In the latest Group of Eight meeting, Chinese President Hu Jintao could not participate. He rushed back to Beijing to take charge of the handling of the disturbances in the Xinjiang province. Yet, China made a statement on the reserve currency. China is engaging in some slippery gamesmanship here. In some sense, it is behaving like US banks. The latter are now blaming all else for their bloated balance sheets. It was all the fault of the borrowers.
Similarly, China moved its national income (growth) risk to its balance sheet by choosing to finance US purchase of its goods, and accumulated dollar assets. Now, it is blaming the debtor for its vast dollar holding. Not only that, but it also wants to be paid back in real dollars and, hence, is riling against deficits, debt issuance and inflation risk in the US. In its view, the raison d’être for the US is only to pay back the debt it owes China, not growth or employment for its citizens. India should refrain from lending its voice to this sovereign blackmail.
To be sure, the US had over-exploited for its own good its reserve currency status by consuming more than it produced for a long period. The result is the amount of debt it carries. In the process, it created many asset price bubbles and busts and destroyed many balance sheets. Hence, an international monetary system that relies on one country behaving responsibly has proven to be utterly inadequate in a world of relatively unrestricted capital mobility.
To an extent, Germany also abused its reserve currency status within Europe when it chose to merge East Germany with the West with its parity-based currency exchange. Hence, there is no doubt that the system needs to be reformed and that the US has to pay for the long period of seigniorage benefits it enjoyed.
At the same time, it would be a folly to ignore the fact that East Asian nations, led by China, are stubbornly hanging on to their export-led growth model, due to their inability to resist powerful local interests that are loath to see prosperity diffuse widely.
If one consequence of the US’ debt binge is that its currency has to weaken to prevent its economy from cratering, then it should be allowed to do that now. Denying America that sovereign right would not help creditor nations recover their debt. In fact, it worsens the odds. Further, any consequence of that development has to be borne by creditors, just as the banks have to bear the losses arising out of their lending decisions. There is no case for an exception from that rule at the sovereign level.
On its part, the US should make an unequivocal statement on where it stands on the dollar, instead of saying that it believes in a strong dollar. That rings hollow. It needs a cyclically weaker dollar. It can say very clearly that it would work hard to prevent a structurally weak dollar and that it is committed to preserving its long-term (beyond three-five years) store of value by going back to the virtues of saving and investing that underpin capitalism. Its households are doing that already. However, the US needs a weaker dollar for the next three-five years. The Asian crisis and the recovery of Asian economies in 1999-2000 on the back of massively weak currencies is an important precedent for the US to cite.
If the US dollar weakens, hitherto export-surplus nations should do their utmost—even if it involves costs for the ruling political elites and their hold on power—to boost domestic demand. If they cannot get to do it—as is very likely—then economic wars would become inevitable. The dollar would weaken against the known and traditional candidates—the euro, the Swiss franc, the Canadian dollar, the Nordic currencies and some select emerging markets countries. They are not in a position to absorb it. They will be compelled to retaliate. Trade wars and related tensions would result. The political elites in low domestic demand countries might end up with the same result that they would have tried to avoid, by not doing the hard work on boosting genuine private consumption in their countries.
Mohamed El-Erian, co-chief investment officer at Pimco, hinted at all of these in his brief guest post at The Financial Times’ Alphaville blog: “As far as I can see, there are no first best policy responses that are readily available and easy to implement. Instead, the economy will continue to struggle, navigating both the adverse implications of last year’s financial crisis and the unintended consequences of the experimental policy responses. Given the inevitable socio-political dimensions, this story will play out well beyond the realm of the economy, policymaking and markets.” Investors should now brace for the crisis moving to its next stage and reduce their exposure to market risk.
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome at firstname.lastname@example.org