Too Big To Fail?

While giant QE programmes have left many analysts speculating about the collapse of the dollar, economic data suggests otherwise

In the 3 month period between March - June in 2020, the Federal Reserve Bank of America printed more money during the early stages of COVID-19 than throughout the global financial crisis of 2008-2012. Marking the largest stimulus programme in its history, the Fed committed over $4 trillion worth of fresh cash into capital markets in response to the pandemic. 
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Such is the scale and ‘limitless’ resources of the US Central Bank that many speculators are now warning of a potential dollar depreciation and risks to inflation should these stimulus programmes continue. Economic theory states that as the money supply increases, the demand for money falls causing a depreciation in the exchange rate and potential currency devaluation. When this happens, imports become more expensive and the result is higher inflation.

Taking the US as an example, its trade balance at the end of 2019 was minus 1.7%. In simple terms the value of its imports exceeded the value of its exports by $47 billion. This isn't a new trend. The US has been running large budget deficits for decades. Applying the above economic theory should result in the US experiencing a currency and inflation crisis. But this is not the case.

High inflation last occurred in the US in the 1970’s when President Nixon severed the dollar’s link to gold, introduced tax cuts, and printed money to finance public projects. Foreign holders of dollars, already sceptical of the dollar’s overvaluation relative to gold, lost confidence in the US economy and began selling the dollar.

The run on the dollar led Nixon to abandon the Bretton Woods Agreement which had been in place since 1944. Under that agreement the dollar was fixed to gold and the other major currencies of the world were fixed to the dollar.

In 1973 when the link to gold was severed, world currencies adopted a floating exchange rate and the dollar lost 30% of its value. In addition to a world oil crisis, a period of high inflation and low growth followed in the US with inflation peaking at 14% in 1980.

Could a similar currency crisis occur in the US in 2020? Despite huge government spending, it's very unlikely. The Fed's stimulus has been primarily targeted at the financial sector and not the real economy. Given the economic fallout from the Coronavirus deflation is more probable than a surge in prices.

The dollar underpins four fifths of global supply chains and two thirds of debt issuance around the world. 70% of foreign currency reserves are denominated in US dollars, hence its status as the world’s reserve currency, or ‘King of Currencies.’

When COVID-19 first broke, world investors flocked to the dollar swopping out bonds in foreign currency. The Australian dollar fell to its lowest point against the dollar since 2002 and the 'cross currency basis’, or swop rate, to exchange Euros for dollars reached its highest point since 2012.

In April, faced with dollar shortages in Latin America and Asia, the Fed intervened by providing emergency credit lines to the emerging markets (EM) and Central Banks of Brazil, Mexico, Philippines and Indonesia. Over $100 billion worth of EM assets were exchanged for dollar denominated securities and bonds.

Since 2014 the US overtook Saudi Arabia and Russia as the largest oil producer in the world. Unlike the 1970’s a spike in world oil prices would have less impact on US inflation today as it can manage its own oil supply. Commentators drawing parallels between two very different points in history might be mistaken in their analysis. The US economy of 2020 cannot be compared to the economy of 40 years ago.

The influence of modern capital markets should not be understated either. The 1980’s marked a watershed moment in US investment banking. The stock market benefited from deregulation, a boom in Mergers and Acquisitions, technological advancements, and global expansion.

Due to increased corporate investment from abroad, and the demand for US treasuries by foreign central banks, net capital flows into the US increased by a multiple of 10 from $1 trillion to $10 trillion between 1990 to 2019.

The New York stock exchange remains the largest stock market in the world accounting for almost 50% ($35 trillion) of all the global stock values.

While US government debt stands at an eye watering $25 trillion, these debts are denominated in US dollars. As the issuer of its own currency the Fed could monetise ('print') the entire national debt away within seconds by the click of a mouse. So long as it has a central bank that can produce dollars, the USA can never go broke.

While many politicians and economists worry about how the US can raise enough taxes to pay for health, education, and housing for example, the truth is the US government doesn't need taxes to pay for public services because it can create money from its central bank. Taxation's role in the economy is to redistribute wealth among Americans and control inflation. This is explained brilliantly by economist, Stephanie Kelton in her book "The Deficit Myth."

US public spending, therefore, is largely achieved by borrowing - issuing US treasuries to foreign and domestic investors. Domestic investors earn interest on the bonds they hold and in doing so, contribute to US net wealth.

Foreign investors, by holding government bonds, provide demand for the US dollar by selling foreign currencies to pay for the US asset (debt). This strengthens the dollar, not weakens it. Large public deficits are not necessarily bad for the US economy.

