Donald Trump is jeopardising the dollar’s supremacy

Markets want the rule of law, stability and leadership. The president risks all three

Edward Luce

In 2016 Hillary Clinton was at pains to show her spending priorities were funded. Donald Trump and Bernie Sanders promised Americans the moon

At the outbreak of the first world war, investors sold dollars and bought sterling. It ought to have been the reverse, since Britain had declared war and the US was standing apart. But crowds rush to safety in a crisis — and sterling was then the reserve currency. Little did they guess that sterling would be undone by war debt.

Markets reacted the same way after the 2008 Lehman Brothers collapse. Although the crisis began on Wall Street, the dollar rose; America was rewarded for its sins. But profligacy cannot go on indefinitely. By his actions, Donald Trump is bringing forward the dollar’s reckoning.

The US president’s most tangible impact is on public debt. If Mr Trump’s tax cuts do not expire, as they are meant to within a decade, US sovereign debt will rise from 77 per cent of gross domestic product today to 105 per cent by the end of 2028. That would roughly equal its highest level in history, which was during the second world war. By comparison, Italy’s debt is 131 per cent of GDP.

Under current law, which is what the Congressional Budget Office must assume, US debt would reach 96 per cent of GDP in 10 years. In practice the only metric that counts is Washington politics, which says that temporary tax cuts are permanent.

But that understates Mr Trump’s impact since it makes no allowance for a recession. At the brink of the 2007 recession, US publicly-held debt stood at 35 per cent of GDP. It more than doubled and has stayed at that level ever since. If another recession were to occur, US borrowing would have to rise much more sharply than before Mr Trump’s tax cuts. He has robbed the US Treasury of ammunition it would need to fight a downturn.

That is before taking into account that the US Federal Reserve has barely started to unwind the nearly $4tn balance sheet that it accumulated as part of quantitative easing. Since the Fed is already bloated, fiscal policy would have to take up even more of the slack. Consensus forecasts put the chance of a US recession in the next two years at about one in three. It is a safe bet that if Mr Trump thinks his 2020 re-election is endangered, he would produce another large stimulus.

This is where the Democrats come in. One byproduct of Hillary Clinton’s defeat was to deter Democrats from balancing the books. Mrs Clinton was at pains to show that her spending priorities were funded. Voters did not notice. Mr Trump, on the other hand, promised Americans the moon — as did Bernie Sanders, Mrs Clinton’s close rival for the Democratic nomination. Democrats have drawn the natural conclusion. Should they regain control of the House of Representatives in November, conditions will be ripe for another big leap in US debt.

For years, Democrats have championed fiscal responsibility while Republicans have only pretended to. Now both rarely bother to pay even lip service. If control of America’s government divides after November, the chances are that Mr Trump would push through an unfunded infrastructure bill. The US badly needs modern ports, roads, broadband and air traffic systems. In my view, they should be funded by taxes, preferably on carbon. But that is not going to happen. The only thing markets should bet on is the continued rise in US public debt.

At what point does America’s broken politics risk the dollar’s supremacy? All things being equal, today’s mess could carry on for another decade or two. It has been building for about as long. Unlike Italy, the US has its own currency, which means it can keep printing dollars at will. Japan, which has central government debt of almost 200 per cent of GDP, shows that red ink need not trigger a crisis. But the global reserve currency must follow a higher standard than Japan’s does.

As Eswar Prasad has argued, investors will keep faith in the dollar only as long as they trust the institutions behind it. The markets want the rule of law, political stability and US global leadership. Mr Trump is putting all three into question.

The world could be entering an era of multiple reserve currencies, as Barry Eichengreen predicts. This has been typical through most of history. In between the world wars, the dollar and sterling shared the stage with the French franc and the Deutschemark. Today, the rival contenders would be the Chinese renminbi and the euro. The transition could even be a smooth one. But it is also possible that the US will have a massive debt shock, caused by a war, or another 2008-scale financial meltdown. A return to protectionism might do similar damage. At that point, the dollar would cease to be king.

We cannot know which path is likelier. We do know that Mr Trump is allergic to smooth transitions.

