Is this the death of the dollar?

June 22, 2009

After two smugglers were stopped last week with what at first appeared to be $134bn in US state bonds, the tension and paranoia surrounding the fate of the dollar hit a new high.

Border guards in Chiasso see plenty of smugglers and plenty of false-bottomed suitcases, but no one in the town, which straddles the Italian-Swiss frontier, had ever seen anything like this. Trussed up in front of the police in the train station were two Japanese men, and beside them a suitcase with a booty unlike any other. Concealed at the bottom of the bag were some rather incredible sheets of paper. The documents were apparently dollar-denominated US government bonds with a face value of a staggering $134bn (£81bn).

How on earth did these two men, who at first refused to identify themselves, come to be there, trying to ride the train into Switzerland carrying bonds worth more than the gross domestic product of Singapore? If the bonds were genuine, the pair would have been America’s fourth-biggest creditor, ahead of the UK and just behind Russia. No sooner had the story leaked out from the Italian lakes region last week than it sparked a panoply of conspiracy tales. But one resounded more than any other: that the men were agents of the Japanese finance ministry, in the country for the G8 meeting, making a surreptitious journey into Switzerland to sell off one small chunk of the massive mountain of US bonds stacked up in the Japanese Treasury vaults.

In the event, late last week American officials confirmed that the notes were forgeries. The men, it appeared, were nothing more than ambitious scamsters. But many remain unconvinced. And whether fake or otherwise, the story underlines one important point about the world economy at the moment: that the tension and paranoia surrounding the fate of the US dollar has hit a new high. It went to the heart of the big question: will the central bankers in Japan, China and elsewhere continue to support the greenback even in the wake of the worst financial crisis in modern history, or will they abandon it as America’s economic hegemony dissipates?

Dollar obituaries are nothing new. The currency has been presumed dead more times than Shane Macgowan. But like the lead singer of The Pogues, the greenback has somehow withstood repeated knocks and scrapes over the years and lived on, battered, bruised and a couple of teeth the lighter, to fight another day. In the 1970s and 1980s there were plenty predicting its demise, although at that point the main challenger was the Japanese yen. And in the years preceding this crisis, economists and investors including Peter Schiff and George Soros were lining up to declare the dollar’s demise as the world’s reserve currency. In the late 1990s, the creation of the euro gave dollar sceptics another stick to beat the currency with, and no doubt the European currency has claimed some of the prominence in its first decade.

Now, following the collapse of the global financial system, those warnings have become louder still, and ever more difficult to dismiss – because this time around there are threatening noises coming from those who actually have the power to do something about it. First came a paper from Zhou Xiaochuan, the governor of the People’s Bank of China (PBoC), a couple of months ago, positing the idea of introducing the special drawing right (SDR) – a kind of internal currency at the International Monetary Fund (IMF) – as an international reserve currency. These calls were then repeated, with more force, by the Russian president, Dmitry Medvedev, who last week declared that the world needed new reserve currencies in addition to the dollar.

And this time around, the dollar is most certainly suffering. Since 2002 its trade-weighted strength – calculated against a basket of other currencies – has fallen by more than a quarter, from 112 to 81 points. In the same period, the proportion of dollars held by reserve managers in leading central banks has also taken a dive. According to figures from the IMF, confirmed holdings of dollars in government vaults, from Beijing and Tokyo to London and Paris, fell from 71pc of reserves to 64.5pc between 2002 and 2008.

However, detecting what is really happening in the world of foreign exchange reserves is notoriously closer to an art than a science. For instance, figures from April seemed to suggest a fall in China’s holdings of US Treasuries – something ‘dollapocalypticists’ pounced on at the time. But according to Brad Setser of the Council on Foreign Relations, the country was merely rejigging its Treasury portfolio rather than liquidating parts of it. In such an opaque world it is little wonder the conspiracy theories over those two Japanese smugglers show little sign of dissipating.

