By Krishna Guha
Published: October 18 2009 18:15
When finance ministers and central bank governors met in Istanbul this month amid angst about the declining dollar, Tim Geithner was anxious to impart a basic message. “We recognise the dollar’s important role in the system conveys special burdens and responsibilities on the US,” the Treasury secretary told journalists. “And we’re going to do everything necessary to sustain confidence.”
Since then the greenback has continued to slide – falling to a 14-month low last week – provoking cries of pain from policymakers in the eurozone and elsewhere. Jean-Claude Trichet, president of the European Central Bank, said last Thursday that it was “extremely important” that the US follow policies that support a strong dollar – saying excessive currency volatility was an “enemy”.
For those who have long feared that the financial crisis – which has dented confidence in US economic leadership, capital markets and public finances – might end in a dollar crisis, this is a dangerous moment. With fear of global meltdown receding, the dollar is no longer supported by safe haven flows – investors taking refuge in low-risk and highly liquid US Treasury bills. But the daunting job of putting the US economic house in order again has barely begun.
A mood of what one expert calls “dollar declinism” is widespread, with expectations of a growing gap between interest rates in the US and elsewhere lumped together with concerns about America’s fiscal outlook, inflation and the future role of the dollar in the world reserve system.
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If this were to coalesce into a currency crisis accompanied by an abrupt shift out of dollars, the consequences would be enormously disruptive for the world economy and financial markets.
There is no evidence this is happening. The dollar’s decline has so far been remarkably orderly, with none of the warning indicators that might signal an incipient crisis flashing even an amber alert.
The US currency’s decline has slowed in recent months, and implied volatility in key bilateral currency markets is much lower now than it was in the early summer. Risk premiums on a wide range of dollar assets have fallen. There is no evidence of a rise in the cost of borrowing for the US government.
“Panicking over the dollar decline to this point is unwarranted,” says Rick Mishkin of Columbia Business School, a former Fed governor. “We haven’t seen a big sell-off in long-term Treasuries at the same time. We haven’t seen a run-up in inflation expectations.”
A UNIT OF LIMITED VALUE
Dissatisfaction with the dollar has renewed interest in the idea of a supranational global reserve currency based on special drawing rights – an accounting unit used by the International Monetary Fund that represents a basket of currencies. But experts are sceptical that such a unit could directly rival the dollar. “Anybody who wants to hold an SDR can do it right now – the weights are known, they can just buy these currencies,” says one former IMF official. Other than between central banks, however, SDRs are not legal tender, nor are they backed by debt markets. Creating liquid markets from scratch with few natural buyers would be a tall order.
Even after the latest moves, the dollar is only fractionally below where it was at the start of the crisis in August 2007. Analysts say its recent retreat in large part reflects the normalisation of financial markets. Indeed, one big driver of dollar weakness has been a swing in US demand for foreign assets – with bullish US investors starting to load up on overseas equities again.
The dollar’s decline, meanwhile, has the benefit of advancing global economic rebalancing by reorienting US economic activity towards the production of exports and import-substitutes.
Nonetheless, Mr Mishkin says, “We cannot be complacent – particularly given the state of public finances.”
Another reason not to be complacent is that market measures of government borrowing costs or inflation expectations might not provide much advanced warning of trouble.
“You could take a sanguine view given the indicators. I personally do not,” says Tim Adams, a former under-secretary for international affairs at the US Treasury, adding that they may be “coincident indicators” – meaning they would move at the same time as a dollar crisis occurred.
There is a danger that the dollar decline could gather momentum and become a self-propelling spiral – particularly if weakness based on both short-term interest rate differentials and longer-term fundamentals appear to make it one-way bet.
“There is always a risk when you get a depreciation like this that people jump on the bandwagon and things get out of hand quickly,” says Anne Krueger of Johns Hopkins University, a former first deputy director of the International Monetary Fund – though she says she does not think this is likely.
The thrust of US policy is to ensure that the orderly and benign dollar decline to date does not become a disorderly rout, by signalling that policymakers are not indifferent to its fate.
If the pace of decline were to accelerate suddenly, the US might join other leading nations in intervening in currency markets – not to defend a currency level but to slow the pace of decline. But Washington’s instinct is to be sceptical about intervention and to focus on the underlying fundamentals instead. Hence Mr Geithner’s focus on public finances.
