Triffin's Dilemma: The 2014 Edition
What does it mean to be the world’s reserve currency?
Everbank’s Chuck Butler sums it up nicely in the following quote:
“Remember, the country with the reserve currency gets to receive loans at discounted borrowing costs. Also, commodities are priced in the reserve currency, meaning central banks around the world must hold the currency in their reserves to facilitate trade.”
“Trading nations need dollars to lubricate trading and as foreign exchange reserves that bolster the value of their own currency and provide the asset base for the expansion of credit within their own nation”
Many different currencies have held reserve status throughout history.
This is important to note because it goes to show that, just like everything else, reserve currency status doesn’t last forever.
At present, the US dollar is the world’s main reserve currency.
That status has been a gift for the US: it has allowed it to run a deficit in perpetuity.
But it has also been a curse:
“The demand for safe assets feeds tha t exorbitant privilege enjoyed by the United States. This contributes to a weakening of US policy discipline as the country tends to excessively rely on easy credit in normal times and very expansionary macroeconomic policies in times of crisis. The outcome is excessive US indebtedness. The corporate sector was in debt prior to the burst of the dot-com bubble in 2001; so were the household and financial sectors before the eruption of the sub-prime crisis in 2007-08; and the official sector is in debt today.”
Let’s assume for a moment that the US recovers, the dollar appreciates in value relative to other currencies, the trade deficit shrinks, and QE comes to end.
That all sounds good, right? Yes, but maybe not for other countries – specifically those with current account deficits.
The end of easy money and artificially low interest rates will not bode well for the emerging markets.
The “faulty five” – aka the “BI ITS” – Brazil, India, Indonesia, Turkey and South Africa are particularly vulnerable because they rely on external financing to operate.
A stronger USD has multiple negative implications for their economies.
Before we continue let’s introduce the idea of Triffin’s Dilemma.
And now for a bit of history:
“Prior to the 1944 Bretton Woods agreement, central banks used gold as the asset to back their currencies. By the end of World War I I , the United States had established itself as the world’s creditor and largest holders of gold. Under the 1 944 Bretton Woods agreement, the US Dollar was fully backed by gold at a fixed value of 1 /35th an ounce per dollar, and foreign Central Banks could use US Dollar assets as reserves backing their currency, in lieu of gold. This agreement avoided the inevitable deflationary pressure a return to pre-war gold/currency ratios would have forced just as Europe was beginning to rebuild, and allowed US debt held abroad to be used as an asset by central banks against their local currencies. (- Zero Hedge)
After WW I I , America was the only industrialized country still intact. Through the Marshall Plan and rebuilding Japan and later South Korea, America was lending huge amounts of dollars to other countries, which in turn were used to collateralize their own currencies. America was able to run huge trade surpluses and our economy was booming. But, then Triffin’s Dilemma came into play. The demand for dollars around the world exceeded America’s ability to back it with gold. Those sneaky folks at the Federal Reserve printed more dollars anyway. And, when other countries figured out what was happening there was a run on America’s gold reserves and so President Richard Nixon had no choice but to stop backing the dollar with gold. However, the dollar remained the world’s reserve currency because of the size and strength of the US economy. ” (Source)
Despite the fact the US dollar is still the world’s reserve currency, “The IMS [international monetary system] is not in a better situation today. The quandary under the BW system – the lack of a credible anchor for international monetary and financial stability – continues to exist. Key issuers and holders of reserve currencies pursue domestic objectives independently of what would best serve the global system and even their longer-run interest. To the extent that these policies pay insufficient attention to negative externalities for other countries and longer-term macroeconomic and financial stability concerns, they tend to produce unsustainable imbalances and fuel vulnerability in the global financial system. In particular, a large body of literature supports the view that a worldwide glut of both liquidity and planned savings over investment – stemming from, respectively, reserve-issuing and reserve- accumulating economies – was a key driver of the hazardous environment at the root of the global financial and economic crisis which broke out in summer 2007” (Source)
Will Triffin’s dilemma be relevant again in 2014 and going forward? Many people believe that it will.
The US is now producing a lot more energy and importing a lot less - on a net basis.
This is causing their trade deficit – which has been negative for the better part of 50 years – to shrink.
If we think of the trade balance as part of the supply of US dollars then – as a result of the dollar’s world reserve currency status – a reduction in the trade deficit means fewer US dollars leaving the country.
This has implications for other countries because they use USDs to buy US assets and for reserves.
Triffin’s Dilemma is that the country that issues the world’s reserve currency will have to choose between:
1 ) running a trade deficit in perpetuity - risking of a loss of confidence in its currency and solvency while the rest of the world enjoys an adequate supply of USDs.
2) running a trade surplus and enjoying an appreciation in the value of the dollar while the rest of the world suffers from a lack of liquidity and collateral.
Either way, there are negative implications for world growth. In the first example – in which the US runs a trade deficit in perpetuity – the US continues to add to its debt and risks undermining its ability to pay off that debt. In the second example – in which the US runs a trade surplus – emerging market currencies are put under pressure by the USD potentially leading to capital outflows, a higher cost of debt, and global financial instability.
When Bernanke first mentioned the possibility of a reduction in asset purchases in May of 2013, emerging market currencies – in particular the BIITS – sold off in a big way.
At the same time, GDP forecasts for the emerging markets (started to get) (were) revised downwards.
That was the tell.
What I mean is that that’s when we first got a glimpse of what would happen if and when this giant monetary experiment came to an end.
In other words, the end of easy money isn’t going to be easy.
If emerging market currencies continue to depreciate then the relative value of the cash flows of companies that operate within those countries will fall.
In that case, it’s likely that net capital outflows from those markets would continue.
This flight of capital could force emerging market countries to increase their interest rates in an attempt to remain competitive for acquiring external financing.
With more money going towards interest payments, growth will be limited even further. What’s more is that an increase in the relative value of the USD will cause the price of imports, financial assets, and external debt to rise in local currency terms.
Lastly, and arguably most importantly, a smaller trade deficit or trade surplus will result in a reduction in foreign exchange reserves held at emerging market central banks.
As those banks use their dollar reserves to buy back their domestic currencies in an effort to curb inflation they will 1 ) reduce their ability to “protect” their currency in the future and 2) reduce the asset base against which bank reserves are backed.
In conclusion, the falling trade deficit in the US is likely to increase the relative value of the dollar.
If, in addition to an improving balance of trade, the fed continues to taper its asset purchases, then it’s likely that emerging market currencies and ETFs will face increasingly negative pressures.
Basically, there is no easy way out of this giant moral hazard driven debt bubble that the world’s central banks, and in particular the fed, have created.
I am hoping for the best but I’m not sure how this will play out. The entire world is in way over its head in debt...
And somehow, whether it’s deliberate or forced, we need to get rid of it all.
What used to be known as the business cycle – i.e. a cycle wherein a period of expansion is followed by a recession which cleanses the system of malinvestment – doesn’t exist anymore. Currently, the entire economic system is centrally planned. Instead of letting the nature run its course, the world’s “best and brightest” minds in economics – the central bankers – have decided to try and outsmart it. I f the US continues to operate without regard to the effects on the rest of the world, then world growth will be negatively affected.
Triffin’s dilemma: the 201 4 edition might turn out to be a prime example of the negative consequences of keeping money too easy for too long – i.e. suppressing interest rates and monetizing deficits. Unfortunately, policies that were intended to “smooth out” the economic cycle have only resulted in bigger booms and busts.
Someone’s going to be left holding the bag. Try not to let it be you.