Reassessing the Reserve Currency Status of the USD
March 31, 2008
By Stephen Jen | London
Summary and Conclusions
Potentially questionable US economic and foreign policies may have hurt the dollar’s attractiveness as an international store of value. However, the dollar’s dominant role as an international unit of account and medium of exchange is well-preserved, in our view. In assessing the merit of the dollar as the dominant international currency, it is important to distinguish between these three uses of international money. We believe that the emergence of SWFs (sovereign wealth funds) may further erode the lead of the dollar as the hegemonic international reserve currency. In the long run, the most likely contender to the USD as the dominant international reserve currency, in our opinion, is likely to be an Asian currency centred on the Chinese RMB. But this risk may be several decades away, we suspect. International Uses of Money With the narrow and broad dollar indices at their record lows, investors may now wonder if the dollar will soon lose its reserve currency status. But we caution against confusing the international role of the dollar as the supreme store of value with its two other roles – as the dominant international unit of account and medium of exchange. These latter two functions of an international currency do not change abruptly and are supported by increasing returns to scale. It will take a long time to supplant the dollar as a reserve currency, though we concede that the dollar’s lead over other currencies is shrinking (see Should Asia Hold EUR Reserves, October 17, 2002). The core of our thought process is a conceptual framework that highlights these three distinct uses of international money. (To our knowledge, the basic framework was first introduced by Peter Kenen (1983). A version of this was also presented in Pollard (1998), The Role of the Euro as an International Currency, NY Fed.) Essentially, there are three uses of money: (1) unit of account; (2) medium of exchange; and (3) store of value. This is what we learned in Econ 101. But in the context of international monies, we need to consider these three uses of money from the perspectives of both the official and the private sectors. 1. Unit of account. From the perspective of the official sector, a country uses an international money as a unit of international account when it pegs to such an international currency. On the other hand, from the perspective of the private sector, an international currency is used as a unit of account in cross-border trades in goods and services, as they are often priced, invoiced and settled in currencies other than those of the two trading countries (e.g., trade between Argentina and Thailand being priced in USD). (Trade between EM economies tends to be invoiced almost fully in USD or EUR. But trade between industrial and developing countries tends to be priced in the currency of the industrial country or the USD or the EUR.) 2. Medium of exchange. International monies are also held by both the official and private sectors for ‘settlement’ purposes. For the official sector, a key reason for holding a certain international currency is for intervention purposes. For countries that are pegged to a certain international currency, usually the intervention currency is the anchor currency and so, naturally, the central bank of the pegging country warehouses most of its reserves in this anchor currency. For the private sector, a certain international currency is preferred to others because exchange rates are quoted in bilateral terms and one particular bilateral exchange rate is almost always significantly more liquid than others. For example, it is cheaper to convert KRW into ZAR through the dollar. The dollar, thus, is the medium of exchange through its role as the ‘vehicle’ currency, and the private sector holds these ‘vehicle’ currencies because of their convenience of use. 3. Store of value. Preserving and enhancing the value of the reserves and private portfolios are important to the official and the private sector, which tend not to hoard international currencies that don’t hold their value over time or are volatile. The Dollar Has Retained Some, Not All, the Qualities Essentially, the dollar still retains its qualities in the first two uses of money – unit of account and medium of exchange – but appears to be a poor store of value. Here are some specific thoughts we have: First, we don’t take seriously the threat that some oil exporters will soon price and invoice their exports in EUR or RUB, instead of USD. In our view, the dollar will remain the most efficient unit of account for many internationally traded commodities. Many of the key commodity exchanges are physically located in the US. It makes little sense for individual oil exporters to unilaterally change their pricing menu to any other currency. Also, pricing and invoicing oil should not materially alter what oil exporters do with the receipts, at least in the short run. Many oil exporters have most of their external debt denominated in USD, mainly because oil prices are in USD. There will, thus, be a great deal of ‘stickiness’ in currency denomination in commodities. (In general, a change in the invoicing currency for commodities will have little effect, except that the exchange rate risk to US importers will increase, while that for EMU importers will fall.) The dollar will reign as the dominant currency in trade in commodities, in our view. Also, ‘South-to-South’, i.e., EM to EM, trade will likely mostly be priced in USD. While the liquidity and reputation of many EM currencies have significantly improved in recent years, it may take many years before Korea will accept THB in its trade with Thailand. (According to Goldberg and Tille (2008), Macroeconomic Interdependence and the International Role of the Dollar, NBER 