Across town, the Fed is focused on inflation expectations. But officials are paying attention to currency developments and would not be indifferent to a combination of dollar weakness, rising commodity prices and rising inflation expectations.
“The exchange rate is the tail on the dog,” says Mr Adams. “If you get the fundamentals right, the exchange rate will follow over time.”
US officials say they will demonstrate to the world that they are serious both about controlling the deficit and about avoiding a bout of post-crisis inflation. They hope this will be enough to rule out any sudden shift out of the greenback – a prospect that indeed seems highly unlikely.
“What currency are they going to go into?” asks Ms Krueger. The euro has won respect but is not backed up by a single sovereign debt market. The economic and demographic foundations of the yen are weak and China’s renminbi is not even fully convertible. Minor currencies such as the Australian dollar cannot absorb large inflows without becoming quickly overvalued. Moreover, economies with dollar pegs that stopped buying dollars would soon find their currencies appreciating against that of the US. It is more likely that those trapped in dollars but unhappy about low rates on US Treasuries will try to buy higher-yielding US private sector assets.
While the financial crisis shattered confidence in some US credit markets, the Treasury market remained highly liquid throughout. It functioned, as advertised, as a global haven – arguably proving that US government bills are still the best assets to have in a crisis.
Yet even if there is no dollar crisis, the latest bout of weakness and the financial crisis that preceded it may hasten the day when the dollar plays a less dominant role than it does now by feeding dissatisfaction with the existing global monetary system.
“There are deep underlying structural problems that have been there,” says Raghuram Rajan, a professor at University of Chicago Booth School of Business and a former IMF chief economist. “Every time the dollar starts depreciating there is angst and everybody starts raising the question what happens if there is a collapse.”
On the subject of these underlying structural problems Fred Bergsten, head of the Peterson Institute, writing in Foreign Affairs magazine, links the dollar’s role as the global reserve currency with the giant capital inflows that fuelled the credit and housing bubbles in the US.
Many experts believe the problems lie in the global exchange rate regime: half floating, half fixed. With China and many other emerging economies to a greater or lesser extent pegging their currencies to the dollar, the burden of dollar weakness falls disproportionately on economies with floating exchange rates – including the eurozone and, in this latest episode, Japan.
Moreover, the financial crisis forced emerging markets with dollar pegs to confront their enormous exposure to the US in the form of their dollar reserves. They find themselves obliged to buy still more dollars to stop their currencies appreciating, with the risk that this could one day overwhelm their capacity to sterilise the inflow and lead to inflation.
“Ultimately, they have to allow their currencies to appreciate against the dollar,” says Mr Rajan. But the currency policies of these economies are paired with economic structures oriented towards export-led growth – just as the US is oriented towards consumption-led growth. “All these things are connected,” he adds.
Change in the role of the dollar will be bound up with deeper changes in the pattern of global economic activity. These appear to be in train following the financial crisis – with an accelerated shift in activity towards the emerging economies, particularly Asia and above all China. Some form of global rebalancing, ultimately including currency shifts, looks unavoidable – even if it does not proceed along the lines the Group of 20 leading nations aspires towards.
As Barry Eichengreen of the University of California argues in a separate Foreign Affairs article, the dollar is unlikely to be displaced by any one rival currency, but there may be a gradual shift to more of a basket approach in which the euro and, one day, China’s renminbi play a more substantial role, supplementing the dollar.
Importantly, the total size of global reserves has tripled since 2000 and has probably reached a level where the total can be split more evenly several ways without big losses in liquidity, providing the underlying debt markets develop to support this.
“The financial crisis has probably brought forward the day when the dollar is no longer dominant,” says Ken Rogoff of Harvard and a former IMF chief economist. But he says the shift may still take several decades – noting that sterling remained the global reserve currency long after the US overtook the UK as the number one industrialised economy.
“I don’t think there is a single serious economist out there saying the dollar’s dominant reserve status will be replaced by another currency in the near term,” says Mr Adams. “Too many things would have to happen. We would have to really screw up policy over an extended period of time.”
Krishna Guha is Chief US Correspondent for the Financial Times.
Copyright The Financial Times Limited 2009.
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