, there is increasing investor concern about potential depreciation of the U.S. dollar, which may require the defensive action of sharply increased interest rates.

The Chinese and Japanese together hold almost $2 trillion of U.S Treasury obligations, or almost one-sixth of the total outstanding Treasury debt. As the largest single holder, the Chinese are particularly concerned. Indeed they have called for “special guarantees.” The great, unspoken risk is that China may slow or even halt its regular purchases of Treasuries, causing great damage to U.S. interest rates. Worse still, China may wish to lower its risk exposure both to U.S. inflation and to a forced increase in U.S. interest rates by switching long bonds for short-dated bills. At worst, China could become a net seller of U.S. Treasuries, putting great pressure on the U.S. dollar and American interest rates.

Little wonder that U.S. Treasury Secretary Tim Geithner visited China recently to calm nerves.
We may never know what “special guarantees” Geithner promised in order to prevent the Chinese from taking ‘unhelpful' or even drastic actions. Whatever they were, it is unlikely they will keep China quiet for long, especially as the dollar's value degrades.

The U.S. dollar is clearly coasting on its legacy. The Obama Administration's actions have eroded confidence to the point that the rapidly developing BRIC membership has risked its own substantial stake in dollar investments to publicly call for an alternative. These comments are the tip of the iceberg. Behind the scenes, we can bet that creditor states are preparing for flight.
Though the dollar's slide has been stayed by pronouncements of confidence from Russia, Japan, China, and others, there will come a time when the pain is too great and the outcome too certain. Private investors who haven't already left the collapsing dollar ballroom may be crushed when the big players stampede for the door.

Published on  Thu, Jun 18 2009, 07:40 GMT