Americans are fond of saying, ‘If life gives you a lemon, make lemonade.” With Bush in the White House, the United States has become the world’s leading producer of lemonade.
A country pays for its imports with hard currency. It obtains hard currency from exports, remittances by expatriates and foreign investments. Even European countries with hard currencies on their own operate in this manner. The only exception to this rule is the United States of America. The U.S does not have to export anything to pay for its imports. They simply have to print more dollars. Surprised?
If an Indian oil company needs to buy crude from the Gulf, it has to pay in U.S. dollars. For this, the oil company pays Indian rupees to a bank and gets US dollars in return. The bank has a supply of U.S. dollars from exporters, foreign investors, expatriates and foreign tourists. If the demand for U.S. dollar is high and not enough to meet supply, then the dollar value in relation to the Indian Rupee will rise. If there is a huge inflow of U.S. dollars and there is not enough demand from Indian importers, then the value of the Indian Rupee will increase against the U.S. dollar. To prevent the value of the Indian rupee from fluctuating wildly and thereby affecting the health of the Indian economy, the RBI accumulates foreign currencies in its forex reserve. When the value of the rupee falls against the dollar (and hurts importers), then the RBI will sell dollars from its reserves. If the value of the rupee rises against the dollar (and hurts exporters), then the RBI will “mop up” or buy dollars from the open market. The ability of the RBI to protect the currency against wild swings is directly linked to the size of our forex reserves.
But the hundreds of billions of dollars in the reserve is not in the form of currency bills. No, there is just not enough room for that. When someone sells dollars to a bank, all it gets is an assurance from a foreign bank that a given number of dollars has been transferred. When the RBI buys dollars from the market, it in effect buys this assurance. The RBI then sells this assurance and buys low-yield American Treasury bonds. These bonds are nothing
but I-Owe-You (IOU) notes. Thus, nothing of real value ever leaves the shores of the U.S.; only assurances. Unlike people in the rest of the world, Americans can go on accumulating huge debts while the world gobbles up ever-increasing amount of counterfeit portraits of dead American presidents.
The central banks of Japan, China, Taiwan, South Korea, India and several other nations have been subsidizing American profligacy by mopping up huge amounts of dollars from the market. The Federal Reserve (the American central bank) had steadily decreased interest rates to 1%. Low interest rates meant that there was no incentive for Americans to save money. Low interest rates also also meant that they could afford to borrow more and care less. Inevitably, the U.S. dollar sank against the Euro. It seemed initially that the Federal Reserve was trying to support American exporters and hurt Eurozone exporters. Unfortunately for the Federal Reserve, European Central Bank did not blink first. Rising oil prices and mounting deficits had their effect and forced the Federal Reserve to increase interest rates.
Although interest rates have moved up since then, the increases have been very marginal. Yet, it has already started hurting. A record number of American citizens and businesses have filed for bankruptcy. Horrified credit card companies have forced the Bush administration to take steps to make it harder for individuals to declare bankruptcy.
Outside the U.S., the world has started showing signs of shifting away from the dollar. Diversification of foreign exchange reserves is the new mantra. The strongest signal so far has come from the Russian central bank, which openly said it was reducing the shares of dollars in its reserves and increasing the share of Euros. Similar but less clear signals have come from Japan,‡ Korea, and even China.† There is now more than $1.5 trillion of American treasury bonds in the reserves of Asian central banks around the world. Should they move even a small portion of this hoard to the Euro, the U.S. dollar will start to depreciate even faster than it does now. It will also make the recovery of the American economy even harder. Even though the price of oil has increased with the fall of the dollar, many Gulf governments are finding the value of their dollar investments* slide. They might also try to shift trade in crude oil to the Euro. Trade in crude oil is invoiced in U.S. dollars and this is the main reason for its strength and prominence. So, when Iraq threatened to shift to Euro, U.S. President Bush launched a war and occupied that country. The same thing cannot be repeated with every other oil producer, as the American military is already stretched thin (The U.S. has troops stationed in over 120 countries.) and the U.S. government has run up a huge deficit, which is slated balloon uncontrollably in future.
