With the beginning of the world financial crisis, remarks about necessity of a new world monetary system started to arise at G20 meetings in 2008-2009: the credibility of the U.S. economy had shaken. Have the international concerns about the U.S. future been serious enough and how to handle them? What would be recommendations for investors in this concern?
Let's start with the sources. By the middle of the XX century the U.S. had about 70% of the world gold reserves. The Bretton Woods Monetary Management System was set up in July 1944 and primarily resulted in recognition of the U.S. dollar as the world currency, while the fixed relationship of dollar to gold was set up as $35 per ounce of gold. The countries participating in international economic relations could freely exchange dollars for gold at a fixed rate, and their currencies were pegged to the dollar. Such a system could function smoothly until the U.S. had enough gold reserves. However, by 60s the dollar reserves of countries' central banks caught up with the U.S. gold reserves. As a result, when one or another country tried to exchange dollars for gold, the U.S. first exchanged and then restricted the exchange and devalued the dollar against gold. By early 70's while the major world's gold reserves were concentrated in Europe, problems with international payments raised as gold production could not keep up with the rapid growth of international trade. The U.S. lost their dominant position in the financial world, which, among other things, was complicated by the country's balance of payments deficit.
As a result the Bretton Woods system proved to be inadequate. A new system of international settlements was established in 1973, the Jamaican Monetary System operating today. Since then, the currencies have not been tied to the U.S. dollar and the dollar has not been pegged to gold. Instead, the IMF introduced a new international reserve asset, the Special Drawing Rights (SDR). In addition to the SDR, the reserves could be held in gold, U.S. dollars, JPY, GBP, SHF, FRF and DM.
Today we can observe that despite the refusal to use the U.S. dollar as the main world reserve currency, about 85% of world's foreign currency exchange transactions involve the U.S. dollars. Besides, more than half of the international reserves of countries' central banks are held in dollars. Thus the dollar, although not secured by gold, has kept the status of the world reserve currency, for the following reasons: will of the U.S. government; the infrastructure created for dollar trade and risks hedging; the size of the U.S. economy (almost a quarter of the world economy). A choice of a currency for international transactions is a question of confidence: America had been trusted prior to the crisis.
Why does the international community question the U.S. economy? Let's consider these complex reasons. Today globalization has spurred the rapid development of the international economic relations. Exports of the U.S. goods and services in 2010 were $1.83 trillion USD, import - $2.33 trillion and a similar pattern has been observed for a long time. However, trade deficit by itself is not a primer reason of concern of international investors.
A trade deficit (the excess of imports over exports) can be tolerated and last for an indefinite time provided that a country attracts enough investments and borrowings to compensate it; the country did not lose confidence; there is no capital outflow in form of withdrawals made by foreign investors or investors' reluctance to lend. In this concern, the 2010 balance of payments data show the U.S. situation as stable: the country receives enough credits and foreign investments to compensate the trade deficit.
Moreover, the capital inflow to the U.S. is strong enough to keep gold reserves. For instance, as per U.S. Treasury report of February 11, 2011, U.S. reserve assets were $132.9 trillion. The U.S. model of international relations presumes high volumes of imports and consumption while creating a favorable investment climate. Such a model will exist as long as there is confidence in the country. The components of government policy in this model of "confidence" are currency stability, favorable foreign investments legislation, moderate taxation, transparency of economy, etc.
Let us consider the second aspect of confidence in the country, its domestic fiscal policy. In 2010, the U.S. budget revenues were $2.2 trillion, the expenses were $3.48 trillion, and the budget deficit was $1.28 trillion. Since the 1970, a budget surplus was recorded only 4 times, during 1998-2001, while during all the other years America had a chronicle short money supply.
Finally, we've come down to detect the main cause of anxiety of foreign investors, the U.S. enormous external debt. The website usdebtclock.org was purposely created to keep track of debt and to provide related statistics. By January 31, 2011 the U.S. Federal Government debt was $14.1 billion. Considering the debt structure, around 33% was held by foreign states while the rest was internal residents' debt. The ratio Debt /GDP was 96.5%. Historically, this ratio reached its maximum in 1946, when it was 121.2% of GDP. If to look at the debt statistics, the U.S. debt had grown more for the period of ten years from 2000, than for the period of 60 years from 1940 to 2000 inclusively.
In the long run, is it any hope for the reduction of debt? The structure of the U.S. project budget for 2020 is as follows: expenses on social security, elderly health insurance programs, free medical aid to poor and interest on debt make up $3.56 billion which is equivalent to 81 % of the total budget revenues ($4.4 billion). That correlation was 61.4% in 2011. Defense and other government expenditures in 2020 will be financed by government borrowings.
According to the government forecasts for the next 10 years of 2011-2020, the total U.S. budget deficit will reach $10.6 trillion, meaning that the U.S. debt will reach almost $25 trillion (14.1 + 10.6, existing debt plus planned debt). The GDP forecast for 2020 is $24 trillion. To achieve this level of GDP the economic annual grow rate should be at least 5%. This value seems to be too high for a developed country.
Alternatively, the government budget forecast may underestimate the prospective social expenditures. On January 1st 2011 the first Baby Boomers will reach 65 years old. The ratio of retired workers versus active workers will grow steadily during the next ten to fifteen years, provided that the state demographic policy remains the same. The U.S. has undertaken colossal expenses related to special medical insurance programs for the retired. At the given rates of economic growth, tax structure and projected Social Security expenditures, the budget revenues would show negative dynamics if adjusted for social expenditures. The recommendations in this concern would be as follows: to raise taxes, although it could have a negative effect on the economical growth rate; or reduce the scale of social programs in order to cut social expenditures. In fact, the latter would be a challenge for most politicians. Need to note, that the issues discussed have not been resolved up to the present date. It seems that the projected medical insurance reform shall be seeking for related budget cuts first, instead of increasing the availability of medical services to Americans.