While the dollar remains a relatively safe store of wealth, the current economic climate provides a challenging environment for investors nonetheless. With interest rates at 0% or negative, investors looking to make gains have been left bereft of meaningful return. Large money printing and quantitative easing (QE) programmes have seen the Fed carrying out Yield Curve Controls by supporting bond prices and reducing yields. The more debt it buys, the higher the demand created for debt, hence the higher price of the bond and the lower the return paid out by the Fed. Central Banks around the world have been carrying out similar programmes. 

The extra liquidity provided by Central Banks explains the recent rallies on Wall Street where, despite data showing large economic contraction, equities and share prices have largely regained their losses from March when the pandemic first hit. Such contradictory data suggests another stock market bubble and a widening of the wealth gap.

Many commentators concerned about future volatility on Wall Street are predicting that China, buoyed by its recent economic expansion, could impose more global dominance as US economic power supposedly wanes. While interest rates in the US are 0% or negative, the Chinese interest rate is 2.5%. In March when markets crashed by 40% on Wall Street, the Chinese bond market rose by 1.3%.

As the US grapples with more economic uncertainty and future waves of the virus seem likely, speculation is intensifying that an increasing number of investors may soon ditch the dollar and chase higher returns in China.

I don't agree. China is highly dependent on a strong dollar for its economic growth. Since its economic transformation over 30 years ago, China has adopted a multi currency bank account system. This means that Chinese exports are invoiced in dollars. For every computer component made in Beijing or Shanghai for example, China receives payment in dollars. Over time the quantity of these dollars has grown exponentially - so much so that China has now become the largest holder of dollars outside of the US. It currently holds over $3 trillion in its reserve account at its Central Bank.

Large dollar reserves allow China to import oil and raw materials from the US using dollars at a lower relative cost than using Yuan because of the exchange rate. Chinese dollar demand is therefore a vital part of its economic strategy and has helped fuel its expansion in recent years.

It is no surprise either, and much to the dismay of President Trump, that China regularly manipulates the exchange rate in its favour by buying dollars in exchange for Yuan on capital markets. By devaluing its currency, China can sell its exports at lower costs to its consumers,  boosting its economic growth. Moreover, devaluing the Yuan has also been used in retaliation to US tariffs imposed on Chinese imports.

The Yuan is therefore a weak currency by global standards, accounting for only 2% of world payments and reserves. In comparison, the dollar makes up almost 70% of global trades. This makes the Yuan unattractive to investors as it limits commercial potential.
From a political standpoint, Chinese totalitarianism and the draconian restrictions it imposes on the movement of information and capital, and its human rights violation under UN law damages investor confidence.

The recent security-laws imposed in Hong Kong has sounded alarm bells across the financial sector and many analysts believe Hong Kong could suffer escalating capital flight. 

Since late 2019 investors in Hong Kong have intensified their swopping of local currency for US dollars. The one-month interbank rate which many Hong Kong mortgages are linked to, is currently 1.7% compared with 2.5% for the equivalent one-month US dollar rate. As a result, more and more speculators are borrowing in Hong Kong dollars (HKD) and selling them for US dollars in order to gain a pickup in the yield. The Hong Kong Central Bank has spent over 80% of its US dollar reserves stemming such outflows and defending its peg to the US dollar. 

Should capital flight continue, an already heavily leveraged economy could be further at risk of default. Private real estate debt to GDP in Hong Kong is a staggering 800%, 200% of which is owed to mainland China. Chinese meddling in ‘domestic’ affairs in Hong Kong is threatening the foundations of a financial system already tethering on the edge of collapse. Viewed from an economic standpoint, further interference from the mainland would seem ill-advised since Hong Kong is China’s second largest export partner behind the US with a 15% share.

Despite suggestions by some that the Chinese economy will avoid the same economic hardships as the rest of the world due to COVID-19, data in March/April show a sharp contraction in output. Overall a 6-10% reduction in Chinese GDP for 2020 is predicted. In May however, and not since 1990 when it first published its goals, the Chinese government refused to publish its growth target for 2020.

The truth is that China depends hugely on the US, its largest export partner, to sustain its economic growth. The 10 year boom period in the US between 2010-2020 helped fuel one of the most impressive economic expansions seen in modern times.

As the economic climate changes however, low US growth is likely to affect Chinese growth. A weak US dollar could damage the economic prospects of the world’s second largest economy. Seen in this context, China’s continued support for the dollar seems very likely. 

​Speculators betting on a dollar crisis any time soon, therefore, may be disappointed. Perhaps - for now - the US is too big to fail.

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