In Asian Currencies We Trust

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In Asian currencies we trust


MICHAEL PREISS

On the back of the US dollar it says; "In God We Trust". Trust in the US dollar, however, is increasingly being shaken by a fiscally irresponsible American government. Recently, news that the US government reached the $7.384 trillion legal limit on how much it can borrow had forced the Bush administration to shuffle funds among accounts and suspend some intra-government payments was not widely reported.

Nevertheless, every investor should pay attention to this and think of the long-term consequences and what it means for your portfolio and net worth, which most people still tend to calculate in US dollars.

The Congressional Budget Office said last month that the deficit was likely to be $415 billion in fiscal year 2004, which ended on Sept 30. That exceeded last year's $374-billion shortfall, the previous record in dollar terms. The debt ceiling covers about $3.5 trillion in publicly traded Treasury securities (more than 51% owned by Japan and Chinese investors alone), plus savings bonds and borrowings from the Social Security trust funds and government pension funds.

Congress set the first debt ceiling of $11.5 billion in 1917. It crossed the $1-trillion mark in 1981. While the US Treasury must sell debt to fund government operations until taxes are received, the rising deficit is forcing the Bush administration to ask that the limit be hiked for a third time in less than four years.

Federal Reserve chairman Alan Greenspan and US Treasury Secretary John Snow have both called in the past for Congress to eliminate the debt ceiling, noting lawmakers determine the amount of debt that must be sold when they approve government spending measures. By any account the US debt levels are unsustainable and one day sooner or later the day of reckoning will come.

Asian central banks led by The People's Bank of China, through the Asian Bond Market Initiative, are co-ordinating how best to diversify out of the dollar. They have become the marginal buyers, or de facto buyers of last resort, of excess US dollar balances in the global economy. Without these purchases, the dollar would be much lower in value versus Asian currencies and US interest rates would be much higher.

This is a potential nightmare scenario for any US administration. John Kerry raised this very sensitive political issue of how much the US depends on Asian creditor nations during his election campaign, very much to the displeasure of the incumbent President George W. Bush.

Global imbalances including the US current account deficit pose a risk to world economic growth and prosperity. Most of the imbalances are concentrated in the external account of the United States. Deficits observed in the mid 1980s led to a significant correction of the dollar.

This time, the magnitude of the problem is so much larger and if market sentiment for a weak dollar increases, there would be a rush to convert dollars into other assets and that could impair the inner workings of the international financial system. Hence, the need to expedite the Asian Bond Market Initiative.

In the meantime, something has got to give and the most elegant solution to China's complex economic challenges is to let the currency appreciate. Asian currencies including the Thai baht, Singapore dollar, new Taiwan dollar, Korean won and Japanese yen should all benefit from this and appreciate in line with the yuan. Once China lets its currency adjust, Malaysia is expected to follow suit and abolish the currency peg to the US dollar.

Especially if oil prices continue to stay at current levels or even rise further, Asian central banks will allow their currencies to appreciate and the soft-dollar block will dismantle.

Rising currencies would reduce the extent to which Asian economies are importing oil-related inflation. And inflation is one of the key challenges facing Asian' economies, foremost China.

I believe the Fed knows that real interest rates should be 2% at this stage of the business cycle, not zero/negative as they are now. This is why gold and commodities have soared in value as the capital markets reflect an extremely expansive monetary policy and the dollar has started to weaken again in earnest. The Fed will tighten in November, in December and several times in 2005. So I expect short-term dollar rates will rise above 3% when this interest rate cycle peaks.

Therefore, I believe the long Treasury bond is irrationally expensive at a mere 4%. With a rising inflation risk, a US trade deficit out of control, potential fiscal gridlock in Washington and a fragile dollar once China revalues, the risks in the US bond market and the dollar are rising exponentially. The US debt markets live in a fool's paradise. Put options on the Chicago long T-bond futures contract never looked so attractive to me.

So while you anxiously follow the outcome of the US presidential election, in order to stay Ahead of the Curve, do not lose sight of the economic realities that all signals seem to point to this: higher US interest rates, renewed dollar weakness and a subsequent rise of Asian currencies.

Michael Preiss is a Research Fellow with the Asian Bond Market Forum and a guest lecturer at the Graduate School of the People's Bank of China. He can be reached at: Michael@michaelpreiss.net