The latest report from Radiant Asset Management’s David Ross on the future of the dollar and China makes for a very interesting read.
Ross starts off by making the point that when you adjust the US deficit for growth and spending, its size does not really look that alarming. In fact, he calls it steady. Note the following chart:
But that’s not really a reason to be optimistic because, as Ross points out, GDP for 2009 is expected to be approximately $14,400bn while total debt by year-end will be $13,000bn - 90 per cent of GDP. By next year that figure is expected to rise to 100 per cent and remain there for as long as the Congressional Budget Office projects.
So here comes the problem, as Ross explains (our emphasis):
It is worth noting that in order to keep the debt at 100% of GDP while still increasing it at the 2010 rate of 9% per year, it is necessary to grow the GDP at 9% per year in current dollar terms. This means that if the GDP grows at 3% per year in real terms, prices have to inflate at 6% or else the debt will grow as a fraction of GDP. Even taking 2012’s estimated $950bn increase in total debt and $16.5 trillion as standard, the CBO estimates assume a combined growth and inflation rate of nearly 6% per year. Meanwhile, America’s ability to fund its deficit is increasingly dependent on foreign appetite for its own debt. As Ross points out approximately half the “privately held” debt of the US is held by foreign entities or individuals. He summarises the year so far:
Debt sales are accelerating, focused on short-term debt and characterized by a return of foreign purchasers and a well-correlated decrease in Federal Reserve purchases. It is obvious that unprecedented quantities of debt are being accumulated. How this burden will affect US retirements and the lives of American children and grandchildren depends greatly on what happens in the rest of the world. The high percentage of US debt purchased by foreign interestes guarantees this importance.
A large chunk of that demand, of course, comes from China - whose purchases via the Caribbean offshore centres and London, Ross notes, have greatly increased this year, a sign the nation might be trying to disguise its future purchasing intentions. Considering the purchasing power of the dollar has to decrease by 6 per cent just to maintain the US deficit balance, it’s no surprise then that China may be looking for other options.
But what can they realistically do?
Well, according to Ross they can:
a) Do nothing; convince their citizens to spend more of their savings - a move that will inevitably strengthen the yuan devaluing their dollar holdings.
b) Change the degree of linkage of the yuan and the dollar - a move that would be unpopular and difficult to sustain as the dollar weakens.
c) Buy gold instead of dollars - but while they can supplement their foreign reserve holdings with gold, there is simply not enough gold produced in the world to cover more than a small fraction of Chinese needs.
d) Go someplace else, purchasing the debt of other countries– although dollar conversion issue would simply accelerate the devaluation of their dollar holdings. Also the world’s biggest supply of debt instruments remains the United States.
Which leads Ross to conclude:
China cannot solve its balance of trade surplus by purchasing debt instruments in quantities much out of line with the surpluses themselves. The only sure way China can move away from US debt purchases is to reduce the trade deficit with the United States.
And that’s no good for China either.
The only option left therefore is a slow and finely balanced transition towards a multiple-currency international reserve system via the increased use of special drawing rights in trade and settlement.
Related links:
Who’s afraid of the US Federal budget? - FT Alphaville
China’s Treasury confidential - FT Alphaville