Nonetheless, for US Treasury Secretary Tim Geithner, who has inherited his predecessors’ role as dollar wallah-in-chief, the currency’s travails have made it all the more difficult for him to repeat the mantra that he “believes in a strong dollar” while keeping a straight face. Indeed, when he tried to insist at a university lecture in Beijing earlier this month that “Chinese financial assets are very safe,” it drew floods of laughter from the audience.

He wasn’t playing for laughs, but the irony of the situation is plain to see. If there were a textbook list of actions one could take to weaken a currency, the US (alongside most other developed nations) would be following it to the letter. It has cut interest rates to a whisker above zero; it has engaged in quantitative easing, pumping cash directly into the economy; it has committed to spending trillions of dollars on a fiscal stimulus package designed to pull the country out of recession; it has pledged tacitly to support its stricken banks so that no major institution is allowed to collapse. In any normal circumstances, actions like these would hammer a currency.

According to Stephen Jen of BlueGold Capital Management: “People are having second thoughts not simply because they don’t like the dollar, but they are having second thoughts about whether US assets are obviously the strongest assets to own.”

Like everything else, the currency’s fate depends on how well the US authorities manage the crisis. The US is balanced on a knife-edge between possible Japan-style deflation as the weight of all its debts bear down on it and potential inflation as the force of all its powerful stimulus measures take root. No one knows for sure which way it will fall, but neither would be particularly good for the currency, and by extension for those who hold much in the way of dollar assets.

And China and all other major central banks which have trillions of dollars in their vaults, face something of a dilemma. Any fall in the greenback will cause the value of their investments to slide. Even if they wanted to exit, there seems no easy way of doing so without provoking some serious self-harm. Indeed, according to Olivier Accominotti, a PhD economist at Paris’s Sciences Po university, the situation is not unlike that faced by France in the 1920s, as it sought to reduce its massive sterling reserves. The Bank of France found itself in a “sterling trap” in which it “could not continue selling pounds without precipitating a sterling collapse and a huge exchange loss for itself”.

Neil Mellor, of Bank of New York Mellon, said: “We’ve got a situation where Geithner is smiling and has no choice but to stress the credibility and stability of the US financial and economic system, while the creditors [such as the Chinese] smile back and say they believe him, while at the same time giving hand signals to their reserve managers to get rid of these things.”

Rather like the brinksmanship on display throughout the Cold War, it is a dilemma which applies itself to game theory. Both sides know that the dollar is set to weaken, but both could be set to suffer if they both allowed it to collapse at the same time. “If you are the Chinese it is in your interest to play the game – you’ve got a lot of dollars at stake – but in the long run you surely want to reduce your holdings and diversify them at the margins,” says Mellor.

Still, with every passing week, the conjunction of different warning signals for the US currency seems to evolve and intensify. Recently, the alarm bell ringing most loudly has been the increase in yields on US Treasuries – a sign, some fear, of acute nervousness among institutional investors about the sheer scale of the cash the Obama administration is planning to borrow in coming years. The Federal Reserve’s meeting next week is likely to be watched attentively by everyone with a stake in the game, as the central bank indicates whether it is planning to plough more dollars of newly-created cash into the economy.

But while the debate fixates on the greenback, the issues at heart here go far deeper. The dollar’s fate is intertwined with that of the global economy. America is on the brink of losing its economic superpower status, which it will have to share with China at least, if not others, in the coming years. Holding such a position confers important responsibilities, none of which is more symbolic than providing the world’s reserve currency – the currency against which all major commodities are denominated, and the de facto international unit of exchange in trade and finance.

It was a position enjoyed by UK sterling during the first waves of globalisation in the Victorian era and the final decades of the British Empire. Eventually, around the time of the Second World War, the dollar inherited the mantle. At first this was something enshrined in the Bretton Woods agreement of 1944, which fixed world currencies to the dollar, but although that system broke down in the 1960s and 1970s, it has remained the de facto currency of choice.