Stronger dollar poses challenge for Wall Street blue-chips

Currency strength seen hurting foreign revenues for multinational companies

Nicole Bullock in New York and Chloe Cornish in London

As the political crisis in Italy has deepened, the euro fell below $1.15

Market turmoil in Europe led by Italy’s escalating political crisis is set to extend the US dollar’s rise, raising questions on Wall Street of a hit to foreign profits for blue-chip multinational companies.

The dollar has gained more than 7 per cent against the euro since the single currency peaked at $1.25 in early February. As the political crisis in Italy has deepened this week, the euro fell below $1.15 — its lowest level since July 2017.

Many of the leading lights in the S&P 500 rely on foreign-based revenues and thus face an unfavourable conversion when the dollar strengthens. It is not a perfect science — companies do not uniformly disclose their reliance on foreign revenues, and they can and do hedge their currency exposure — but few are likely to escape unscathed if the rising dollar trend continues.

Still, since mid-April, the dollar has steadily climbed against a basket of other major currencies, which include the euro, buoyed by signs of a stronger economy that has added more than 5 per cent to its value.

“A rising US dollar translates into a negative currency headwind for many of the companies in the S&P 500,” said Martin Jarzebowski, vice-president and portfolio manager at Federated Investors.

The dollar’s recent turn also coincides with the first-quarter reporting season by US companies. A surge in US corporate profit growth in the wake of tax cuts, estimated at about 25 per cent year on year by Factset, has failed to drive the S&P 500 back to its record peak set in late January.

This reflects a sense among some investors that earnings may have peaked for the cycle, with such apprehension reinforced should the dollar gain further altitude.

David Donabedian, chief investment officer of CIBC Atlantic Trust, said: “I do not look at this 4-5 per cent rise in the dollar as a big game changer in earnings.” Still, he added that the rebound in the currency “is supportive of the idea that after the third quarter you get a deceleration of earnings”.

Some industries and sectors are more sensitive to shifts in the dollar than others. Tech companies as a group, for example, derive more than half of their revenue outside the US. Consumer staples groups also have significant overseas exposure, while telecoms companies, utilities and the real estate sector are largely domestic.

“Regional banks, homebuilders — there is a whole group of industries that really do not have a lot of exposure outside the 50 states,” said Mr Donabedian. “But this is not a big enough move [in the dollar] to be playing that — not as of yet.”

FactSet data also show that Wall Street analysts forecast companies that make more than half of their revenue outside the US reporting greater revenue and earnings increases for the second quarter compared with those that are more domestically focused and the overall S&P 500.

Market moves also reflect that exposure to economies outside the US remains in favour.

The S&P 500 US Revenue Exposure index, which measures the performance of companies in the index with higher than average revenue exposure to the US, is down for the year, whereas an index that measures companies with a higher than average revenue exposure outside the US is up nearly 3 per cent. Over time, however, the latter’s performance has been driven more by bullish or bearish sentiment about China than the moves of the dollar.

The dollar’s recent ascent helps to explain why the shares of small companies, which tend to generate most of their revenue at home, have outperformed the S&P 500. The domestic focus also insulates small-caps to the trade tensions that have emerged this year and makes them a bigger beneficiary of cuts in the corporate tax rate and a stronger economy.

According to David Lefkowitz, senior equity strategist at UBS Global Wealth Management, the back of the envelope calculation indicates that a 10 per cent change in the dollar spurs a 2 per cent shift in S&P 500 earnings.

Mr Lefkowitz said the dollar “would have to rise another 10 per cent before that tailwind [to S&P 500 earnings] would go away. The move is pretty small in the scheme of things”.

Meanwhile, the strengthening dollar and weakening pound provides a boost to international stocks in London, where the FTSE 100 index hit an all-time high earlier this month.

“North America accounts for roughly 20 per cent of [FTSE all share] revenues,” said James Illsley, a UK equity portfolio manager at JPMorgan Asset Management, adding that approximately 40 per cent of UK-listed dividends are declared in dollars: “Think about big oil stocks, HSBC . . . You can receive [these dividends] in sterling as a UK investor, so dollar strength will obviously help”.

Mike Fox, head of sustainable investments at Royal London, said growth differentials — currently in favour of the US over the UK and Europe — tend to be a short-term driver of key foreign exchange rates . . . “It’s very useful for GlaxoSmithKline, AstraZeneca, BP”.

