China planning to accumulate strategic oil reserves in four locations

Section:

Eventual lunch bill may spell end to dollar's dominance

By Gary Duncan
The Times, London
Monday, October 11, 2004

http://business.timesonline.co.uk/article/0,,16849-1303426,00.html

Imagine a place where you could spend far more than
you earned for years without consequence. Imagine a
place where you could pay your way by writing
cheques that nobody would bother to cash.

Welcome to America, today.

Over the past decade or more, the United States has
been living far beyond even the vast means commanded
by the world's largest economy. America's households
have spent far more than they earn, borrowing
extravagantly against the rising value of their homes
and other assets. The U.S. government has been no
less profligate, dramatically increasing spending while
making hefty cuts in taxes.

The consequences have been predictable. Over the past
five years, America's national spending has outstripped
its income by more than a fifth, leading to a rising tide
of red ink. In little more than a decade, the United
States has become the world's biggest debtor. America
now runs an annual current account deficit approaching 6
percent of GDP, or more than $660 billion (370 billion),
while its government's borrowing this financial year is
heading for a record $422 billion.

All of this has been made possible by confidence in the
continuing outperformance of the U.S. economy and its
financial assets, and the unprecedented willingness of
foreigners to accept vast piles of American IOUs in the
form of dollar holdings and U.S. Treasury bonds --
effectively, cheques that go uncashed. And the keystone
supporting the weight of this system has been the dollar's
dominant status as the world's international reserve
currency -- a status now seen as being under threat.

Over a decade, the proportion of U.S. government debt
held overseas has more than doubled from 20 percent to
about 45 percent. Underpinning this massive expansion
of overseas borrowing has been an inadvertent and
undeclared currency pact between America and Asian
economies.

Desperate to prevent their currencies rising against the
dollar and undercutting their booming exports to the
United States, Asian nations have bought up billions of
dollars and U.S. Treasury bonds to shore up America's
greenback and keep their exchange rates pegged
against it. The accidental quid pro quo has been that
Asia has been able to continue to keep selling its goods
to Americans at highly competitive exchange rates, while
America has been able to run up ever-increasing debts
to pay for them -- helpfully financed by the Asian central
banks.

Asia's huge appetite for American assets to maintain its
currency parities with the dollar has sustained heavy
demand for U.S. Treasury bonds. In turn, this has kept
U.S. market interest rates remarkably low, at levels of 5
percent or less, even as America's debts have ballooned.

As Niall Ferguson, the economic historian, has remarked,
this looks like "the biggest free lunch in modern economic
history." He and others have compared this
Asian-American dollar area to a reincarnation of the
post-war Bretton Woods system of largely fixed exchange
rates. Taking in China, Japan, and other Asian states, this
dollar-dependent zone accounts for more than half of the
world's GDP.

The trillion-dollar question is, of course, whether America
can continue to dine out at the expense of its Asian
neighbours.

For optimists, the answer remains a resounding yes. This
confidence is based on the belief that the U.S. economy
will continue to outstrip its rivals, preserving the
attractiveness of its assets, while Asia's central banks
will continue to snap up dollars and Treasury bonds, backed
by the unlimited finance of their own printing presses.

But just as Bretton Woods I collapsed in the early 1970s,
a growing number of commentators believe that the
present "Bretton Woods II" will ultimately collapse under
the weight of the burgeoning imbalances it has
institutionalised. As ever, what looked like a economic
free lunch will emerge as a mirage.

No one can predict with certainty if or when the edifice
will crumble, but it seems more and more inevitable that,
sooner or later, it will. Already, a reviving Japan has
abandoned efforts to restrain a rise in the yen, removing
one key prop for the system. Perversely, Washington
seems intent on kicking away another, persisting in its
efforts to persuade Beijing to scrap its currency's dollar
peg and revalue the yuan.

Only last week President Bush was on the telephone to
Beijing, pressing his Chinese counterpart on the yuan
issue. Yet, as Avinash Persaud, the leading currency
economist, suggested in a speech last Thursday, a
yuan revaluation, or even the first steps toward one,
could prove the catalyst for collapse of "Bretton Woods
II," and a period of economic trauma for America.

There can be little question of the intensely painful
implications for the United States should the present
Asian-American equilibrium unravel rapidly. A sharp
fall in the dollar and the U.S. bond market would
simultaneously stoke inflation and drive up market
interest rates. And as Professors Persaud and
Ferguson, as well as others, have argued, such as
scenario could well spell the beginning of the end for
the dollar as the world's reserve currency. Without
that status, America could face an avalanche of
uncashed Asian IOUs, and U.S. interest rates could
be pushed much higher, with horrible repercussions
for America's heavily indebted Treasury and
households.

This frightening prospect raises a fascinating and
fundamental question: Which rival might take the dollar's
place as the world's dominant currency? For Ferguson,
the euro is the strongest candidate, not least since
more international bonds are already issued in euros
than in dollars. However, the euro's claim could be
hindered by the eurozone's persistent failure to foster
strong growth.

Instead, Persaud argues provocatively that the dollar
will be displaced by the yuan as China's economy
overtakes America's in coming decades.

It is a tantalising prospect, although one that will
depend on China's ability to preserve political stability
as its prosperity grows. However, it is not impossible
that, in our lifetimes, markets will hang not on the words
of Alan Greenspan or his successor but on those of the
chairman of China's central bank.

The implications of such a shift would be truly seismic.

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