13820, 66-85% of AXJ’s exports and imports are invoiced in dollars. Roughly a third of EMU’s exports are invoiced in dollars.) Second, the dollar’s role as the medium of exchange is well preserved, in our view. More than half of the bilateral pegs in the world are still referencing the USD. While the number of pegged regimes is declining, this is due more to these countries’ need for independent monetary policies, than to the USD pegs being replaced by EUR or other pegs. Further, the dollar remains the main intervention currency even for most countries that are not pegged to the USD (e.g., Japan). As long as the dollar is still the intervention currency of choice, central banks will need to keep the bulk of their official reserves in USD. At the same time, with the exception of the European currencies, almost all the bilateral exchange rates are priced against the dollar. As trade globalisation and financial globalisation accelerate, these USD-crosses – ‘paths of least resistance’ – should become even more efficient. The dollar, therefore, may have even enhanced its vehicle currency status, in our view. The analogy is the use of English language. One need not debate whether this is the best language in the world; the more people speak it, the more it will be used. However, the dollar has a major problem as a store of value. Reflecting the still-large US C/A deficit and the financial crisis in the US, the dollar has obviously become unattractive as a store of value. (Similarly, the poor economic performance of the US in the mid-1970s and late 1980s contributed to both the weakness in the dollar as well as its declining reserve currency status during those periods. However, in both cases, the dollar eventually recovered its reserve status.) The main argument for investors not to sell the dollar now is that it already appears extremely under-valued, measured by many valuation models, including our own. Having said this, however, it is important to note that these policy and macro problems can be fixed, and a flexible economy such as that of the US should be able to re-orient itself. At the same time, what is almost not reversible, in our view, is the structural improvement in the economic and institutional fundamentals of many EM countries. To some extent, the rest of the world has copied and improved upon the American model. It is now up to the US to restructure itself to compete in a more competitive world. Other Thoughts on the USD as a Reserve Currency Here are some additional considerations: 1. SWFs may further erode the USD’s hegemony. The roles of the unit of account and medium of exchange don’t matter to most SWFs, but the store of value is all-important. To the extent that official foreign currency holdings are transformed from official reserves to SWFs, the support for USD as a reserve currency may be further eroded. 2. The weaker form of ‘Bretton Woods II’ is still dollar-supportive, though its strong form may be USD-negative. BWII is more famous than our own ‘de facto dollar zone’ idea (see A De-Facto Dollar Zone, May 13, 2003). However, there is a major conceptual difference between these two models that really matters now. Our ‘de facto dollar zone’ idea is not built on the framework of currency pegs to the dollar. Rather, it is built on the notion of convertibility, i.e., as long as currencies are not fully convertible, even if they are no longer pegged to the dollar, they will still be reliant on the dollar, thereby forming a ‘dollar zone’. The act of de-pegging from the USD itself is not automatically dollar-negative, simply because most of the international transactions will still be conducted through the dollar. This applies to most Asian countries, Latin American countries and the GCC economies. 3. Asset diversification. It is well known that US real money accounts have been major currency diversifiers since 2003 (see The Real Diversifiers Are American, Not Asian, May 18, 2006), and that several Asian countries have also begun to reduce their financial ‘home bias’. What is less well known is the fact that other countries and regions have done less diversifying. We will elaborate on this point in a forthcoming note, but for now, we point out that just as asynchronous diversification drove down the EUR in 2000-01, it is artificially depressing the value of the USD now, making it look like it is more unloved than it actually is. Replacement for the USD Given the advantages of being an incumbent, we believe that it will be extremely difficult for any currency to supplant the dollar’s role as the dominant international reserve currency. Not only will another country or a currency area need to significantly surpass the US, both economically and financially, we believe that the US will need to make some serious policy mistakes for it to relinquish the dollar’s lead. The EUR is clearly the first challenge the dollar has faced since surpassing the GBP after WWII. However, our guess is that only China, or an Asian economy/monetary union, has a good chance at becoming significantly bigger than the US. The size, depth and liquidity of the financial markets are key pre-requisites for a dominant reserve currency. This is one key reason why the EUR has gained market share. But we do not believe that the EUR, with its well-known structural issues, will be able to overcome the incumbency advantage of the USD. Bottom Line In our view, the dollar has well-retained its international roles as the unit of account and medium of exchange. However, its status as an international store of value has deteriorated significantly. The emergence of SWFs will accelerate this process. However, it may be premature to jump to the conclusion that the USD will lose its reserve currency status. The USD’s incumbency advantages are almost insurmountable for the EUR, but perhaps not for an Asian currency centred on China.
