Comment 52: The pulse of globalization (1) From sovereign wealth funds to currency wars
Sovereign wealth funds are investment vehicles owned by various governments in lieu of official foreign currency reserves. As the size of such funds grows their financial and political influences have become hot topics among monetary and economic policy makers as well as in political circles. Some estimate that the aggregated size of sovereign wealth funds will reach 2.4 billion dollars at the end of 2007, and will reach more than 10 trillion dollars by 2015. Simply looking at the official foreign currency reserves will not be sufficient to understand the global financial influences of various governments. Unfortunately the operations of sovereign wealth funds are shrouded in mystery, not like official foreign currency reserves that are tabulated and published openly. The secrecy is actually the selling point of sovereign wealth funds. For example, a large sovereign wealth fund has recently provided capital for a large US bank that has been clobbered by the subprime mortgage woes. This move of the sovereign wealth fund is welcomed by politicians, economists, financial market observers and market participants alike as if the arrival of a financial messiah, and had triggered a sharp stock market rally. If not for the existence of such a sovereign wealth fund, the foreign government needs to invest directly from its foreign currency reserve. A strong commotion will be stirred among the US public from the fear of the nationalization of the bank, by a foreign government in this case, though the actual effect of the investment from the sovereign wealth fund or from the official foreign currency reserve makes little difference.
Let us first examine some statistics about sovereign wealth funds and official foreign currency reserves. Since many aspects of sovereign wealth funds are not well known, private estimates need to be used in this discussion. We rely on the estimate by Morgan Stanley quoted in a May 24, 2007 article of “Economist” as our source. The largest sovereign wealth fund is owned by the government of The United Arab Emirates with the inception year of 1976. The fund is estimated to have an asset of 875 billion dollars, whereas the official foreign currency reserve of The United Arab Emirates is only about 26 billion dollars at the end of 2006. Similarly the oil rich Saudi Arabia has a sovereign wealth fund valued at 300 billion dollars, but its official foreign currency reserve is only 25 billion dollars as of April 2007. Singapore has two long running sovereign wealth funds with combined assets of about 430 billion dollars and an official foreign currency reserve of 152 billion dollars as of September 2007.
Total amount of foreign currency reserves of the whole world is about 6.6 trillion dollars. At the end of 2006, 66% of the total foreign currency reserves of the world was held in US Dollar, and 25% in Euro. It is interesting to note that Japanese Yen is not very visible as official foreign currency reserves. This is due to Japanese Government's persistent policy of maintaining more than 100 billion dollar trade surplus per year so that any yen released to other countries will be quickly reabsorbed into Japan. The largest foreign currency reserve is held by the mainland China, about 1.4 trillion dollars, followed by Japan's 950 billion dollar reserve. Many governments have bought large sums of US dollars from the open currency markets in order to keep their currency weak against US Dollar so that their exporters can continue to export to the US. This kind of practices has swelled the foreign currency reserves of those governments and has been the main cause of the runaway US trade deficits. US Government has not only tolerated such currency market manipulations, but have often encouraged such manipulations under the catch phrase of the “strong dollar policy”.
Some readers may wonder why US Government tolerates such currency manipulations and the runaway trade deficit. A group of clever economists have realized that trade deficits can play the role of personal savings as the seed money to financial markets. Financial markets use the seed money to lend out repeatedly to increase the total amount of debt to many times of the seed money. The whole economy thus runs on the expanding debt. With the runaway trade deficits US consumers do not need to save anything to lubricate the economy, and can spend all their earnings to boost the consumption and the GDP. This is a typical script to borrow from foreigners and spend as prescribed by the promoters of the globalization scheme. As trade deficit expands, labor intensive manufacturing jobs and entry level high tech jobs are outsourced to developing countries that are exporting extensively to the US. However, the massive imports of inexpensive consumer goods suppress inflation and allow The Federal Reserve Board (abbreviated as FED) to maintain low interest rates for a long period. The consumption boom from zero saving and the stretched period of low inflation and low interest rates cause the creation of many service jobs. Thus the duration of economic booms is prolonged to an unprecedented level. On the other side of the ledger, developing countries import knowhow and capital to produce inexpensive consumer goods to be exported to the US, based on their very low cost labor reserve and free to pollute environment. Following this script, the developing countries are able to transfer their under utilized labor resource into productive use. As an enormous amount of dollars from capital inflow and trade surplus floods into those developing societies, their governments buy up those dollars in order to maintain their currencies at the substantially undervalued level vs. US Dollar so that their exporters can continue to export to the US. When a government of a developing country buys up a large amount of dollars to swell its foreign currency reserve, it must release the matching amount of the local currency into its own financial system, and thus creates an enormous liquidity bubble. This liquidity bubble then induces runaway construction booms and pushes economic growth to near 10% per year or even higher. To the eyes of unsuspecting observers, such an explosive economic growth indeed looks like a “miracle”. This globalization scheme has been pushed strongly by the Reagan administration in 1980's and the promotion has been followed up by all US administrations since that time.