Managing China’s Global Risks

Andrew Sheng , Xiao Geng

Employees work on a solar panel production line at Shenzhou New Energy Co

HONG KONG – The world economy and international system are now characterized not only by deep interconnectedness, but also by intensifying geopolitical rivalries. For China, the situation is complicated further by US President Donald Trump’s evident view of the country as a strategic competitor, rather than a strategic partner, not to mention massive domestic social change and rapid technological disruption. The only way to mitigate the risks that China faces is with a tough, continuous, and comprehensive reform strategy.

A key risk is financial. At least four “mismatches” lay at the root of past global financial crises, and three of them plague China today. First, with its bank-dominated financial system, China (along with Europe and many emerging economies) suffers from a maturity mismatch, owing to short-term borrowing and long-term lending. Yet, unlike many emerging economies, China does not struggle with a currency mismatch, thanks to its large foreign-exchange reserves and persistent current-account surpluses, which make it a net lender to the rest of the world.

But China has not avoided the third mismatch, between debt and equity: The credit-to-GDP ratio doubled over the last decade, from about 110% in 2008 to 220% in 2017, highlighting China’s under-developed long-term capital and equity markets. Nor can policymakers afford to ignore the fourth mismatch – between ultra-low nominal interest rates and the relatively higher risk-adjusted return on equity (ROE) for investors – which has contributed to speculative investment and widening wealth and income inequality.

These structural risks are largely a result of China’s transformation from an agriculture-led economy to one driven by manufacturing exports. As technology continues to progress, with robotization becoming more accessible, companies that once relied on cheap labor and manufacturing exports increasingly need to produce goods and services closer to domestic consumers in open and globally competitive markets.

In this context, China’s only option is to abandon its low-cost manufacturing export model and move up global supply chains. To that end, the government has already introduced industrial strategies – “Made in China 2025” and “Internet Plus” – to support technological development, adoption, and innovation. The US, however, has taken these industrial policies as evidence of mercantilist state intervention that justifies punitive trade tariffs and other sanctions.

Complicating matters further for China, the rush to create an open, market-oriented economy has fueled corruption and rent-seeking. And, as recent European post-crisis experience has shown, it is politically very difficult to carry out structural reforms when vested interests have captured the regulatory system. That is why Chinese President Xi Jinping has been engaged in a comprehensive anti-corruption campaign – often misrepresented as a power grab – since assuming office in 2012.

Yet China’s problems extend beyond structural imbalances to two types of cyclical macroeconomic risks. The first risk stems from the business cycles in advanced, market-based economies, where interest rates, inflation rates, and growth rates rise and fall together.

The second type of risk reflects the cycle experienced in underdeveloped, non-market-based economies as they make the transition to a market-oriented economy. In this fast-moving cycle, housing and fixed-asset prices (as well as the currency’s value) will increase faster than productivity growth in the tradable sector, owing to supply constraints. As households and investors borrow cheaply to invest in rapidly appreciating housing and fixed assets, bubbles form and then burst, spurring crises. Yet, because the usual response – socialization of bank losses, with a privileged few keeping the profits and bonuses they accrued while the bubble was growing – creates moral hazard, the cycle is likely to be repeated.

Abandoning the distorted and imbalanced incentive structure, and ensuring that both creditors and debtors share and manage risks, would help break the cycle. China could create a system in which broad equity stakes – held by pension, social security, or sovereign wealth funds – are professionally managed, thereby guaranteeing not only that the long-term risk-adjusted ROE is higher than the real (inflation-adjusted) GDP growth rate and the nominal interest rate, but also that the gains are shared widely among the population.

A widely shared positive real ROE would mean less financial repression and a fairer income and wealth distribution. Meanwhile, with more skin in the game, venture capital would be more accountable to investors and savers.

In addition to structural and cyclical risks, China must address the “gray rhino” (highly likely, but often ignored) strategic risks arising from the intensifying Sino-American geopolitical rivalry. Here, the emerging trade war is just the tip of the iceberg. The US and China are set to become immersed in a long-term competition for technological and strategic supremacy. To stay ahead, they will use every kind of leverage and instrument at their disposal. If this competition is left unchecked, it will surely have far-reaching spillover effects.

