Many commentators were shocked and are still in awe of the US Federal Reserve after its decision last week to purchase many debt securities, including US treasurys, to the tune of nearly a trillion dollars. Mainstream financial media in the West closed ranks behind the Federal Reserve. In particular, the Financial Times called it an act of “prudent boldness”. The Economist wrote that Ben Bernanke had done his part. Those who would like to learn more about what the Fed had done before reading further should click on this link: www.ft.com/cms/s/0/8ada2ad4-f3b9-11dd-9c4b-0000779fd2ac.html
This newspaper noted that the purchase of long-term debt securities by the Fed would bring down the interest rates and thus reduce the margin that banks enjoy by borrowing short and lending long. It is insightful, but this is not a new situation. The yield curve in the US was mostly flat between 2004 and 2006. Banks, in theory, should have had it tough. But their profits were booming. How? They made up in volume what they lacked in prices. That is why we had the credit boom up to 2007 followed by the bust. Now, Bernanke wants them to repeat the same pattern of behaviour.
Lower interest rates are not only meant to support households with their existing debt obligations but also to encourage them to borrow more. Otherwise, banking will not return to health. Normally, households must pay down their debt by saving more out of their current income. That means savings rates of US households must rise. Lower interest rates discourage savings. The US remains locked into a policy mode of punishing savers and rewarding borrowers with low interest rates, first to borrow and second, to bail them out. It is unable to muster and articulate the case for bearing the pain required to break free of this unhealthy policy shackle.
Further, for savings to rise, jobs with incomes must be available. The last economic expansion from 2001 to 2007 was the weakest on record for job creation. Further, three categories—financial activities, professional and business services and construction—created nearly 43% of the incremental private sector jobs, in the US, in the six years ending in December 2007. These three sectors will be shedding jobs for at least a couple of years more. Manufacturing must pick up the job slack. That requires the sector to be competitive which, in turn, requires a substantial devaluation of the dollar.
The announcement by the Fed on Wednesday to engage in asset purchases did just that. The dollar fell sharply against most currencies after the announcement. Well, not so fast. If the dollar decline spirals out of control, then its global reserve currency status and its seigniorage benefits would be lost. The idea is to get the dollar to depreciate, but not crash. Quite simply, the dollar must depreciate gently, but persistently as it did between 2002 and 2007. How to go about it?
Consider the fact that a weakness of the dollar bails out China’s export sector as it weakens the yuan, too, given the country’s tight peg to the dollar. If China’s exports pick up or do not fall further, China would have to continue to channel the trade surplus into US assets. That would grow China’s reserves again, helping to cover the fact that the dollar decline depletes China’s foreign exchange reserves.
Given the weak global demand, other countries will have to work harder to protect their export competitiveness in the face of this lifeline thrown by the US to China’s exports. They will have to make sure that their currencies do not appreciate against the dollar too much. They too will have to buy dollar assets. Significantly, the Fed’s action came after the treasury report on net foreign purchase of US assets showed a precipitous decline in January. Moreover, in the three months ending in January, money fled all long-term US bonds (source: blogs.cfr.org/setser/2009/03/18/a-bit-more-to-worry-about-foreign-demand-for-long-term-treasuries-has-faded/).
The US corned global savings for the better part of this decade. Some American commentators have tried to blame foreign savers for that. This move helps to quash such arguments. The quantitative easing programme launched by the Fed reinforces the Faustian bargain it had stuck with China on supporting the latter’s export sector in return for its support (directly and through distorting other nations’ exchange rate policies) in financing excess demand in the US. The source of excess demand has shifted now to the public sector. The problem remains. America’s claim on savings in rest of the world is set to increase. The Fed’s move is central to its success.
In short, America is trying to erase 2008 and restore the world of and up to 2007. Rising global incomes helped to gloss over the unsustainability and dangers of that world order. In its absence, a big question mark hangs over the success of the latest audacious Fed move. Hence, to be safe, private investors, too, should help America achieve its aim of weakening the dollar.
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