The Makings Of A Meltdown
If investors needed a wake-up call about how heavily the global financial system relies on the actions of Asia's central banks, they received a nasty one on Nov. 26. A widely reported remark by People's Bank of China Policy Board member Yu Yongding that Beijing planned to trim its purchase of U.S. Treasuries quickly sent the dollar to four-year lows vs. the euro and the yen. The markets, spooked just a week earlier by statements from Federal Reserve Chairman Alan Greenspan, were filled with speculation that the day of financial reckoning was coming for America and its soaring trade and government budget deficits. If China were to start dumping U.S. assets, the theory goes, other Asian central banks would likely follow to protect the value of their foreign reserves from a dollar crash.
It looks like a false alarm. Beijing quickly moved to quell the fears by declaring that Yu had been misquoted. Soon after, Chinese Prime Minister Wen Jiabao repeated for the umpteenth time that Beijing will not change any time soon its policy of pegging its currency, the yuan, at 8.3 to the dollar. That means China would have to keep adding dollars to its $515 billion in foreign reserves, which this year have been growing at about $15 billion per month, in order to offset inflows from foreign investment and export earnings. While the dollar continued drifting to 102 yen and the euro hit $1.33, many analysts argue that it may be poised for a technical rebound as Japan, South Korea, and other nations intervene in the markets again to halt the sharp appreciation of their currencies.
Still, those days of jittery trading have exposed a raw nerve that is likely to run through the world financial system through 2005. How much longer, asks a growing chorus of economists, can the U.S. continue to rely on Asian central banks to finance its skyrocketing twin deficits? China, Japan, and other Asian nations already have amassed $2.2 trillion in foreign reserves, much of them recycled into U.S. Treasuries. Meanwhile, the U.S. current-account deficit, expected to reach $665 billion this year, or a record 5.7% of gross domestic product, would hit 6.3% of GDP in 2005 and 7% in 2006, based on current oil prices and import and export trends. And given its low domestic savings rate, the U.S. will likely have to step up its offshore borrowing to finance the gap. As a result, traders sense the approach of a mega-realignment of the dollar vs. global currencies.
Look closely at U.S. data, however, and fears of an Asian dollar stampede look overblown. They show that Asian central banks, with the exception of Japan, already have been weaning themselves off dollar assets for the better part of the year -- without triggering a spike in inflation or U.S. rates. Taiwan and South Korea have increased their dollar holdings only modestly, those of Thailand and Singapore have stayed virtually flat, and Hong Kong's Treasury holdings have dropped by $5 billion. As a result, the Singapore dollar is up 4% this year against the greenback while the Korean won has leapt 14%. "Everybody has been scaling back, and the whole exercise has been pretty benign," says emerging-market strategist Chen Zhao of Montreal-based BCA Research.
China has been quietly diversifying its holdings as well. Even though its foreign reserves have swelled by $100 billion over this year's first nine months, China has purchased only $17 billion worth of Treasuries and other U.S. bonds, BCA estimates. This is way behind the pace of 2003, when China bought $60 billion in U.S. bonds. Even though China still needs to buy Treasuries to offset investment inflows, that need is less urgent than before. In recent months, analysts say, China's repeated insistence that it will not change its currency peg soon apparently has helped stem the China-bound surge of speculative money. That means Beijing doesn't have to buy up as many dollars.
So where has Beijing been parking some of its mounting reserves? Some 20% are now in euros, estimates UBS Securities Asia (UBS ) economist Jonathan Anderson, while China also has put more in yen and pounds. "China has already diversified away from U.S. dollars," says Zhao Xijun, vice-director of the Finance & Securities Institute of Beijing's People's University. The shift has helped put upward pressure on the euro, which the Europeans are understandably concerned about: Europe has unfairly borne the brunt of the world's currency dislocations. But the Chinese move to diversify has created just a ripple in the $4 trillion U.S. Treasury market.
There are other reasons Asian central banks will probably not lead a panicky charge out of dollars. For one, Asia's economies still depend heavily on exports to the U.S. for growth and jobs. If Asian central banks stop buying dollars and send U.S. interest rates soaring, they will tank their biggest and most strategic market. "It's probable that over time central banks will want to reduce their exposure to a single currency like the dollar," says Nick Bennenbroek, senior currency strategist at Brown Brothers Harriman & Co. "But there's not much risk this will happen anytime soon."
In fact, some Asian central banks could start jumping back into Treasuries. After boosting its holdings in U.S. bonds by 46%, to $721 billion, in this year's first eight months, Japan has since stayed on the sidelines. As a result, the yen has risen by 6.8% in six months against the dollar. But Japanese Vice-Finance Minister Koichi Hosokawa has signaled that Tokyo will aggressively hold the line if the yen nears 100 vs. the dollar. South Korea already has begun to intervene again after the won hit a seven-year high.
This does not mean the scary dollar meltdown scenario will disappear. As Asian governments stepped back, hedge funds dramatically boosted their holdings of U.S. Treasuries this year. They're a far more footloose bunch than central bankers. That's why Yu's comments triggered such angst among those who see the makings of a dollar meltdown.
And as America's twin deficits continue to breach uncharted territory, "the chances of a hard landing for the dollar increase," says economist Nouriel Roubini of New York University's Stern School of Business. As Washington's borrowing needs rise, it may have to sharply raise bond rates to lure buyers. The risk also remains that some central banks with smaller U.S. holdings, such as Russia or India, would instigate a sell-off by deciding to dump U.S. assets if they sense that the dollar is ready for another big slide. Roubini also notes that the longer China maintains its rigid peg to the ever-dropping dollar, the more its currency will have to rise when it does decide to break the link. A dramatic revaluation would immediately affect the value of dollar-denominated assets. A 20% appreciation of the yuan, for example, would mean a $100 billion loss in the value of China's reserves -- equal to about 8% of GDP.
The U.S. and Asia can mitigate this risk by moving aggressively to correct the imbalances. The Bush Administration must devise a credible plan to narrow its yawning fiscal deficit and boost savings. Asian governments could start cutting their addiction to cheap currencies. "If the U.S. is ever going to reduce its trade deficit, somebody [in Asia] has to reduce their exports and increase domestic demand," notes Akio Mikuni, founder of credit rating agency Mikuni & Co.
The remedies are obvious -- but difficult. Don't expect Asian banks to instigate a dollar crash soon by bolting, but don't expect a risk-free correction in the financial system either. A real fix will take years.
By Brian Bremner in Tokyo and Pete Engardio in New York