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The press never misses a chance to dance on the greenback's grave these days. So the news that China's holdings of gold had almost doubled got a lot of coverage last week.
At first glance, this looks like proof that unhappiness with America's profligate ways is finally boiling over. China is preparing to dump the dollar and switch into something a little more durable. Or so the story went.
Unfortunately for gold bulls and dollar bears, this was a bit of an over-reaction. In the long-term, the US does have a currency credibility problem. But it's highly unlikely that China – or anyone else – is preparing to dump trillions into the foreign exchange markets any time soon.
As long as this crisis continues, the dollar looks pretty secure...
There's not enough gold to replace China's dollars
First, let's take a closer look at this gold story. According to China's official news agency Xinhua, state gold reserves are now 1,054 metric tonnes, up from a steady level of 600mt since 2002.
But that doesn't mean China has bought 454mt in the last few months. The State Administration of Foreign Exchange (SAFE), which looks after the country's gold, is pretty secretive. It's quite likely that it has been buying steadily over the last six years, but just hasn't told us about it.
Secondly, let's put the amount in context. Even if China bought all that gold last year at the peak price, the cost would be around $15bn. By comparison, its foreign exchange reserves increased by $419bn last year. So any suggestion it is diversifying out of dollars in a meaningful way doesn't really stack up.
Nor could it, even if that was SAFE's plan. China's foreign exchange reserves now total around $2trn. At today's prices, that's more than 40% of all the gold above ground today. Any significant move out of dollar and into gold would send the metal rocketing. And if this were the intention, tipping us off that it's in the market - by revealing its reserves have grown - would be rather stupid.
So nothing in this story suggests the dollar has anything to fear from China at the moment. And neither does anything in the currency markets.
Investors are taking on more risk
It's true that the dollar has weakened slightly over the last couple of months. Within Asia, the fall has been greatest against the South Korean won and the Indonesian rupiah. This suggests that investors are becoming a little more willing to take on risk (both the won and rupiah fell sharply during the panic as a result of companies in these countries having substantial dollar-denominated debt).
click to enlarge
What's more, you can see below that US investors were net purchasers of foreign equities in January after being net sellers every month since June. We don't have March's numbers yet, but it's likely they were back in the black as well.
But while investment flows have recovered a little, dollar liquidity remains low on other measures. For example, we can look at FX swaps, which measure the cost of swapping one currency into another.
Borrowing dollars is still expensive
In a US dollar FX swap, an institution, typically a bank, arranges to supply a given amount of local currency for a fixed period to another institution. In return, it receives a corresponding amount of US dollars. For this, the first bank pays the second bank interest on the dollar loan at a market rate (usually the three-month USD London interbank offered rate), while receiving interest on the local currency it has lent in exchange (usually at the three month local currency interbank offered rate).
When markets are functioning well, and supply and demand are balanced, the difference between the two interest rates should be small and relatively stable. But in a dollar shortage, the USD borrower will have to pay a considerably higher rate for the dollar borrowings it receives on its local currency loan. In other words, the difference between the two rates or the "basis swap spread" becomes very negative.
The charts below show five-year USD basis swap spreads for the Japanese yen and the South Korean won. As you can see, the yen spread has come in a little from its widest point, but remains much more negative than usual at -43 basis points (one-hundredths of a percentage point). It's a similar story in Singapore dollar and Hong Kong dollar spreads.
Bloomberg's series for USD-won swaps is much shorter, so we can't see a long-term average – but we can see that -221 bps is far wider than the levels we saw in 2006 and early 2007. (The huge difference between the spread for yen borrowers and won borrowers reflects Korean banks' high dependence on short-term US dollar borrowings.)
All this suggests that global US dollar liquidity remains poor, despite the Federal Reserve's efforts to pump more money into the markets. The problem is that just because the Fed boosts the base money supply, it doesn't guarantee that the wider money supply rises in the American economy and it certainly doesn't guarantee that global liquidity rises.
Dollars have to make their way into the wider world, either through investment flows or trade. As we saw above, investments flows have turned positive – but only after several months of contraction. Meanwhile, the US trade deficit continues to shrink, as you can see below. While this continues, dollar will stay in short supply.
We can't change the reserve currency overnight
So for now, we can expect the dollar to remain fairly strong. 'For now' is the key phrase there: once the US economy picks up and trade and investment outflows resume, a noticeably weaker dollar is likely. But unless the Fed gets its quantitative easing horribly wrong and we end up with hyperinflation in the US, that's still a different matter to a dollar collapse.
The dollar is still the global reserve currency. There's been a lot of talk about it losing this status, but that seems unlikely. A reserve currency is tightly integrated into the global financial system and it takes a long time to shift to a new one. The dollar only formally supplanted the pound after World War II, even though the American economy passed Britain in size in the 1870s.
What's more, there's no real contender to replace the dollar. The euro is the closest, but it has plenty of problems of its own. And any idea that the renminbi is ready to take over is a fantasy. China is moving to make its currency more of a factor in international finance, by establishing swaps with other countries that would potentially allow bilateral trade to be settled in renminbi. But these are very early steps.
The renminbi is not yet freely convertible into other currencies. And even if the Chinese government were to make it convertible, there simply aren't enough renminbi-denominated assets yet for foreign renminbi holders to store their wealth in. A crucial part of the US dollar hegemony is America's deep and highly liquid capital markets.
Doing the shopping in SDRs
But is there another way? Part of the speculation about the dollar's future came after Zhou Xiaochuan, the governor of the People's Bank of China, published a paper arguing for an end to the dollar standard.
He argues that any system in which a reserve currency is also a national currency is flawed. Instead we should use a super-sovereign reserve currency managed by a global institution. In particular, he suggests Special Drawing Rights (SDRs), which are essentially an internal unit of account at the International Monetary Fund (IMF) and a handful of other international institutions.
