Must Read: When Reality Meets Fiction
Submitted by Nic Lenoir of ICAP
Everyone who grew up watching James Bond must have had a kick reading the news last night or this morning, and finding out about secret meetings between China, Russia, Gulf countries, France, and Brazil, plotting to organize the demise of the US dollar. Unlike in Goldfinger, the villains this time weren't planning to plant a bomb in Fort Knox, but rather stop using the greenback, and instead price currencies against a basket of currencies composed of (drums please): the yuan, the ruble, a newly created Arab currency, the euro, the yen, and gold. I don't remember reading the Brazilian real but we could throw it in there so we don't hurt anybody's feelings.
Let's be serious. Russia was inches from begging the IMF for money last fall. The Yuan is not freely tradable and money supply in China is growing at twice the pace at which it is growing in the US, the UK, or Europe. The Chinese government actually believes the acronym GDP stands for printing money to buy commodities. The Euro has shown how using a single currency for a set of different economies is extremely difficult to manage. Spain and Ireland used the euro to fuel (or extend) bubbles before completely collapsing in near-depression. Setting appropriate rates is very difficult and there is little doubt that if more Eastern European countries get integrated the problem will be magnified, as these countries will jump on the opportunity to become centers of production, and this time they will be protected under the same exchange rate regime as the rest of the EU, unlike last fall where many of them almost went bankrupt. Then comes the Yen, it has been used as part of jokes involving gazillions in several Hollywood comedies over the past 20 years but other than that it has mainly fueled every carry trade before the USD joined it.
Honestly people need to think really hard before they start discussing a new world reserve currency or other options of the sort to replace the USD. Every currency needs to be associated with an interest rate regime, which takes you back to the problem discussed before regarding the Euro. All you will achieve with a unique currency is kill any cost of production differences across the countries adopting the new currency, and align everybody on a single living standard benchmark. With different currencies, if producing abroad is cheaper a country will import, and with a negative balance of payments the currencies will adjust to reflect, thereby smoothing out the process. Eliminate foreign exchange as your equalizer and all you will have is the alignment of everybody's living standard on that of Chinese farmers. That's not even discussing bubbles that could be formed by having a standard rate curve for everybody under that new currency. Imagine if Brazilians could borrow at 0% instead of 10%? Would the Bovespa be only up 4 folds since 2000? I think not. The second issue is liquidity management. While recently it seems the method applied has been a ruthless flooding of the markets with liquidity, it remains that overall the Fed has an unmatched expertise when it comes to managing liquidity. It took all that experience and an incredible arsenal of innovative tools to insure there would not be a run on a bank last year. Managing a central bank on a more global level would be almost impossible.
Certainly many countries are concerned about using the USD as the reserve currency, and when the market for funding became tight last year many of them were afraid of going bankrupt... but it was mainly because they were short USD. Let's be very clear, if you borrow a currency and it suddenly appreciates you are in trouble. That will be true even if you used gold or copper as your benchmark. If suddenly the price of copper rose sharply and a country has some debt to refinance in copper or gold, things will be difficult. It's easy for countries whose currency don't inspire any confidence to borrow in dollars and then complain. Maybe managing their finances and currency differently would allow them to sell bonds in their local currency. After all with Turkey's CDS at an all time low, there is risk appetite for emerging anything so that financing in local currencies should be possible.
And if you decided to use a precious metal as your new currency, wouldn't there be a huge political risk with all the producing countries. Maybe it's worth going through the list of gold producing countries and make sure there are no surprises... Having unstable countries control a vital resource is dangerous, this is nothing new, and that has been a problem with oil in the past, a more serious problem than the USD can potentially be I might add. It is ironical to have countries manipulating their currencies turn around and complain about the dollar because our finances are not in order. It is reminiscent of having Lybia or Iran complain about the lack of democracy at the UN. It certainly is a fair attempt at using our politically correctness against us, but it cannot be answered seriously. Our finances are not in order, we know that, but no one is really in a position of giving lessons on the subject right now. We have an imperfect system for world trade, but it took us far and it's the best option for now, so let's not mistake misplaced malicious regional interests for inevitable future consequences, and let's have a proper open reflection on the subject.
Good luck trading,