The island of Taiwan with a moderate population was the pioneer to use the script provided by the globalization scheme to climb up the economic ladder rapidly, so we call this development model, “Taiwan model” (see Comment 39 for details). As the manufacturing costs rose in Taiwan, waves after waves of “Taiwan merchants” have migrated into the mainland China, carrying with them their entire businesses and capital. Thus China has been transformed rapidly into the consumer-goods factory of the world, and has been exporting heavily to the US. Other Southeastern Asian countries follow this development model, too, but South Korea and India adopt the variations of the “Taiwan model” respectively. There are also many on the US side who have benefited handsomely from the globalization scheme. Incumbent politicians are big winners. Riding on the prosperities brought on by the runaway trade deficit, they win reelections easily. Another huge winner is the Wall Street and US financial institutions. As the returning dollars from the runaway trade deficits and the money generated by the resulting liquidity bubbles pass through their hands, the Wall Street and the US financial institutions and their workers have become enormously rich; as the consequence, the city of New York and the surrounding area also profited substantially. California ports have prospered from the torrent of imports from Asia-Pacific region, and the housing prices in California went through the roof thanks to the waves of cash flowing in from Asia, first from Hong Kong, Singapore and Taiwan, then from China. In general the industrial heartland of the US are the biggest losers as manufacturing jobs disappear fast. High level managements of large corporations are still another group of big winners. As those corporations shut down their manufacturing and computer-software facilities in the US and move them to Asia, their profit margins improve. The Wall Street, flushed with cash from the liquidity bubble, then bid up the prices of the stocks of those corporations to stratosphere; the high level managements of those corporations make outrageous gains through stock option plans. The coalition of economists, politicians, businessmen, the Wall Street, and the regional winners like New York and California upheld the globalization scheme as the holy-grail, and routinely denounces anyone who casts a critical eye on the scheme as “protectionists”. Thus the globalization scheme has dominated the world for more than two decades.
Reading the analysis presented in this comment so far, many readers will question naturally when such a system based on the vastly inflated dollar and the runaway trade imbalance will crumble. The visible signs of cracks developing in the foundation of this globalization scheme is reported here, and the danger that rapidly expanding sovereign wealth funds will pose on the system is analyzed in the next section.
Some general patterns can be deciphered from the intertwined relations between US Dollar and the US trade deficit as follows:
(1)US trade deficit will shrink or its growth stagnate two to three years after a sharp drop of US Dollar, whereas the US trade deficit will expand rapidly two to three years after a strong dollar rally.
(2)When US trade deficit starts to shrink or its growth stagnates, US Dollar will rise, whereas US Dollar will fall when the US trade deficit expands rapidly.
Of course, there are other factors that will move the dollar and they are listed below:
(3) A sovereign government can artificially suppress the value of its own currency or slow down the natural rising trend of its currency against foreign currencies, since the government can always issue as many of its own currency as necessarily and dump them on the open currency markets to buy foreign currencies. However, it is usually difficult for a government to lift artificially the value of its currency or to slow down the depreciating home currency since it needs to buy up its own currency by dumping a large number of foreign currencies that most likely it does not have.
(4) Large interest rate gaps between two countries can influence the relative values of their currencies. A good example is the exchange rate between US Dollar and Japanese Yen. Japan's near-zero interest rate policy adopted in the middle of 1995 had widened the interest rate gap with the US substantially, and had pushed up the value of Dollar vs. Yen rapidly by unleashing the tsunami of yen carry trades. There are other numerous examples of this sort.
(5) US Dollar can collapse under its own weight when it is inflated too much. The collapses of Dollar in 1998 and 1999 serve as good examples. Those two sharp drops of Dollar were due to the spread of Asian currency crises to Russia and Latin America respectively. Asian currency crises were the result of unwise pegs to the high flying Dollar that was pushed up by the near-zero interest rate policy of Japan as discussed already in (4).
In the spring of 2002 US Dollar started its long slide. From the beginning of 2005 the growth of US trade deficit started to slow down, and since the end of 2005 US trade deficit has stopped to grow at all. Measured from the broad trade weighted dollar index compiled by FED, US Dollar made a small bounce in 2005 and has resumed its fall since the end of 2005. According to the trade deficit weighted dollar index compiled in article 9, US Dollar only stagnated through 2005 and then resumed its fall on the face of stagnating US trade deficit. Among major currencies Dollar only rallied vs. Yen from the middle of 2004 to the middle of 2007 as FED raised short-term interest rates many times. However, Dollar has fallen vs. Yen, too, as the financial panic sets in and FED has started its interest rate lowering campaign since the summer of 2007. Presently Dollar is falling against, Euro, Chinese Yuan and Japanese Yen, three major currencies of the world. This, of course, makes both the trade deficit weighted dollar index and the trade weighted dollar index to fall with accelerated speed. According to category (1) mentioned previously US trade deficit will turn in time from stagnation to an outright decline. Since US prosperity has been the result of the liquidity bubble created by the runaway trade deficits, the stagnation of the trade deficit since the end of 2005 has started to deflate the liquidity bubble, and has caused both the current liquidity squeeze and the financial crises as discussed in Comment 46. If FED keeps lowering interest rates to counter the liquidity squeeze and to try to re-inflate the liquidity bubble, US Dollar will fall more viciously. Thus US trade deficit will continue to shrink and the liquidity squeeze will last far beyond 2010.
