An Economic Playground

John Mauldin - Wed 19 Jan, 2005

"...What happens when the US dollar loses its reserve currency status? Jumbo shrimp will sell for jumbo prices in Texas and Oklahoma..."

We are all familiar with the seesaw. Who among us did not play upon one as a kid? Seesaws work as long as both partners work together. Indeed, with the proper cooperation, they are quite fun.

However, there are more than a few of you who let your partner get to the top of his ride...and then jumped off, allowing him to drop to the ground. I, of course, never did that to my younger brother.

Today, the world is in a kind of seesaw economy, precariously balanced between massive trade deficits in the major English-speaking economies - particularly the US - and foreign central bank buying of US Treasuries. In general, I think the game continues though 2005. It is in no one's best interest to stop it. It should be another good year for the world economy, but we are getting closer to the endgame, when one partner decides they are doing all the heavy lifting and the other partner is just along for the ride. And as I explain at the end, it may not be America’s foreign partners who bail out of the game first.

On the global economic front, first and foremost, the US trade deficit looms large upon my mind. There are those who say deficits no longer matter. No one cares that Oklahoma has a trade deficit with Texas, so why in a global economy should we care if the United States has a trade deficit with Asia? Clearly, the US has been running an ever-increasing trade deficit for years and our growth is just fine, thank you. Arthur Laffer maintains in last week's Wall Street Journal that a trade deficit is a sign of strength, not weakness, as it means that people are lining up to invest in the United States.

Well, not exactly, Art. First, there is no currency risk between Oklahoma and Texas, so doing business is merely an issue of solving credit risks. Doing business in another currency (and with another government) poses major additional risk to the lender and the borrower. The United States has so far gotten away with a trade deficit that is almost - and unprecedented - at 6% of GDP, but that is primarily because we are the world's reserve currency.

But that may be slowly changing. Roughly half of China's growth in foreign exchange since 2001 was placed into dollars. However, last year China saw its reserves grow by $112 billion, but the dollar portion was only $25 billion (source: Bank Credit Analyst).

China has made it clear they are spreading out their reserves and putting less emphasis on the dollar. It is reasonable to suspect that this move to diversify out of the dollar is also putting upward pressure on the euro and other "floating currencies".

Secondly, the level of private investment in US securities has plunged dramatically in the past four years. The difference has been made up by (mostly Asian) central bank's buying of US Treasuries. Roughly half of that buying has been by Japan in an effort to keep the yen from rising too much against the dollar and the renminbi, with other Asian countries doing their part.

This buying spree by primarily Asian Central Banks, and not the lack of Fed action, is what has kept longer-term US rates low. It has allowed US consumers to accumulate even more debt at low costs and spend it on Asian goods.

In the 90's, private foreign investors lined up around the corner to buy US stocks and invest in America. Today, the private foreign flow is inconsequential. There is little or no foreign investor confidence in the United States. Indeed, look at the very astute Bill Gross's latest column from Pimco, the world’s largest bond fund management firm. He is not exactly a raging bull on US securities, suggesting foreign bonds as among his favourite investments. This is from a conservative US bond guy!

Foreign central bank purchases of US Treasuries in order to maintain a competitive currency valuation to attract the US consumer is not a sign of strength. It is a sign of desperate foreign central banks trying to maintain their economies, which are dependent upon US consumers. They KNOW they are going to get hosed on their dollar holdings, but feel they have no choice.

This is a trend that cannot continue indefinitely, but it can (and probably will) go on longer than we think. The world must re-balance from US-centric growth to a more balanced growth, with Japan and Europe - as well as the rest of Asia - becoming their own consumer engines. But this will not happen overnight, or even in a few years. This is a longer, more drawn out process. When it starts, it will not be fun.

This next part of the process will start in earnest when the Chinese let the Renminbi float. "Ah," you ask, "but when is that?" It will be when we least expect it, or at least when the market does not expect it.

The Chinese agreed to let their currency float by 2007 when they joined the World Trade Organisation, so we have an ‘end date’ in the process. They would be foolish to wait until then, as the pressure would become too big, with no way to gauge the response. The longer they put it off, the more the market knows they must move.

So, it is likely to be done before then. My guess is that it is done gradually, starting sometime no earlier than the last half of this year (and of course, since I do not expect it until the last half, that means it will almost certainly be at some other time). There are two likely ways for them to go. They could simply set a limit or a ‘band’, say 5%-10% of the current peg, and over time increase that limit. That would allow for gradual change.

Let me point out that it is not altogether clear that the renminbi would immediately rise if the currency were allowed to float and the Chinese people were allowed to hold non-Chinese currencies. There might be a lot of Chinese companies and individuals who would like to diversify their holdings. Over time, the renminbi almost surely rises, and perhaps significantly, but the initial moves could be a surprise. Since the Chinese Central Bank and government do not like surprises, they are likely to approach things on a gradual basis. And they will also do it when it benefits them the most.

Or, they might announce that instead of having a dollar peg as they do now, they are going to peg the renminbi against a fixed basket of currencies - perhaps trade-weighted, perhaps not. That would allow the renminbi to rise against the dollar but stay relative to their neighbours. It would also allow Asian currencies to stop the competitive devaluation contest they have been in for a decade. They could all allow their currencies to rise, more or less in tandem, against the dollar.

The Asian organisation SEATO, composed of ten major Southeast Asian countries, basically announced such a basket of currency reserves policy when they declared last quarter that they would work toward a free-trade zone including China. It would be the largest such zone in the world. Part of the deal would be to value their reserves in a basket of currencies of their trading partners, lessening their dependence on the US dollar.

So, how does the United States respond to the growth of free trade everywhere? Maybe asking to join? No, we slap a huge multi-billion dollar tariff on foreign shrimp today.

Now, there's a threat to the US economy - coming to a restaurant in both Oklahoma and Texas soon: Jumbo shrimp at much higher prices!


Regards,

John Mauldin
for The Daily Reckoning