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Faith in dollar keeps US going

July 29, 2008 10:22 IST

On October 30, 1938, the American radio drama series Mercury Theatre aired The War of the Worlds, directed by Orson Welles. Adapted from H G Wells' novel, the first half of the broadcast was scripted as a series of dramatic news bulletins of a Martian invasion.

Listeners who had missed or ignored the opening credits assumed that the invasion was real. People fled their homes. Police phones were swamped by panicked calls.

Today the financial equivalent of this broadcast would be the announcement: "We interrupt regular programming to announce that the United States of America has defaulted on its debt!"

Lenders to the US government have suffered significant losses. The losses have not been from non-payment but because repayments have been in a constantly debased currency -- the dollar.

Assume a Japanese investor bought 30-year US Treasury bond in 1985 when the $/yen exchange rate was $1 = Yen 250. Based on a current exchange rate of $1 = Yen 105, the investor has lost 58 per cent of the investment.

European investors who bought US government bonds in recent years would have also suffered significant losses. Based on the highest $/Euro exchange rate (Euro1 = $ 0.85) and the current trading levels (Euro1 = $ 1.56), the investor would have lost (up to) 46 per cent.

Despite 'strong dollar' official policies, a case can be made that the US is in the process of defaulting on its obligations via a systematic devaluation of its currency.

The US national debt as of March 2008 stands at $9.4 trillion -- over $30,000 per citizen. Of the $4.7 trillion in private hands, $2.4 trillion (51 per cent) is held by foreign investors.

Japan holds around $600 billion (24 per cent) and China holds $500 billion (around 20 per cent). The United Kingdom, Brazil and oil-exporting countries own about 6 per cent.

The debt figures do not include significant private sector debt (both corporate and consumer). It does not include 'hidden' liabilities -- unfunded public (social security) and private pension arrangements or unfunded medical and health obligations (medicare and medicaid).

It does not include 'off-balance sheet' liabilities -- the $5.3 trillion in debt and guarantees of the government sponsored enterprises (GSE) -- Fannie Mae and Freddie Mac.

US national debt is also shortening in maturity. In December 2000, the average length of US public debt held by private investors was 70 months. InĀ  March 2008, the average length had shortened to 53 months (a decline of 24 per cent).

Seventy-one per cent of this debt is due in less than five years; 39 per cent is due in less than one year. The US must now 'roll over' significant amounts of debt in the coming years. The levels of debt are compounded by the 'twin deficits.'

One mainstay of the US economy has been its financial system -- but confidence in US financial markets has declined and the banking system needs additional capital despite having raised over $200 billion to date.

So why hasn't the "electronic herd" abandoned the US? Facts it seems don't matter, at least until they do.

High levels of debt are sustainable provided the borrower can continue to service and finance it. Warren Buffett in his 2006 annual letter to shareholders noted that the US can fund its budget and trade deficits as it is still a wealthy country with lots of stock, bonds, real estate and companies to sell.

The real reason that the US actually has not experienced a sovereign debt crisis is that it finances itself in it own currency. This means that the US can literally print dollars to service and repay it obligations.

The dominance may be coming to an end. There is increasing discussion of re-denominating trade flows in currencies other than the US dollar. Exporters are beginning to invoice in Euro or Yen.

There are proposals to price commodities, such as oil and agricultural goods, in currencies other dollars. Some countries have abandoned or loosened the linkage of their domestic currency to the dollar. Others are considering such a move.

Foreign investors, including central banks, have reduced investment allocations to the dollar. The dollar's share of reserves has fallen from a high of 72 per cent to around 61 per cent. Foreign investor demand for US Treasury bonds has weakened in recent times. Low nominal (negative real) rates on interest and dollar weakness are key factors.

Foreign investors may not continue to finance the US. At a minimum, the US will at some stage have to pay higher rates to finance its borrowing requirements. Ultimately, the US may be forced to finance itself in foreign currency. This would expose the US to currency risk but most importantly it would not be able to service its debt by printing money. The US, like all borrowers, would become subject to the discipline of creditors.

For the moment, the dollar is hanging on -- just. This reflects structural weakness in the Euro and Yen based on deep-seated problems in the respective economies. The artificial nature of the Euro is also problematic.

The dollar is also a beneficiary of the "too big to fail" syndrome. The IMF estimated that Gulf Cooperation Council (Saudi Arabia, the United Arab Emirates, Qatar and other Gulf States) may lose $400 billion if they decide to stop pegging their currencies to the dollar.

Does any of this matter? The US must ultimately pay the piper.

In the twentieth century, the US and the dollar overtook Great Britain and the Pound Sterling as the pre-eminent global economic power and currency. A similar epochal tectonic shift in global economic order may be commencing.

The shift is not inevitable. There is much to admire about the US. It remains wealthier than other nations including the new titans -- China and India. It remains a science and technology powerhouse. America's economy with its mix of growing population, secure legal and property rights and well-developed financial markets has been attractive to investors.

The Economist magazine wrote that: ". . .public credit depends on public confidence. . .The financial crisis in America is really a moral crisis, caused by the series of proofs . . .that the leading financiers who control banks, trust companies and industrial corporations are often imprudent, and not seldom dishonest. They have mismanaged. . . funds and used them freely for speculative purposes. Hence the alarm of depositors and a general collapse of credit. . ."

The words appeared over 100 years ago on November 2, 1907 during the 1907 crash.

The US faces a challenge to re-establish its economic credentials. Without drastic and radical action, America's ability to continue to borrow from foreign investors to meet its financing requirement is likely to become increasingly difficult.

The mass hysteria and panic that followed the broadcast of Orson Welles The War of the Worlds played on fears about an attack by Germans. It is interesting to speculate whether a broadcast on a default by the US on its sovereign debt would play on the secret fears of global markets triggering a similar panic.

"We interrupt regular programming to announce that the United States of America has defaulted on its debt!"

The author is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall). At the time of publication the author or his firm did not own any direct investments in securities mentioned in this article although he may be an owner indirectly as an investor in a fund.

Satyajit Das
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