Risks are normally mitigated through avoidance, hedging, insurance, and diversification. But the Chinese and US economies are both too big and too interconnected to fail, making avoidance and hedging far too dangerous and costly. Insurance would also be impossible, owing to the lack of markets. Diversification may work, if both countries pursue a variety of low-cost, high-return, cooperative win-win options. These include technological innovation that addresses social problems and promotes inclusive growth; further market opening; tough measures against rent-seeking speculators and interest groups; and tax reforms to improve income and wealth distribution.

The fact that trade negotiations are being pursued in tandem with talks over North Korea’s nuclear program suggests that China and the US understand that, in today’s interconnected global system, cooperation is necessary for managing multiple global risks. But if China is truly to build a balanced, resilient, and anti-fragile real economy and financial system, it will need to go further, developing a comprehensive set of risk-sharing mechanisms. It is a task that can no longer be ignored or postponed.

Andrew Sheng, Distinguished Fellow of the Asia Global Institute at the University of Hong Kong and a member of the UNEP Advisory Council on Sustainable Finance, is a former chairman of the Hong Kong Securities and Futures Commission, and is currently an adjunct professor at Tsinghua University in Beijing. His latest book is From Asian to Global Financial Crisis.

Xiao Geng, President of the Hong Kong Institution for International Finance, is a professor at the University of Hong Kong.

A Conversation About U.S. Credibility

By Jacob L. Shapiro

In an era in which reality is so often defined by how well something can be quantified, politics is a stubborn outlier. Some aspects are quantifiable, especially as they relate to military strength or economic conditions: We can measure the number and range of Iran’s missiles, or the widening wealth gap in the United States. But data (especially economic data) is imperfect, and it’s often deceptive. For instance, that Iran has a certain number of missiles says nothing about the quality of the missiles, let alone whether Iran would use them. “Political science” emerged as an academic discipline in the 19th century out of a desire to treat politics like a science – to define its truths in terms of empirical data, not ancient Greek philosophical principles. But exclusive reliance on data is no better than exclusive reliance on theory. And unfortunately, especially in the United States, political science has become not just data-driven but data-obsessed.

The limitations of this approach can be observed clearly in a debate raging over the importance of U.S. “credibility” in the world. The U.S. made three major foreign policy moves this month: It pulled out of the Iran nuclear deal, it has been inconsistent on trade disputes with China, and canceled, at least temporarily, a planned summit with Kim Jong Un next month. In both the U.S. and abroad, it is becoming a common refrain to hear that U.S. credibility has been damaged as a result of these moves, and that this has the effect of eroding U.S. power and creating more geopolitical instability.

Determining whether this is true is more difficult than it may seem. After all, how does one measure credibility? We could survey a large sample of people in a foreign country and ask whether it is commonly believed that the U.S. will follow through on its promises, but the results would be imprecise – and mostly irrelevant. Answers would vary based on the issue, and more important, it’s foreign governments, not their citizens, that must decide whether the U.S. is trustworthy after the foreign policy decisions of this month.

And Americans themselves are unreliable judges of U.S. credibility abroad because of the political history of the term in America. The credibility question was ubiquitous in the 1960s not because of the United States’ relationship with foreign governments but because a “credibility gap” opened up between the Lyndon B. Johnson government and the American electorate. The Johnson government relied on key statistics (like “body count”) to claim that the U.S. was winning the Vietnam War even as the situation was getting no better. Richard Nixon’s Watergate scandal widened the trust gap still further. Ironically, when Americans refer to the credibility of the U.S. abroad, they are often projecting their own lack of confidence in their government onto others.

Yet despite the shapelessness of the term credibility, and despite the political landmines surrounding discussions of it, it is not a discussion that can be avoided. The reliability of U.S. promises is not an academic question. The U.S. became involved in the Vietnam War precisely because it feared the implications for its containment policy against the Soviet Union if it allowed Vietnam to fall into communist hands. What was at stake was not so much Vietnam but the value of a U.S. security guarantee. The same is true, albeit on a much smaller scale, of Russia’s 2008 invasion of Georgia.

Russia was not interested in conquering Georgia so much as it was interested in demonstrating that a U.S. security guarantee was worthless, and therefore that countries in the Caucasus would do well to make their peace with a resurgent Moscow.