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Spending SWF Money
March 31, 2008
By Stephen Jen | London
Summary and Conclusions SWFs (sovereign wealth funds) are meant to be spent, eventually. Since countries have varying levels of demand for new infrastructure and other types of public spending, governments with SWFs have to balance the trade-off between spending some of the SWF money early (now) or later (in future generations). The social welfare and economic benefits generated from spending US$1 billion today on infrastructure or healthcare need to be traded off against investing that US$1 billion in foreign financial assets, and this proposition is different for different countries. In this note, we present some of the key considerations for investors in thinking about this issue. Economic Impact of SWFs Much has been written about SWFs. One reason why SWFs are such a hot topic now is that they are related to many other important structural trends. The causes of SWFs are structural in nature: i.e., financial globalisation, demographic pressures, a revolution in wealth creation and the rise of emerging powers have all helped to propel the emergence of SWFs. The effects of SWFs are also multi-dimensional. We have written about the financial impact of SWFs, out-sourcing, their portfolio construction and the controversial subject of financial protectionism. The focus of this note is on the last ‘effect’: the economic impact of SWFs. SWFs are meant to be spent, either for the current population or for future generations, and how they are invested and managed should be a function of the ‘opportunity costs’ of not spending the money now on physical investments. Some countries have a more urgent need for tapping these resources today than others. For example, the likes of Russia, Saudi Arabia, Brazil and India have legitimate needs for significantly more spending on infrastructure to enhance the overall efficiency and diversification of the economy. The recurrent and lasting benefits of significant spending today could easily be justified in some cases, assuming that the government has the capacity to implement these projects efficiently. At the same time, countries like Norway, Japan, Korea and Singapore already have fairly good infrastructure and therefore investing in overseas financial assets through SWFs, so that their future generations can decide on how to spend the wealth, is quite clearly preferable. Moreover, while there is a need for significant spending – relative to the size of the economies – on infrastructural investments, the smaller GCC (Gulf Cooperation Council) countries will still have the bulk of their oil export earnings available to be invested in foreign financial assets. We calculate that roughly 90% of the energy export receipts of the GCC countries will not be spent (see A Petrodollar Tsunami Warning, February 21, 2008). According to the IMF, on average, through 2005, oil exporters used close to half of the additional fiscal oil revenue to increase non-oil primary spending and/or lower non-oil primary revenues (see The Role of Fiscal Institutions in Managing the Oil Revenue Boom, IMF, Fiscal Affairs Department, March 5, 2007). Meanwhile, with oil prices having risen substantially further since 2005, fiscal spending in these countries may be lower as a percentage of total oil revenues, but has risen further in absolute terms. In any case, the key point here is that investors should, in addition to focusing only on the cumulative recurring investments of SWFs, also start contemplating how some countries may start to tap their SWFs to support their budgets. Here are some key considerations in thinking about this issue: • Consideration 1. Three distinct types of external surpluses. SWFs and official foreign reserves are derived from balance of payments (BoP) surpluses. However, as highlighted by D.Y. Park (see Spending Reserves on Domestic Projects: Macroeconomic Implications, Asian Development Bank, 2007), it is important to distinguish three types of external surpluses: Type 1 surpluses are current account (C/A) surpluses based on commodities exports (e.g., GCC countries, Norway and Russia in recent years); Type 2 surpluses are based on non-commodity exports (e.g., most Asian countries); and Type 3 surpluses reflect primarily capital inflows (e.g., India and what Russia may look like in coming years). In thinking about tapping these SWFs/official reserves, governments should consider the durability of these types of inflows. Type 1 surpluses should be relatively predictable and long-lasting. Most GCC countries, for example, are expected to remain large energy exporters for the next 70-100 years or so. Type 2 surpluses, however, could be relatively variable in terms of durability. (Nevertheless, they still reflect savings surpluses that allow the country in question to increase its claims on foreign assets.) For example, Korea’s external balance experienced tremendous changes in the past 15 years. (Prior to the Asian