DJ, to ease the pain :0) The onset Collapse is closer :0)
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The Dollar, China and U.S. Deficits
Jan 24, 2005
Summary
A survey of central bank managers around the world shows a shift away from U.S. dollar reserves in favor of the euro. This trend will put more downward pressure on the dollar and more pressure on those countries banking on a strong dollar, notably China. U.S. dependency on China to fund its current account deficit likely will deepen, and with economic troubles looming in China, a U.S. currency shock may not be too far behind.
Analysis
In a survey conducted from September to December 2004 of 65 central bank managers who collectively control $1.7 trillion in reserves worldwide, 70 percent said they had begun to buy a greater proportion of euros relative to the dollar over the past two years. Results of the anonymous survey by the Royal Bank of Scotland, released Jan. 24, show that 47 percent of the managers expect that growth in dollar reserves will slow to less than 20 percent in the next four years after averaging 66 percent in the previous four. This reflects not only the relatively low rate of return to U.S. assets at present because of low interest rates but also an increasingly common view that the United States' $650 billion trade deficit, along with the growing U.S. budget deficit, is reaching unsustainable levels. Average dollar holdings by central banks around the world fell from 66.9 percent at the end of 2001 to 63.8 percent by the end of 2003.
The trends illustrated by the survey highlight the downward pressure that is building against the dollar, and the results are likely to intensify that pressure. This is not a surprising development, but with central banks reducing their dollar exposure, countries with a vested interest in a stronger dollar will have to assume more responsibility in propping it up.
The Chinese government has been primarily responsible for funding the U.S. current account deficit by purchasing massive amounts of U.S. debt in order to maintain the exchange rate. The exchange rate, in turn, guarantees that Chinese exports remain cheap and in high demand in the United States. Beijing will continue purchasing U.S. debt regardless of global perceptions of the dollar's value. As U.S. fiscal and trade deficits have increased and perceptions around the world have dimmed, the United States has become increasingly dependent on China's ability to soak up U.S. debt, just as China has grown dependent on the United States to soak up Chinese imports. The problem is that China is on the cusp of economic turbulence that eventually will make it unnecessary for China to continue these purchases at their current pace. When China reaches that point, the U.S. dollar could be in for a full-on freefall.
Stratfor believes that 2005 will see the Chinese economy turn downward as U.S. interest rate hikes begin to bite. Once these rates reach 5 percent and more, Stratfor believes the United States will begin attracting foreign capital to the detriment of China's export sector, and the higher cost of credit will become too expensive for many firms operating at razor thin margins in China to maintain their presence. Without foreign funding, output in the export sector -- currently the engine of the Chinese economy -- will fall. With fewer exports to support and diminished speculative pressure on the currency peg, the amount of U.S. bonds that China will need to buy to maintain the peg and the exports will fall as well.
In due course, the capital flight leading to decreased output in the export sector will have another impact that will further decrease China's need to bankroll the U.S. current account deficit. The departure of capital will pick up as exports begin to drop, and the resulting loss of income in the Chinese economy will make it more difficult for the Chinese government to subsidize its massive and inefficient state-owned enterprises (SOEs). For decades, it has been doing this through the country's equally massive and inefficient state-run banking system, but when enough capital leaves the banks will hit the wall.
Struggling under Himalayan-sized mountains of bad debt, the banks -- which provide 90 percent of the Chinese economy's financing -- will find themselves unable to extend cheap and easy credit to the country's hulking SOEs without foreign capital and exports to keep the rest of the economy going forward. Interest rates will have to rise, and the SOEs -- completely dependent on cheap loans from state-run banks -- will begin collapsing, since they will be unable to access credit. Simultaneously, they will be unable to make loan repayments at higher interest rates, and this will threaten to bring down the banking system entirely.
As a result, the government will be forced to step in to directly subsidize the banks and SOEs, but it will be unable to do both for long. When the government is no longer able to provide life support to the banks and SOEs, economic output will fall even more -- and further reduce China's need to bolster its output by purchasing U.S. debt. As those purchases decrease, the noose will tighten around the dollar.
Japan and other Asian countries likely will step up their purchases of U.S. treasuries in an effort to ward off a substantial slide in the dollar's value to safeguard their own exports, but they will be unable to pick up the slack on their own. Without the flow of cheap financing coming from China, U.S. interest rate hikes intended to ward off inflation will not compensate sufficiently to create demand for U.S. debt.
As a consequence, the government will need to pay more to entice people to buy its debt. This will translate into higher interest rates and higher credit costs throughout the U.S. economy, which will bite into economic growth not only in the United States but around the world. While the timing of these events is uncertain, the interdependence that now exists between the U.S. and Chinese economies suggests that the probability of their occurrence is high.
Copyright 2004 Strategic Forecasting Inc. All rights reserved.
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