On Tuesday of this week, China and Russia, during their bilateral trade talks, agreed to drop the dollar as their medium of exchange in favor of their own currencies. Is this simply a matter of two countries recognizing the importance of one another in their trade regimes, a matter of practicality with regard to settling transactions, or is there a deeper, more disturbing significance to this development?
The U.S. dollar has long been the reserve currency, meaning that countries around the globe have used the U.S. dollar as a store of value and a medium of exchange. With the mind-numbing progression of measures undertaken by the Fed and Treasury to stimulate the economy and stop the financial crisis from become contagion—spreading all over the planet and destroying the global financial system, the dollar may have lost its luster. The most recent round of quantitative easing, which is estimated (so far) to amount to $600 billion, underscores the continuing pressure that the dollar is suffering. Quantitative easing, in simple terms, is printing money to buy securities, such as treasuries and mortgage-backed securities, to pump cash into the economy and thereby stimulate growth. The downside is that when you print currency, you devalue it—more supply equals a lower price.
While all I have written above is true in a theoretical sense (all other things being equal), in the real world, things are not so clear-cut. For example, even though we are printing money and thereby pressuring the dollar’s value, other countries are doing the same or similar things that also put pressure on their currencies. Then there is the all important perception factor, meaning that people’s perceptions of what is happening within a given country have a direct and significant impact on the value of that country’s currency. For example, if people believe that a country is a bad place to keep their money, they will sell that country’s currency and buy the currency of another country—one that they feel is safer. We are seeing this in Ireland today—people are afraid that their debt is going to overwhelm the government, and that they will be forced to restructure their sovereign debt. Many investors are not comfortable with this risk, and so they are selling Irish debt and moving their money elsewhere. Perception becomes reality and currency values adjust.
Keep in mind also that anytime we discuss the value of any currency and state that it is strong or weak, we are making a comparison to another currency. In fact, a given currency can be at once strong and weak—the dollar may be strong against the yuan and weak against the pound sterling. These interrelationships are critical because they are the foundation for international trade and for many of the decisions international investors make—an international investor may think investing in a country is attractive, but may refrain from making the investment if he or she feels that the currency will fall in value against their home currency.
Recently, at the G20 meeting, China and Germany took the lead in criticizing the Fed’s current policies. Just this week, the Fed announced a revision of their 2011 economic outlook, stating that they now believe that economic growth in the U.S. throughout 2011 will be slower than anticipated (readers may recall that I have been stating for many months that although we are in a recovery, I believe that the recovery will be very anemic.) As a result, we can expect the Fed to not only keep short-term interest rates low, but to also support additional stimulus measures, including more quantitative easing. Some economists have estimated that it will take as much as $2 trillion of additional quantitative easing to support a recovery in the U.S. (far more than the $600 billion currently on the table).
China made a number of significant economic and political announcements over the past few weeks. The People’s Bank of China hiked deposit and lending rates by a quarter of a percent on October 19, the first rate increase since December 2007. On October 20, third-quarter 2010 figures were released, which showed economic growth may be easing. The economy expanded at a 9.6 percent vs. 10.3 percent in the previous quarter. Their inflation rate is estimated to be 4.4%, and their target inflation rate is 5.56% (so they are willing to accept even more growth and inflation).
The most frequently mentioned potential problem for the Chinese economy is the property bubble. Property prices have risen remarkably since 2008, primarily in residential real estate, in major Chinese cities. Ironically this is the time when our real estate market began its collapse. Prices for new apartments in Beijing and Shanghai rose between 50 and 60 percent in 2009 alone. The types of financing options, such as negative amortization products or no money down loans, that helped bring down the U.S. property market are not available in China. The degree to which you can get into trouble as a real estate investor when you pay cash is far different than when you put no cash down. Approximately 25 percent of home purchases in China are all-cash deals. Furthermore, there is a requirement to put a minimum of 30 percent of the purchase price down in cash on a first home larger than 970 square feet and 20 percent down on smaller homes. It would appear that, although their real estate market is expanding rapidly, they do not face the same threat of complete financial meltdown that we experienced in the West.
China’s long-term economic success will depend largely on their ability to transition from an export-driven economy to a more balanced economy with domestic consumption. The Chinese central government has issued a series of five-year plans over the last several decades. The new five-year plan puts a high priority on increasing domestic consumption. There is a large number of companies in China waiting for regulatory approval from the China Securities Regulatory Commission to launch an initial public offering (IPO), many of which are consumer products companies. The government, following their five-year plan, may fast-track some of these businesses, supporting a more rapid development for the domestic consumer segment of the Chinese economy. Additionally, the government may remove some regulatory barriers to allowing outside consumer-based companies, including those from the U.S. and Western Europe to operate more freely in the Chinese market, even in smaller cities.
The ongoing growth and prosperity of China could bode well for the U.S. dollar, in that, at least so far, the Chinese have been happy to own dollar-denominated assets, including about $2 trillion in U.S. treasuries. We are certainly highly dependent on this funding source, to support our ongoing government spending needs, and to service our rapidly expanding debt ($13 trillion and counting). It remains to be seen if the recent bilateral trade agreement between Russia and China, which includes dropping the dollar, will be a precursor to more significant global trade issues. With all that is occurring in Europe, especially with the massive debt woes of Ireland, Greece, Portugal, Spain and others, the dollar will remain a relatively safe place to store value. However, in the longer-term, we will face serious inflationary pressures which could significantly devalue the dollar, which could send the Chinese (and everyone else) scrambling to dump dollars in favor of other currencies.