Most economists rejected this idea outright. Now, it's fair to say that economists don't have a great track record when it comes to spotting how major shifts in the financial system will play out. Take the 1970s, by when decades of growth in crossborder capital flows had made it impossible to sustain the Bretton Woods system, in which the dollar was pegged to gold and other currencies were pegged to the dollar.
It seems that most analysts thought that switching to floating rates would reduce cross-currency flows - a conclusion that seems hopelessly misguided given our hyperactive modern foreign exchange markets. According to economic historian Charles Kindleberger in Manias, Panics, and Crashes:
"Most economists had thought that the adoption of floating exchange rates would kill the movement of interest-sensitive capital and that once currencies were floating central banks would be able to follow independent monetary policies without untoward external effects. Economists differed about whether speculative capital movements would be stabilizing or occasionally seriously destabilizing; the general view was that fear of exchange losses would deter capital flows. That view proved mistaken; many banks regarded currencies as a new asset class to be traded for a profit."
Still, it certainly looks like there would be a lot of issues with adopting something like the SDR as a reserve currency. The issues with the renminbi apply on an even larger scale. There are no assets priced or traded in SDRs; not even bank accounts in SDRs. While we can never be certain about these things, the prospect of SDRs – or anything else – replacing the dollar in the next few years look very remote.
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Obviously the USD will crash when the Treasuries "bubble" bursts - and people are dumping TRILLIONS in U.S. bonds. Looking at bond prices, perhaps this has already started.
What happens eventually in 20-50 years is a different story. Nobody knows.
I agree but what really matters is that the dollar is going to get the crap kicked out of it for the foreseeable future (see recent USD vs. AUD for a prelude).
Awful, awful advice for the near term. Sweden is in big trouble, forget about the krona. AUD and CAD you have to believe there is a massive commodities bull market coming. And it's coming, but not anytime soon. BRL is much more complicated. Unless you're a professional FX trader, stick with EUR or USD for the near term. Deflation is not over yet and the world is stuck with the dollar as reserve currency (as the author notes) for decades or more to come. The time for the USD to resume its value decline is not here yet. If you truly believe the world is coming to an end and no currency can be trusted, buy gold.
If China doesn't grow as expected, commodity exporters (Australia, Brazil, Canada) will go down big time ... no real hedge for US$.
Only China can save US, Europe, and global economy.
Still - why do they even need to have an SDR? what's to keep China or any central bank from making it's own synthetic SDR? Create a diversified blend of reserves with a mix of dollars, yen and euros?
If Zhou Xiaochuan thinks that is the way to go, he can certainly build his own, he doesnt need a special governing body to do so.
However, rising long term Treasury yields, a possible resumption of inflation, rising commodity prices, and demands for higher bond yields does not spell good news for dollar bulls if there are any remaining after Bernake. That in itself speaks mountains as to why the dollar is doomed with such a weak and indolent Federal Reserve.
The next question is do you believe the rising bond yields and commodity prices spell a exit from the recession, the Feds loss of control keeping interest rates low, or sparks of inflation threatening to light the Fed and Treasury's money binge on fire?
I think the author notes some important evidence, that the markets seem to be betting against any immediate demise of the dollar.
The Fed is Losing.
(SO happy i lived long enough to see this!)
not enough gold to replace china's dollars seems extremely bullish. i buy metals for insurance but your article is bugging me.
It scares the h__l out of me. I live in Brasil but my income is from home in US$s. But even big companies have to worry. Take Avon for an example. It's biggest income is from Brasil. If the US$ falls in value here they can not bring home as much profit.
No more threats of "dumping the dollar" after that. Changing the dollar as the major world currency, yes, but no more dumping threats.
The consequences of this action will be that the Federal Reserve will have to print even more money - monetize even more of US government expenditures.
This will lead to a much weaker US Dollar over the next few years and much higher inflation.
while china may not reduce USD holding in absolute terms, it will in relative terms by diversifying to other assets. at the end of the day, this is good news to all of us. it will give us time to adjust our financing arrangements rather than rely on speculation and fear.
Markets are nearing a resolution which is graphically illustrated by the relationship between the 50 and the 200 EMA. Fundamentally, the economic news flow will either continue to support the recovery thesis or we will see renewed deterioration. The author's expectation is that the fundamentals will continue to show gradual improvement and the markets will manifest this with a bullish crossover of the 50 and 200 EMA.
Having largely completed its initial impulsive short covering rally off an historically oversold bottom produced by a generational Financial Panic, the nascent Bull Market will now consolidate during a transitional period technically characterized by the interplay between price and the 50 and 200 EMA's. Investors will use this period to buy the dips to accumulate positions. Bears will attempt to reposition for an anticipated decline by selling rallies. Trapped longs will also sell rallies into technical resisitance in the SPX 975-1015 range. The overall effect will be a range trade for several months with the eventual 50/200 EMA crossover indicating the longer term trend.
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You are absolutely correct about the USD heading lower. The other dramatic event last week was the USD closing below 83.45 on Friday. That was a key support level. Now that it has been broken it is highly likely we will see it move below 80 in the next month. The commodity bull has resumed in "full force".
Yank
On May 09 11:36 AM Tony Daltorio wrote:
> The author is missing the key point. Yes, China will not dump trillions
> of dollars onto the market at once. But, China has already started
> down the road of GREATLY reducing their future purchases of US Treasuries.
>
>
> The consequences of this action will be that the Federal Reserve
> will have to print even more money - monetize even more of US government
> expenditures.
>
> This will lead to a much weaker US Dollar over the next few years
> and much higher inflation.