In The Devil’s Dictionary by Ambrose Bierce, an alliance is defined as the
union of two thieves who have their hands so deeply inserted in each other’s pocket they cannot separately plunder a third. The situation with the dollar is similar to that. The fortunes of Japan and China are so deeply wedded to the American economy that they are unlikely to dump the dollar in a flash. But, things are so bad that the dollar will crash even if there is no diversification i.e., it will crash if either central bank stops its purchase of American treasury bonds. Strangely, if the U.S. dollar does crash in the end, the American economy will not be the one that is most affected. Surprised?
When you owe a bank a thousand dollars, the bank owns you. When you owe the bank a billion dollars, you own the bank. If the US Federal Reserve goes bust, then central banks holding American treasury bonds¤ will have no option but to recyle American money into toilet paper, much like what Russia did with the Soviet Rouble. And, we in the Third World have the most to suffer because governments never go bankrupt; they force others into bankruptcy.
UPDATE (11/04/05): I found this article about Jim Rogers in Corporate Dossier of The Economic Times. Rogers is a (former?) associate of George Soros. George Soros is famous for his bet against the British Pound in the early 90s when the Britain had entered the European Exchange Rate Mechanism (ERM). Had the arrangement been successful, Britain would have eventually adopted the Euro. When Britain was forced out of the ERM, Soros supposedly earned $2 billion. While many people remember Soros on this bet, a lesser known fact is that he lost $2 biilion when Russia defaulted on its debts in 1998. He later lost $700 million when he predicted that dotcom stocks would go bust and they failed to do so. He then made huge purchases in the same group of stocks and when the boom eventually did go bust, Soros had lost almost $3 billion. Now, that should have made me think twice before quoting Jim Rogers. Rogers is also an eccentric analyst and many of his world views are a bit bizarre. Anyway, I am going ahead with quoting him, as I had forgotten about the derivatives timebomb in my article. Derivates are complex financial products. They have become extremely controversial after the failures of Long Term Capital Management (LTCM) (run by Nobel Prize winning economists) and the 233-year-old (British) Barings Bank. The Clinton administration took the unusual step of intervening in the market to prevent the LTCM failure from having a cascading effect on the U.S economy.
The American economy may well go down just like the Roman or the British Empire did. America owes to the rest of the world $8 trillion (trillion with a “t” as in tandoori) and it’s a very serious debt.
(Semi-government mortgage) Companies like Fannie Mae and Freddie Mac have over one trillion dollars in debt, and they don’t even know how much debt they have. They have so many derivatives that they don’t know about that too. Companies like GE are carrying on a sham, it’s not a real company — there’s huge financial engineering and the largest bank, JP Morgan Chase, owns trillions and trillions of derivatives and we can have a gigantic debt collapse soon.
The worst-case scenario maybe that we fall into some kind of debt crisis both due to the gigantic foreign debt as well as huge internal debt. I’m not saying that it’s going to happen, but if something precipitates America can go bankrupt very quickly. The currency will lose a whole lot of value, there’ll be exchange control in America and that’ll be very bad for the world.
* – With rising interest rates, General Motors is close to going bust. It has $300 billion in debt. What’s bad for General Motors is bad for America?
p class=”notes”>‡ – On 11/03/05, Japanese Prime Minister Junichiro Koizumi addressing the parliamentary budget committee said “I think that diversification of the reserves is necessary. We should decide what investments are profitable and dependable at the same time.”
† – Ukraine has dropped its dollar peg and has linked its currency to a basket of currencies, which includes the Euro.
¤ – Recently, Indian goverment mooted the idea of using a portion of the forex reserves to fund infrastructure projects. This makes sense because the dollar has lost 30% of its value in the last few years. Alarmed at the prospect of having to pay on its debts, the U.S. government got the International Monetary Fund (IMF) to warn India against tapping the foreign exchange reserves. Rating agency Standard & Poors (S&P) threatened to downgrade India’s investment ratings. Both China and Thailand, which were also thinking along the same lines, have received similar warnings.