Crisis in 1997/98, Korea ran a small (1-2% GDP) C/A deficit. While its C/A position surged into a sharp surplus after the Crisis (11.6% in 1998), Korea’s C/A balance deteriorated steadily and is about to show a deficit in 2008.) Also, even though Russia (as a large oil and gas exporter) has enjoyed significant C/A surpluses in recent years (exceeding 10% of GDP in recent years), with the rapid increase in imports, its C/A surplus is projected to become a deficit within three years. Finally, the Type 3 surplus is the least ‘dependable’, as capital inflows could suddenly reverse if foreign investor sentiment changes. The external surpluses of India and Russia, for example, are increasingly dominated by net capital flows. India, in fact, runs a C/A deficit (2.1% in 2007), in contrast to the other BRIC countries. Thus, whether official reserves or SWFs should be spent is a function of the durability and the ‘reversibility’ of the surpluses. For countries with Type 3 surpluses, official reserves will need to be kept high and in liquid assets to guard against ‘sudden stops’ in capital inflows or even a reversal, as we witnessed in Thailand in 1997. • Consideration 2. ‘Fiscal reserves’ versus ‘central bank reserves’. Park (2007) also highlighted a point that we believe is important. Whether official foreign assets should be spent for domestic purposes also depends on whether they reflect sovereign resources the government in question can spend without incurring additional debt; these are considered ‘fiscal reserves’. This is Type 1, as the C/A surplus reflects a genuine increase in financial wealth on the balance sheet of the government. (Conceptually, selling crude oil and buying financial assets is a ‘conversion’ from one type to another type of assets (see GCC: Transforming Oil into Financial Wealth, November 15, 2007). Also, in principle, the wealth belongs to the general public, not the government.) Increases in official reserves from a Type 2 surplus, however, reflect a simultaneous increase in domestic public liabilities (the debt issued to finance the currency interventions) and assets. (However, the investment returns and valuation changes on the foreign exchange holdings are ‘fiscal reserves’, not ‘central bank reserves’, for the purpose of this discussion.) In other words, the rise in official reserves arising from trade in merchandise exports reflects more a genuine wealth creation by the private sector; through interventions, the public sector merely takes on a currency risk, with no net gains in wealth. This, in fact, is one of the main objections that Japan’s Ministry of Finance has to endorsing the proposal to form a SWF out of the reserves it holds. (Whether Japan should form its own SWF and whether Japan should spend its reserves on domestic projects, however, are two separate issues.) Also, spending official reserves for domestic purposes has implications for the exchange rate. Thus, from this perspective, only the reserves/SWFs derived from a Type 1 surplus should be allowed to be spent on domestic projects. Also, only a Type 1 surplus should be invested in riskier assets, while Type 2 and Type 3 surpluses should be managed more conservatively, and in liquid forms, from an ALM (assets-liabilities management) perspective. • Consideration 3. Trade-offs between inflation today and disinflation tomorrow. There is much talk about whether it is demand or supply that is behind the inflationary pressures in countries that face infrastructural constraints (e.g., Saudi Arabia, the UAE and Russia), and that rising inflation argues for more public spending on infrastructure. Public spending on infrastructure is inflationary today (it adds to demand growth through investment), but disinflationary tomorrow (it could enhance the economy’s potential growth rate). The issue, of course, is that not all governments are able to execute these major infrastructural projects efficiently, and that the ‘temporary’ inflationary pressures could turn out to be less temporary than planned, and the efficiency gains less than originally envisaged. But if we set aside the issue of governance and efficiency of public spending, inflationary pressures should be positive for the currencies in question, in the short run, as interest rate and exchange rate policies should be expected to change to counteract the inflationary pressures. Over time, as potential growth and productivity are enhanced, the currency should strengthen as well. Bottom Line SWF money is meant to be spent. Some countries may want to spend it today, while others have the luxury of saving it for the future generations. In this note, we propose some key considerations to keep in mind when thinking about this issue, as spending SWF or reserve money on domestic projects has implications for inflation, the exchange rate and potential growth. Further, depending on the source of the external surplus, some of the reserves/SWFs should not be spent at all, or invested in particularly risky or illiquid assets.
