Who’s pulling the strings

Who benefits from spreading such a story? Just like traders “talking their position,” countries get an announcement effect from talking about diversification that adds immediately and measurably to their bottom line.

But wait a minute. If central banks are long-term holders of reserve assets, such “profits” are only paper gains that can vanish the next time the currency reverses direction.

That is true, but meanwhile they derive a sense of power from being able to produce an announcement effect. This could come in handy in high-level negotiations over things such as whether a 2.1-percent Chinese yuan revaluation really qualifies as delivering on the G7’s urgent calls for a “more flexible forex regime.” China has hinted more than once it feels it has the upper hand on this score. In September, a Chinese state research official said China should be diversifying reserves into oil and oil-producing assets, a comment the government had to “clarify” the next day by saying it wasn’t seriously considering any such thing.

Who really has the upper hand — the big Asian economies, which hold so many dollars and so much U.S. government paper, or the U.S. itself, which is, after all, the source of the dollars in the first place? An Asian central bank can threaten to sell dollars and get an instant effect, whereas the U.S. cannot realistically threaten to stop buying everything from socks to stents from Asia, because the U.S. literally does have a free market.

Ultimately, the status quo is in both parties’ best self interests. Both businesses and consumers in the U.S. get an endless supply of cheap goods, which holds inflation down. The Asian economies get income from export sales that fuel their factories. Without the American consumer, where would all those people work? Until these economies are self-sustaining — able to support their domestic manufacturing bases with domestic sales — they need the U.S.

Talk of reserve diversification probably won’t go away any time soon, even if every trader in the business comes to believe it’s just a scam to manipulate the market. Like intervention, it’s too big a factor to ignore even if you know you’re being jerked around. It’s not an empty threat, as we saw in the fall quarter last year, but increasingly market participants are coming to question whether it’s the U.S. current account deficit and accompanying dollar accumulation or the emerging economies’ dependence on the U.S. consumer that is “unsustainable.”

The question is unanswerable; it seems like a stalemate. What is shocking is the amount of money the U.S. owes the rest of the world — as of the end of June, the date of the most recent data, over $5.2 trillion, an increase of $600 billion from the year before. It’s scary to think that during 2004, foreign investors bought 98.9 percent of all new Treasury issuance — $358.5 billion of $362.5 issued. They also took almost 90 percent of Agencies (the debt instruments of U.S. government agencies such as Fannie Mae and Freddie Mac) and 43 percent of corporate bonds. Note that this is all foreigners, including private investors, not just central banks (www.gillespieresearch.com/cgi-bin/s/article/id=666). At this point, foreigners own 45 percent of all the Treasuries ever issued.

Well, so what? The U.S. bond market is bigger than the other top three bond markets put together (UK, Eurozone, and Japan), and we saw from the ease with which Citibank manipulated the European bond market over the summer, by far the most liquid. In July, net capital inflows into the U.S. totaled $87.4 billion (and June was revised up to $80.9 billion), or a two-month total of $168.3 billion.

We don’t have the Q3 current account deficit yet, but the Q2 deficit was $195.7 billion, or 6.3 percent of GDP. If Q3 delivers a similar deficit and if capital flows are about the same, we have no problem. The world is willing to fund the current account deficit. In fact, the world should be worried the U.S. will stop running deficits, since it lacks low-risk, high-liquidity capital markets of its own.

This leads to the observation that the U.S. couldn’t “fix” the deficit by itself even if it tried. Treasury Secretary John Snow says other countries have responsibilities too. They need to encourage higher growth in their own economies, not only to provide markets for their own factory output, but also to raise the return available to investors. If you were a Japanese pension fund manager and you had a choice of 1.30-percent domestic bonds or 4.30-percent U.S. bonds of the same maturity, which one would you prefer? It’s a no-brainer.