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The Coming Currency Crisis

Chart 5 shows foreign holdings of US investments. The numbers are enormous. Japan alone has bet over $1 trillion on the dollar’s ability to hold its value. That’s enough to breed uneasiness in any portfolio manager. And the numbers keep growing because the US keeps importing goods by the boatload and paying with dollar-denominated IOUs. The breaking point is getting closer at a rate of $2 billion per day.

(Click on image to enlarge)

Relying on the Kindness of Foreigners… Who Hate Us?

The great irony is that the US is counting on foreigners to invest $2 billion per day… at a time when we are not winning many hearts and minds abroad. The counterproductive and unwinnable war in Iraq is just the unhappiest part of the current picture. Among other reasons why hatred for Americans is rising are:

  1. We maintain military bases that locals don’t welcome, and not just in Islamic countries. Many Germans feel that their country is still occupied after a war that ended before they were born. The US keeps troops in over 130 countries, where most people are no happier to see them than Americans would be to see Russian or Iraqi soldiers shopping at their hometown WalMart.
  2. The US earnestly attempts to impose government-issued “American values” on others. Bush says he wants to democratize Iraq – with no regard for whether the Iraqis want to be “democratized” or not and with no thought to what actual practice will slither out of the slogan. We chastise others, including China, about their human rights record, but our words now appear hypocritical given the heavy-handed US occupation of Iraq and the indefensible existence of the Guantanamo gulag.
  3. The US helps governments run by dictators and murderers stay in power, and surviving victims remember. They won’t forget that Saddam Hussein was once an ally. Iranians who hate Americans don’t do so because they hate Calvin Klein underwear, but because they felt oppressed by our former protégé, the Shah. The same goes for many current US allies in “the ‘stans,” the most noticeable recent example being Vice President Cheney’s trip to Kazakhstan to cozy up with that country’s ruling despot. The pattern long held true in Latin America; the effectiveness of anti-American political rhetoric for politicians like Chavez, Morales, and their ilk should come as no surprise.
  4. We talk about freedom and free trade, but the threat of massive violence seems to be the main tool of our diplomacy, and US subsidies for farmers don’t provide much of a free-trade lesson to Third-World farmers.

In short, the American global cop, far from harvesting the gratitude of a world made safer, is perceived as a hypocritical and plundering thug – hardly the sort of thing that makes foreigners line up to invest in America.

US heavy-handedness abroad and the ill will it inspires are dangerous for many reasons, including their effect on the US dollar. War in Iraq and saber-rattling over Iran are driving the price of the oil and other imports up in the US, which increases the trade deficit, which adds to the pile of dollar-denominated IOUs held by foreigners. And the same belligerence confirms in many Middle-Eastern minds that the US is driven by an anti-Islamic agenda. It gives them a non-financial motive for embracing alternatives to the dollar: the euro, the yen – anything not made in the US. Other foreigners see the belligerence as more evidence that the US government is a reckless spender and heedless of the consequences of its growing debt.

When the Drums Stop

The foreigners who hold all those dollars are getting restless. Chart 6 below shows recent changes in foreign holdings of US Treasury securities. The pattern is shifting.

(Click on image to enlarge)

It is striking that, in keeping with its official statements, Japan (the largest foreign holder of US Treasuries) has indeed begun lightening its load of American paper. This is not an “if” or a “maybe,” but a real and very significant shift… happening now.

Other changes are happening, not major dollar dumping yet, but rumbling. Look at the UK bar – it has more than made up for Japan’s negative number in recent months. That’s interesting in and of itself – why the UK?

The UK, like Luxembourg and the Cayman Islands, two other major sources of US debt buying, is a financial way station for international transactions – particularly from the Middle East. We suspect that the spike in UK purchases reflects a desire by investors in the Middle East to avoid dealing directly with the US – Arabs with a lot of oil money who don’t want their US-based assets exposed to rising anti-Muslim sentiment, for example – but who are not yet ready to dump the dollar altogether. It’s an important sign. It indicates a shift in the attitude of the most sophisticated elements of the Muslim world away from thinking of the US as a financial safe haven.

And there’s more. Consider this statement from Mr. Yu Yongding, an official of the People’s Bank of China:

Regarding the need for China to reduce its holdings of US dollar reserves: Firstly, in the first stage we must reduce accumulation, then later we should reduce our reserves… [China and Asian countries] don’t need that large an amount, more than $2 trillion, of foreign exchange reserves… Then, all East Asian countries have tremendous foreign exchange reserves and they all want to get rid of them, but if you do this then you cause competitive devaluation, not of their own currencies, but of the US dollar. So we should do this in an orderly fashion. If Asian countries moved too fast, everyone would lose… It would be utterly unfortunate if Japan sells a proportion [of their reserves] that causes problems. Then China panics and China sells a proportion – it would be very damaging.

Mr. Yu articulates the anxiety shared by other central banks: a desire to unload excess, overvalued dollars that is checked by the fear of triggering a cascading fall in the dollar. They won’t tolerate life in this box forever. All it will take is for one central bank’s governing body to get spooked, to decide that it had better get out of the dollar before everyone else does. The stampede will be unstoppable, and the dollar’s foreign exchange value will tumble.

Where will all that money go? The euro? The yuan? The ruble? The one thing that seems certain to us is that a significant fraction will go into gold, not only as an investment but as a means of wealth protection. Just a few days ago, Mr. Yu was quoted in the press saying: “We need to use some of the reserves to buy other assets such as gold and strategic resources such as oil.”

We don’t know which central bank will be the first to tiptoe toward the exit or when it will try. The process may already have begun. But we do know that important changes are already taking place among US trading partners. The US government’s daydream of spending its way to prosperity may not last the year.

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