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No Recession in Sight, but CAD Could Be at Risk
March 31, 2008
By Charles St-Arnaud | London
Summary and Conclusions The Canadian economic slowdown will likely be deeper and longer than previously thought. The recession in the US, coupled with weaker growth elsewhere, will likely mean that the drag coming from exports will persist for longer than expected. In addition, continued pressures in the financing market have increased the cost of borrowing for corporations and consumers, while some confidence effects will moderate domestic demand from the current strong level going forward. With slower growth, continued financial market frictions and low inflation, the Bank of Canada will likely continue to cut rates aggressively, and I expect a 50bp cut at the April 22 meeting. In the medium term, I see some risks that USD/CAD will move sharply higher following a USD appreciation, coupled with lower commodity prices. State of the Canadian Market The latest GDP figures confirm that the Canadian economy is in fact a two-faced economy. On one side, you have weak external demand and the strong Canadian dollar putting a drag on the economy. On the other side, you have a very buoyant domestic economy supported by the strong labour market, increased purchasing power coming from the past appreciation of the currency and strong income growth. However, I now expect the slowdown to be deeper and the rebound to be very gradual. Our US economics team now expects the recovery from the recession to be more gradual than before. In addition, forecast updates from other members of our global economics team point to weaker global growth for 2008. With exports representing about 35% of GDP, this will likely put a further drag on Canadian exports and the economy in 2008. On the domestic front, I continue to see consumer spending moderating more than previously expected, but still remaining solid. The combination of a strong labour market and high income growth will continue to provide support. However, continued fears that the recession in the US will spread to the Canadian economy, continued job losses in the manufacturing and export sectors (that could spread to other sectors of the economy) and persistent pressures in the financial markets (that limit the availability of consumer credit) are all factors that could dampen consumer confidence and lower spending more than previously expected. Business investments are also expected to moderate as the slowing economy will likely erode profits, while the pressures in the financial market increase the cost of borrowing. Spreads between corporate bonds and government bonds have increased dramatically over the past few months and are now at high levels. However, lower-rated corporations have been hit the hardest by the rising cost of borrowing, while highly-rated corporations still seem to be able to find financing at a reasonable price. This is, in part, a much-needed repricing of risk, but much of the movement is also a reflection of liquidity problems. All this will likely dampen business investment going forward. Overall, the Canadian economy should grow by 1.2% in 2008 and 1.9% in 2009, in my view, compared to 1.7% and 2.6% previously. (Some of the downward revision to growth in 2008 comes from the weaker-than-expected GDP growth in 4Q07.) I expect growth to be weaker throughout 2008 and the rebound to be in early 2009 instead of 2H08. As a result of weaker growth, inflation will likely be lower in 2009, in my view. In the context of slower global and Canadian growth, an uncertain global outlook, lower inflationary pressures and continued financial market turbulence, I believe that the Bank of Canada will continue to cut rates aggressively. I now expect the BoC to cut rates by 50bp at the April meeting and by 25bp at the subsequent meetings, reaching a level of 2.75% in 2Q. I also expect the BoC to continue to provide liquidity to the market via normal and term purchase and resale agreements. I have warned in the past that the BoC may have to reverse some of the cuts sooner rather than later, but this has now been pushed to early 2009. Risks There continues to be a lot of uncertainty regarding the economic outlook. On the upside, domestic demand could remain more resilient, supported by strong income growth, a solid labour market and the stronger purchasing power coming from past CAD appreciation. On the downside, a longer and more prolonged US recession and weaker global growth are the main risks. In addition, continued financial market stress could impact Canadian growth as credit availability is reduced and its cost increased. Commodities and Risks for the CAD In this section, I want to highlight some risks for the Canadian dollar going forward. Over the past four months, USD/CAD has traded in a tight range, between 0.98 and 1.03. The lack of direction can be explained by the tug of war between record-high commodity prices and broad-based USD weakness on one side and the uncertain outlook for Canada, given the spillovers from the US recession, on the other. This could change rapidly, as seen briefly last week, when USD/CAD gained more than 3% in two days. Since the USD started its gradual depreciation in 2001, there seems to have been a very tight relationship between the declining USD and rising commodity prices. Judging by this relationship, it seems that part of the increase in commodity prices may be linked to the numeraire effect, not just strong demand and tight supply. In this context, the Canadian dollar is vulnerable over the medium term, in my view. The expected USD rebound later this year will likely be broad-based, and we will likely see USD/CAD move higher as a result. In addition, given the relationship presented previously, an appreciating USD could mean weaker commodity prices. Given the very strong link between the CAD and commodity prices, this would put further upward pressure on USD/CAD. Further, according to our fair value models, USD/CAD is currently undervalued, which should support the move. Therefore, USD/CAD is at risk of moving sharply higher. This is, in part, what happened last week, when USD/CAD gained more than 3% in two days. I agree with our strategy team, which is recommending a long USD/CAD position partly on these arguments. This depreciation of the Canadian dollar and lower commodity prices would have diverse economic impacts. On the upside, a weaker currency could help to stimulate exports and restrain imports, moderating the drag to the economy coming from the external sector. On the downside, weaker commodity prices would reverse part of the terms-of-trade gains Canada has enjoyed over the past years, and this could dampen income growth and consumer spending in Canada if the move is sustained for a period of time.
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