Business Standard, 5 May 2004
One of the most interesting questions facing the world today is what may be called ``the USD problem''. What will happen to the USD and to US interest rates? If large market movements take place, who will be the gainers and losers?
The US today imports capital worth 5.1% of GDP to pay for its fiscal deficit of that exact magnitude. Among the largest suppliers of capital are the governments of China and Japan. As of April, Japanese reserves were at $827 billion and China (+Hong Kong) was at $565 billion.
What is not widely understood is that these countries now have a big stake in the USD. In the bad scenario, the USD will lose value, and US interest rates will go up (i.e. US bond prices would go down). This would inflict pain on the USD securities held by China and Japan.
Normal financial reasoning suggests that the reserves portfolio should be diversified across many currencies, and particularly avoid currencies such as the USD where a large depreciation may be in store.
However, China and Japan have such large holdings of US securities, that they can no longer think like a normal portfolio investor. In a recent paper, Dooley, Landau and Garber argue that these countries are no longer price takers, it is now a strategic game. The size of their holdings has robbed them of room for maneouver. If China and/or Japan sell USD in a normal quest for portfolio diversification, it would set off dramatic events in financial markets all over the world. It would generate large losses and fiscal costs for the two countries, and disrupt their prevailing currency regime.
China and Japan may have once embarked on reserves accumulation in order to "obtain insurance", but they are now riding a tiger. Their situation is that of a large market manipulator, who finds it easy to keep buying on the way up, but finds himself stuck with warehouses overflowing and no easy exit at the top. The situation of China and Japan on USD securities is not unlike that of LTCM in August 1998, where positions have become so large that the flexibility of portfolio management has been lost.
Thus both countries stand to lose by following existing policies, but there is little they can do about it. China and Japan are in `the USD quagmire': It is not easy for them to extricate themselves from this situation.
What impact does this have on the world economy? Given the size of Chinese holdings of US government bonds, and given the role of the Chinese reserves accretion in funding the twin deficits of the US, difficulties in China will spill over into the USD currency and bond markets. Kenneth Rogoff has recently written that if there is a financial crisis in China, the IMF does not command the scale of resources that are required to mount a rescue.
This is a rich and interesting situation, and all kinds of interesting scenarios can be considered. For example, one juicy scenario involves blackmail. China could go up to George W. Bush with a list of demands, backed by a threat to sell $300 billion of US government bonds. This threatened sale of bonds would generate massive financial market turbulence and a rise in US interest rates, which would make it much harder for Mr. Bush to get re-elected in November.
Another fascinating twist on this story is the interplay between China/Japan and US monetary policy. Suppose the US Fed chooses to seek higher interest rates, reflecting the end of recessionary conditions in the US. In this quest, the massive pace of US bond buying by China and Japan, which induces low interest rates, comes in the way.
The impact of a change in private expectations about the USD and US bonds could also be dramatic. The sale of USD by foreign private holders could lead to dollar depreciation. Would Japan and China step in to rescue the USD? If they don't, their wealth declines and their currency regime gets disrupted; if they do, they add to the size of their problem.
It is obviously very difficult to anticipate where this is going, and to accurately describe how the story will unfold. But the underlying tensions are very real. Things that can't go on, don't. The Chinese bubble economy, the US fiscal deficit, the US current account deficit, the Japanese currency manipulation and the reserves accumulation of China and Japan: all these unhappy plot elements are deeply inter-related. A dramatic denouement may take place, which resolves all these problems. This will involve plenty of excitement in finance and macroeconomics. It is important to start envisioning the outlines of that endgame, and to speculate about the identities of the gainers and losers.
What does all this mean for India? Our main goal should be to distance ourselves from the Japan-China-US triad and the USD, so as to minimise the extent to which dramatic events on the USD quagmire can affect us in the future.
Luckily, India's name has not figured in any of the above paragraphs. Our first goal should be to keep it this way, i.e. to avoid the Chinese/Japanese problems of absurd levels of reserves. We are already well past sensible levels of reserves, and our goal should be not to pile on any more. We should never allow our reserves position to become so large that we lose room for maneouver.
Second, RBI did very well in moving away from the USD as the right time, and roughly 50% of reserves are now USD. India should continue to go down this path to much lower USD holdings. Would you hold gold or USD in your portfolio if you knew that their prices were going to fall? While China and Japan have holdings which are so large that such rebalancing is not possible, India faces no such constraint. Barry Eichengreen has argued that smaller economies still have the scope to diversify without any serious problems. We can dump the hot potato and the trapped Japanese/Chinese will probably buy up our holdings.
The third element of an Indian response is to shift NRI deposits to being Euro denominated. The Euro and the GBP are currently a safe harbour: currencies which are not direct participants in the USD quagmire, and backed by sound economic institutions who do not engage in market manipulation. We should constantly find ways of delinking ourselves from the USD and using EUR/GBP instead.
The fourth element of an Indian response is either move to a floating exchange rate, or atleast to shift away from pegging to the USD to pegging to a basket. In recent months there is evidence of a retreat from the traditional tight narrow band of 10-15 paisa per day. A further increase in the width of the band, and a shift away from the USD as the target currency, will set the stage for shedding our excess baggage of reserves.
The author is at NCAER. These are her personal views.
Ila Patnaik
ipatnaik at ncaer dot org