The category (2) is violated as US Dollar has failed to rally on the face of stagnating US trade deficit since the end of 2005. The currency market is viewing the US trade deficit too large to sustain, and is demanding a substantially lower dollar to correct the problem, no matter how painful the correction process may be for the global economy and especially for the US economy.
Sensing the market consensus that the dollar's sharp drop is inevitable, large holders of dollar denominated foreign currency reserves, China and Japan, must be very anxious about the situation. Their first concern is quite obvious. As Dollar falls big, their dollar holdings will lose substantial amount of values. The arguments why the governments hold such large losing dollar positions will rage among their politicians and citizens. Their second concern will be about the shrinkage of US trade deficit or its stagnation. Why China should be anxious about this aspect is apparent, considering very large trade surplus of China against the US. Japan is using exports to prop up its economic growth at the time when its consumer spending is lagging for more than a decade. Though Japan's direct trade surplus with the US is capped, indirectly Japan's overall trade surplus relies heavily on the US trade deficit. For example, Japan has a hefty trade surplus with Taiwan, and Taiwan has a large trade surplus with the mainland China. If China's trade surplus with the US weakens, Japan will feel the heat, too.
Let us first consider how China and Japan will cope with the problem of shrinking US trade deficit. To analyze this issue we need to look into the movements of currencies since the middle of 2005 when China has started its gradual revaluation of Yuan under heavy pressures from outside. From June 2005 to November 2007, Chinese Yuan had appreciated 11,5% against US Dollar, Japanese Yen has depreciated 2.1% vs. US Dollar, and Euro has appreciated 20.8% vs. US Dollar. This means that both Yuan and Yen have depreciated substantially against Euro. As China's trade surplus with the US is leveling off, China's trade surplus with the Euro region is surging rapidly. Thus for China and Japan to solve the problem of declining US trade deficit is to push up Euro and export massively to the Euro region.
To address the problem of the massive dollar holdings as US Dollar tumbles, China and Japan have no choice but to divest from dollar denominated assets in order to minimize their losses. The tool of divesting dollar denominated assets will be none other than the secretive sovereign wealth funds. The largest holders of dollar assets, China and Japan, will not openly run away from US Dollar in their official foreign currency reserves, otherwise US Dollar will collapse totally, bringing down with it the global financial system aka the house of cards of the derivatives, and the globalization scheme itself will be wiped out. China has already established a 200 billion dollar sovereign wealth fund, and Japan is contemplating to launch a 100 billion dollar sovereign wealth fund. The aim of those funds is to gain higher profits than the official foreign currency reserves at the time of falling US Dollar. Where should they invest? For Japan the logical destination is Euro denominated assets, since China does not allow foreigners to buy Yuan at open currency markets. The logical destination for the China's sovereign wealth fund will be both Euro and Yen denominated assets. As the action of China's fund pushes up Yen, Japanese Government will undoubtedly issue large amount of yen to buy up Euro in order to suppress the value of yen as it used to do with US Dollar. From two front attacks, that is, from China and Japan, Euro will appreciate even more rapidly. Such surging Euro will suit China and Japan fine since they can shift their massive exports toward the Euro region even more easily.
If sovereign wealth funds of China and Japan indeed divest from US Dollar and rush into Euro, US Dollar's demise will accelerate, the liquidity squeeze will intensify further, and the US economy will slide into a prolonged recession, though US trade deficit will disappear fast. What will the Euro region do as its trade deficit skyrockets, the result of the surging Euro? The Euro region at that time will be experiencing a liquidity bubble generated by the runaway trade deficit just as the US has experienced. It will be very difficult for the European Central Bank to lower interest rates in order to weaken Euro, since lower interest rates will act as pouring oil on the fire of inflating liquidity bubble. Of course, the Euro region can abandon the globalization and the free trade, and start to impose import quotas as it is used to do. Baring from such drastic steps, The European Central Bank can issue a vast amount of Euro to buy up US Dollar and Japanese Yen and at the same time launches an all out attack on China to force it to open up the Yuan market so that The European Central Bank can buy Yuan, too. Thus a fierce currency war will erupt with China, Japan and the Euro region hitting each other hard and accusing others of manipulating the currency markets. What will be the end result of such outpouring of open hostilities? Probably the globalization scheme will be scrapped eventually, and everyone will reestablish trade barriers just like in the old days.