In a globalised world, with trade being carried out between hundreds of different nations by thousands of different companies, having an international standard makes sense: it enables traders to exchange goods more quickly and efficiently than they would have done otherwise. It may be invisible to us, but the vast majority of foreign exchange transactions – particularly those between smaller nations – involve the dollar. Exchange your sterling for Thai baht and you’re actually swapping pounds for dollars for baht, whatever the exchange booth says. Even the much-vaunted exchange arrangements by the Brazilian and Chinese are designed not to disrupt these foundations, but merely to smooth things over for importers and exporters.

But a by-product of the dollar’s dominance has been the skewing of the world’s monetary system. By dint of having this blessed position, the US has been able to finance ever-larger current account and fiscal deficits, with both the government and the public borrowing from overseas, at cheap rates of interest. It has been able to sell US Treasuries at interest rates that other countries can only dream of because of this position as reserve currency. It has had a captive consumer – both because its government bonds are something of a safe haven and because those wishing to peg their currencies against the dollar and enhance their trade flows have little choice but to buy US Treasuries.

And this mutated international monetary system that has evolved since the 1960s is largely responsible for the crisis into which the world has tipped. Because it was able to borrow off other countries at such low rates without enduring the market punishment – in other words higher interest rates – America was able to build up massive current account deficits which poured a record amount of debt throughout its economy, which manifested itself in the financial crisis.

Indeed, as Mervyn King said in a speech earlier this year: “At the heart of the crisis was the problem identified but not solved at Bretton Woods – the need to impose symmetric obligations on countries that run persistent current account surpluses and not just on countries that run deficits. From that failure stemmed a chain of events, no one of which alone appeared to threaten stability, but which taken together led to the worst financial crisis any of us can recall.”

When the PBoC’s Zhou referred to the SDRs he was not merely questioning the dollar’s pre-eminence. He was indicating something far more radical – that China supports plans for a new Bretton Woods-style agreement to manage the flows of cash around the world. At that seminal conference in 1944, John Maynard Keynes’s original idea, which was watered down by Harry Dexter White of the US Treasury, was for an international reserve currency, Bancor, fixed against a basket of 30 currencies, and that countries would be penalised if their current accounts swung too far into surplus or deficit. It is an idea which is now being dusted off from history books by officials in finance ministries around the world, including in China.

Such a radical shake-up would cause earthquakes in the currency markets, a prospect which perhaps makes it unlikely. So in the absence of such a deal, how is the dollar’s role likely to evolve in the coming years? The short answer is that no one should expect it to lose its reserve currency status any time soon. It took around half a century for Britain to cede this position to the US, even after being overtaken in true economic might.

One possibility is that the SDR may be used increasingly as a means of denominating assets in accounts, but this is something which would take place gradually, over a course of some years. But even if that is a bridge towards a multi-polar world, in which other currencies vie with the dollar for influence, it will take some time – perhaps 30 years or more, according to Stephen Jen. “People should look at history,” he said, referring to sterling’s pre-eminence in the first part of the 20th century. “There’s a real incumbency advantage.”

Jim O’Neill, chief economist at Goldman Sachs, sees the next few years as something of a “vacuum period”.

“The BRIC countries [Brazil, Russia, India and China] are becoming so much more important, while the G7, including the US declines, which raises issues about the degree of dominance of the dollar. The problem is that the currencies of the BRICS are the ones that matter, but they won’t let you export or use their currencies.

“Until we see another five years’ of evidence over whether China is a more consumer-driven economy, becoming bigger and bigger, and whether the euro can have a successful second decade, the dollar looks set to remain dominant.”

China has made some hints about loosening its hold over the yuan in recent months, but these are only early manoeuvres. A second step would be to allow the yuan to become a part of the SDR – whose own value is determined by those of a basket of currencies including the dollar, pound and euro. As Jen adds, there are certain prerequisites any contender to the crown of world reserve currency needs in its pocket.

“We have to ask this question: is Russia going to provide asset market that will be as liquid, reliable property rights, the rule of law, currency convertibility and so on? Will we see the same from the likes of China? Their task is very daunting.”

Referring to the forged Treasury bonds picked up on the Japanese smugglers on the Swiss border, he adds: “There is a message here: we haven’t heard much about anyone counterfeiting roubles. That is probably telling you something.”