Currencies | Jun 11 2009
By Greg Peel
As the US Treasury put away a US$19bn auction of 10-year bonds last night (See Overnight Report) for a 3.99% yield – a level last seen pre-Lehman – Russia was again stirring the pot of reserve currency substitution. Alexei Ulyukayev, first deputy chairman of Russia’s central bank, Bank Rossii, suggested last night some of Russia’s US$140bn of foreign reserves held in US Treasuries may be moved into newly issued International Monetary Fund bonds instead.
This is the latest service game in a rubber the US Treasury secretary Timothy Geithner no doubt hoped he had brought to a conclusion when he visited China earlier this month. The great reserve currency debate has taken on an air of wartime diplomacy, when rivals meet with hearty handshakes while concealing a knife in the other hand. Only last week Reuters reported an “unnamed source” suggesting that all of the BRICs – Brazil, Russia, India and China – along with Japan and Middle East creditor nations had rallied around to confirm their allegiance to the US dollar as the global reserve currency. The argument was simply that they were all too entrenched in US investment anyway and thus it would only prove an internecine move to start abandoning US bonds.
Geithner returned from China claiming there was enough demand to absorb record sales of US debt, despite Chinese Premier Wen Jiabao having called for the US to “guarantee the safety of China’s assets” back in March. Chinese officials have a habit of individually speaking their minds however, and at the same time Chinese central bank governor Zhou Xiaochuan proposed a a new global currency to reduce reliance on the dollar.
The pot was further stirred by Russian President Dmitry Medvedev earlier this week when an interview aired by CNBC had the Presiident once again talking about the world’s need to expand into more regional reserve currencies in order to balance out the influence of the greenback. In Russia’s case, such a regional reserve currency would at least see the euro and rouble getting together.
And earlier this year China and Brazil reached an agreement for China to fund Brazilian oil development in return for guaranteed oil shipments, transacted only in an exchange of renminbi and real. No reserve currency here please.
In late May, Russia’s finance minister announced Russia would buy US$10bn of IMF bonds. China has pledged US$50bn, and yesterday the Brazilian finance minister chimed in with a US$10bn pledge as well. These are merely pledges to date, because as yet there is no IMF bond – never has been.
The IMF – set up after WWII as part of the Bretton Woods agreement – has always largely been a plaything of the US. As victors over Germany and Japan and creditor to the allies, there was little argument that the US should call the shots and the US dollar become the reserve currency (albeit gold-backed, up until 1972). The role of the IMF is to provide financial assistance to nations in economic difficulty, and as such it has remained a means for the US to control the world while appearing benevolent at the same time.
But since the GFC, the IMF has begun to take on more of a life of its own. Just like the United Nations councils, emerging economies such as China have demanded greater representation. Now it’s the US who has little means with which to argue with one of its biggest creditors.
The IMF long ago established the Special Drawing Rights facility, which was once intended as a reserve currency alternative. The current SDR is a basket of 44% US dollar, 34% euro, 11% pound and 11% yen. Those ratios have occasionally been adjusted over the years, but the constituents have not changed (other than the euro was previously a mix of marks and francs).
The vague intention of the IMF is to issue its first SDR-denominated bonds some time around July. As to whether the make up of the SDR would remain as is, or as to whether the bond might be issued with some new SDR combination (including renminbi, rouble, real, rupee, or anything else?) is not yet certain. Either way, the IMF is supposedly assured of the equivalent of US$70bn worth to start with if the above numbers are reliable. The IMF nevertheless does not intend, at least at the outset, to make IMF bonds available to anyone other than central banks. There will be no secondary market, as there is in US Treasuries, from day one.
One might suggest this is all part of a softly-softly approach of easing away from the US dollar without causing mutual destruction. Even if the BRICs buy IMF bonds as an alternative, at present that would still mean a 44% investment in the dollar. Timothy Giethner put his foot in it earlier in the year (particularly if you’re a staunch Republican) by suggesting such a move was inevitable and probably not such a bad idea. That set the stars and stripes a-quivering.
So what does it all mean? In short, it should mean further weakness in the US dollar. It should mean less money will be lent to the US (or at least a higher rate of interest will be charged) and that will mean Americans simply have to curb their lifestyles. Anyone arguing?
But it will also mean inflation, on the basis that commodities such as oil (which, one might say, is the true reserve currency), which are denominated in US dollars, must rise in price. This is exactly the fear the world has at present, and a significant reason as to why oil is now back over US$70/bbl. In theory, the US dollar should really tank, but on the flipside, as we have seen this week, there are forex traders now buying the US dollar in anticipation the US Federal Reserve will simply be forced to raise its cash rate. The spread between the short end and long end of the US yield curve is as steep as its ever been. This means investments are eroded by inflation.
The Fed is between a rock and a hard place. While chairman Ben Bernanke is convinced there is no inflation risk given the deflationary effect of a global economy struggling to grow at all, he cannot deny that if the world keeps demanding a higher and higher rate of interest to buy US bonds then he will have no choice but to raise rates. That is why Bernanke has recently warned Congress (and implicitly the Obama Administration), that the forecast US$1.75 trillion fiscal deficit the government intends to run in 2009 (it was “only” US$455bn in 2008) in order to prop up the US economy must be reined in as quickly as possible (or we’re all done for, he didn’t add).
From Australia’s point of view, a weaker US dollar will mean higher import an export prices but also a higher Aussie dollar as an offset in either direction. Which begs the question: Why does Australia sell iron ore to China in US dollars? Why not deal direct just like the Chinese and Brazilians. The short answer is because at the moment the greenback is still the reserve currency and there would be a bit of adjustment needed from the Reserve Bank to deal with any shift. The longer answer is we are also one of America’s staunchest allies. We might have a Mandarin-speaking prime minister, but we’ve also just sold Chinalco down the river.
I’m not sure we really know just where we stand at the moment, quite frankly.