Credibility, then, is as much perception as it is reality. The Iran nuclear deal is a useful example. The stated goal of the Joint Comprehensive Plan of Action (as it is officially known) was to prevent Iran from acquiring nuclear weapons. But the U.S. and Iran each conceived of the JCPOA in very different terms. The U.S. wanted a willing partner in the fight against the Islamic State. It got a partner that was too willing, because after IS was all but defeated, Iran aggressively pushed into the region and began testing missiles. Iran wanted to rejoin the global economy and secure legitimacy for its foreign policy moves in the region. The deal was concluded by two weak administrations, and in the U.S. it wasn’t even given the status of a treaty, meaning it was easy to cancel.

Those who advocate remaining in the JCPOA argue that leaving the deal is catastrophic for U.S. credibility. They find useful corroboration of this position from Iran’s president, for whom the U.S. withdrawal is disastrous, and from European leaders who are primarily interested in buying cheap Iranian oil. Those who advocated leaving the deal think that Iran is a menace with no credibility of its own and that it is better to take the hit to U.S. credibility than to remain in a political arrangement that empowers a U.S. adversary. It’s hard to argue that U.S. credibility has been damaged while Iran is trying to buy the Iraqi election and is building bases on the Israeli border.

The U.S.-North Korea issue is different, if less immediately weighty. The Trump administration appeared poised for a summit with Kim Jong Un, only to withdraw from the summit via a letter that boasted of the United States’ own nuclear arsenal and gave the primary reason for the cancelation to be the “tremendous anger and open hostility” of recent North Korean statements. The Trump letter came days after the U.S. insinuated that Libya was a good model for North Korean denuclearization, an eyebrow-raising suggestion considering the U.S. helped topple Moammar Gadhafi’s regime in Libya in 2011. Now the U.S. and North Korea are talking again, and the summit may be back on – or it may not. The whole issue has become a farce.

But it is a farce that could be damaging to U.S. credibility. North Korea released U.S. prisoners, toned down its criticism of U.S.-South Korea military exercises, and appeared to dismantle a nuclear test site. Though Iran, strictly speaking, was not violating the terms of its deal with the U.S., Washington could at least point to violations of the spirit of the agreement. Not so with North Korea.

The U.S. has also been losing the larger credibility battle in East Asia. U.S. credibility in the region won’t rise and fall depending on whether Trump and Kim share a cheeseburger, but it matters whether countries in the region trust the United States. And on this issue, North Korea already achieved a major objective months ago when it exposed deep cracks in the U.S.-South Korea security relationship by pushing the U.S. to the brink of a military strike. North Korea also successfully demonstrated to U.S. allies like Japan that U.S. resolve in halting North Korea’s nuclear program is mainly rhetorical.

What this all really comes down to is that the United States is at the center of the world order, and when the United States acts in ways that other countries don’t like (or that political factions within the U.S. don’t like), it often manifests as the weakening of U.S. credibility.

Sometimes the issue of reduced U.S. credibility is real, as it is in Asia, where the power of the U.S. is declining (compared to China and Japan), and where the United States’ inconsistent approach to the North Korea issue is producing unease, not a tactically useful level of unpredictability. Sometimes, however, credibility is simply a scapegoat for a policy disagreement or divergent strategic interests. Either way, the issue is not so much that the U.S. broke this or that agreement as it is a much broader lack of strategic clarity dating back to 1991 about how and to what end the U.S. wields its power in the world.

More than anything, the conversation about credibility is a veneer that hides the true nature of international politics. Ultimately, the best indicator of how a country is going to behave is not what its leaders have said or agreed to, but what its interests dictate. Consider that in 1939, Nazi Germany and the Soviet Union signed a non-aggression pact. I can think of no two political regimes whose credibility in keeping the terms of such a pact could have been lower – and yet they signed the pact, even though both were planning on eventually breaking it. Those who worry about U.S. credibility have a notion that U.S. exceptionalism means the U.S. keeps its word when all other countries don’t, or more optimistically, that politicians can be trusted.

That’s a pleasant fiction. The U.S. is a country like any other, and it can be trusted to act in its interests at all times. The problem isn’t so much that the U.S. cannot be trusted, but that the U.S. is often unclear about what those interests are, an unfortunate byproduct of thinking about politics as an algebra problem.