Currencies | Nov 26 2010
By Greg Peel
There is a massive global imbalance between those nations running trade surpluses and those running trade deficits. Trade balances feed into current account balances which stand alongside national budget balances to provide a net balance sheet for an economy. The Australian government, for example, is hoping the commodity export boom will provide an ongoing trade surplus which will feed into the budget (via taxes) and return it to surplus by 2013.
Australia is currently a net exporter but it is the manufacturing nations of Germany, Japan and China for example which account for the greatest trade surpluses, and the excess foreign reserves collected by the big exporters have to be invested somewhere. For decades that “somewhere” has been mostly US Treasury bonds which provide a low but supposedly “risk free” return. The US dollar is, after all, the world's reserve currency and the US is the world's biggest economy which is 70% driven by the consumer. In recent decades US consumption has been a lot more about imports and a lot less about locally produced goods.
It's a symbiotic relationship, given the exporters collect US dollars by selling their products which they then reinvest in US bonds which effectively means they are lending money to Americans to buy more goods. The more goods the US buys the more US dollars are lent back to the US and the more goods they can buy. The system has worked a treat, right up until about three years ago.
America went broke in 1972 and thus the gold standard was abolished and the US economy became a powerhouse built solely on debt that never has been, never will be, and never was intended to be paid back. Instead, the debt is just perennially serviced, thus providing the exporters with a return on their investment. What could possibly go wrong?
Well a plethora of things, but the two that stand out are the relaxation of leverage rules in the US which exponentially multiplied debt obligations and the emergence of China as an export powerhouse fueled by its currency's artificial peg to the US dollar. A global imbalance already existed but the scales were really tipped when China came in and very quickly became America's biggest creditor.
The reason why China is reluctant to revalue its currency too quickly is that it has passed a dangerous point by having hesitated all this time. A currency revaluation means the devaluation of China's US dollar investments, which are massive. The US can bark at China and insist upon revaluation but China holds the draw card because it can just sell its US bonds and kill the US economy in one fell swoop. But if it did sell its US bonds the resultant collapse would wipe out its foreign reserves and the collapse of the US economy means the collapse of China's second largest export market and thus the collapse of its own economy.
Stalemate.
It is this stalemate which has led to the current Currency War. The US has decided to effectively devalue its own currency through QE means and the rest of the world is suffering as a result. There is much bitterness aimed at the US because the US has taken the reserve currency and turned it into Monopoly money. And nearly brought down the world's financial system in the process.
The only option available to the world's surplus nations is to quietly extract themselves from overweighted US dollar investments without setting off any dominoes. To date this has meant diversifying freshly acquired foreign reserves into gold and other currencies (and in China's case in particular, commodities and foreign mining company investment) and ever so quietly reducing existing holdings of US investments if possible.
The problem is, where do you go? The euro became the diversification of choice after the GFC but now that's potentially toast as well. The yen is another alternative, but Japan has been a basket case for decades. Gold investment has become increasingly popular amongst the surplus nations, but gold does not pay an interest rate. Pounds are now too much of a risk, and Swiss francs are only really good for secret bank accounts.
Aside from the legacy export economies of Germany and Japan, and the new powerhouse of China, other emerging nations such as Brazil and Russia have met with the same problem of where to invest, and also how to avoid being caught by a weakening US dollar. The reserve currency is also the world's trade currency, but then it doesn't have to be. To that end, trading partners across the globe can choose to swap their own currencies and thus avoid the US dollar, which they have begun to do, but they still need to do something with the reserves they accumulate.
Russia, through its massive oil and gas exports, now boasts the world's third largest foreign reserve surplus. Not bad for a country that went broke in the nineties and defaulted on its debt .(Ireland take note: there is another option to a bail-out). And like BRIC companions China and Brazil, Russia has been looking to diversify out of its US dollar investments. But it's still a slow process.
In 2006, Russia's reserve investments were split into 50% US dollars, 40% euros, and the balance in pounds and yen. At last count those ratios had shifted to 47% dollars, 41% euros, 10% pounds, 2% yen and the balance in Swiss francs. That's the currency split, but Russia has also been raising its proportion of gold reserves from a very low earlier base.
While subtle, these sort of ratio shifts are becoming common among the surplus nations, and at the same time there is a strong push to oust the US dollar as reserve currency and replace it with an instrument based on a basket of currencies. The IMF already offers such an instrument, albeit only in small volume. America wouldn't have a bar of it of course, as it would further devalue the US dollar and thus devalue America's lifestyle in the process. But in the cold hard light of day, even sensible Americans could see that such a move would help correct the dangerous global trade imbalance.
In the interim, just what sort of secure investment does one enjoy from euros? Or pounds? Or even yen, which Tokyo is busy manipulating? At the heart of all trade on the planet is trade in the raw materials needed to produce goods for sale, and if ever you were looking at what might be a sensible investment, instead of lending more money to nations already seriously in debt, then investing in those nations providing the commodities rather closes the circle in a logical way, as opposed to the current circle of lending more money to those who buy the goods.
To that end, Russia has announced its first, modest foray into Canadian dollar investment. While the initial volumes concerned are not really enough to move the dial, the intention and implications have been enough to send the Loonie, as the Canadian dollar is affectionately know, soaring.
Of course, as Australians well know, a soaring currency is not good news for an export economy. But look out, because Russia has its sights on the Aussie dollar as its next target of foreign reserve investment diversification.
Which begs the question: if other export nations are already starting to trade between themselves in their own currencies, how long will Australia continue to sell all its worldly goods based on US dollar-denominated prices? Trade volumes with the US continue to slip further down the rankings.