It is suggested, that the country's debt can be analyzed better if to look at the Debt/GDP ratio, rather than consider debt separately. For instance, Debt/GDP ratio in Greece is 176.8%, in Portugal - 231.2%, in England - 428.8% and in Japan is over 200% for 2011 (source: CNBC). What is a proper benchmark for a secure level of debt? The ratio Debt/GDP in Germany and England is considerably higher compared to the ratio Debt/GDP of the U.S. Nevertheless, these countries continue to grow. Certainly, it is a matter of confidence. Nor Germany neither England act as global warrants or serve 85% of world currency transactions.
Comparing to Japan's Debt/GDP ratio which is two times higher than the U.S. equivalent, it is notable that about 95% of Japan's debt is owed to the country residents: local banks, households, pension and insurance funds, industrial enterprises. This defines a very low risk of foreign capital outflows. The U.S. situation is different, as 33% of debt is financed by foreign countries; China holds about 8.2%, Japan 6.3%, GB 1.9% and Russia about 1%.
To keep its international confidence, the U.S. as a global currency warrant should not accumulate debt. The U.S. is approaching the 100% Debt/GDP ratio. This situation has a negative psychological effect, bringing anxiety in the world. Moreover, as it has been already stated, the world community is concerned not only about the debt size, but also by its growth rate, which is being unprecedented in the U.S. history. To finance the budget deficit in the future, the U.S. will have to depend on foreign countries, primarily China. This situation may become dangerous due to the risk that China and other countries may eventually stop buying U.S. treasury bonds. This would result in sharp increase of interest rates, lack of means to finance debt and possible cascade of defaults on the U.S. treasury bonds of different issues.
Another reason of anxiety is that even if countries and institutions would continue buying U.S. treasury bonds despite an increased debt, the interest on debt may exceed the levels that the U.S. budget can afford. In the U.S. budget of 2011 the net interest payable is about 6,7% of the total budget expenditures, defense expenditures - 22.7%, social security expenditures (excluding medical programs Medicare Medicaid) - 19.6%. Based on this U.S. budget structure, we conclude that the current debt settlement expenses are not as burdensome as other expenditures. However, while about $250 billion is assigned for interest-on-debt payments in 2011, this amount will increase nearly fourfold to $912 billion in 10 years.
Thus, there is a probability that the U.S. interest rates will grow. Although inflation which influences interest rates dynamics can be handled by the U.S. without difficulties (deflation is a more apparent issue now), credit risk growth can be barely managed. The U.S. debt has been growing much faster than the economy has, so the investors may be unwilling to get interest revenues which do not reflect actual level of risk. Let us consider the dynamics in the U.S. cost of borrowing.
The U.S. interest rates have been decreasing since 1994. Thus the U.S. debt has become cheaper along with its overall growth. This proves confidence in the U.S. economy. At the end of 2008 when the financial crisis became apparent investors rushed to buy out American treasury bonds in hope to preserve their savings. That caused the rates of return to fall down to 2%.
The current U.S. dollar value has almost reached its historical minimum. Obviously, this means higher investment risks. The U.S. is a net importer meaning that its imports exceed its exports, and it finances the trade deficit by external borrowings and investments. One of the characteristics of a strong and opened for foreign investments economy is a strong currency. Weak dollar risk implies that the interest of foreign investors to the U.S. assets may diminish, causing the U.S. to lose important means of trade deficit financing.
Another current threat to the U.S. dollar is appearance of alternative world reserve currencies. In January 2011 the Bank of China began direct sales of RMB to the U.S., while the Chinese Yuan was traded on the MICEX in Russia December 15 of 2010. The fact that the Yuan has started to be subject of international transactions, shows that China has been implementing competent foreign and domestic economic policies. By promoting its currency, China has become more integrated into the world monetary system. At the same time, China has been shifting the core drivers of its economic growth towards domestic consumption (from exports and infrastructure). In 2010, it was actively discussed that China had overtaken Japan in respect to the size of its economy. If we take Purchasing Power Parity for calculations, the size of the U.S. economy is $14.62 trillion, the size of the Chinese economy - $10.08 trillion, the size of Japan's $4.31 trillion, according to the International Monetary Fund data. Thus, in terms of real purchasing power, China's economy has been ahead of Japan's economy for a long time. Indeed, the Chinese GDP per capita is far lower than that of Japan. However, a country as a world leader and guarantor is not solely defined by the GDP per capita value, but by the absolute size of its economy and its ability to influence international relations. China has been realizing this strategy with honor, although the full convertibility of the Yuan's has not been achieved yet. Another important competitor to the U.S. dollar is Euro, as the EU's economy and the U.S. economy are comparable in size. Thus, the U.S. dollar is being stalked.
The question of choice of the most appropriate international reserve structure is being actively discussed by all countries. At present, more than a half of current reserves are denominated in the U.S. dollars. The theory suggests that a structure of reserves should depend on the country trade partners. For instance, given that 30% of the total country's international trade and investments are made with China, 30% of reserves should be held in Yuan. This theory hasn't found a practical application though for a number of reasons, like non-convertibility of currencies; political risk, etc. Reduction of the dollar-denominated reserves by countries would have dire consequences for the dollar, as the U.S. treasury bonds are included into international reserves of many countries.
Thus, we have considered the U.S. investment risk factors. They may not present any threat if taken separately, but create discomfort for the international community if taken altogether. The worst case scenario would be the U.S. default on its debt. Let us consider this scenario.
It is unlikely that anyone could see a point when American creditors may lose patience, say, a month prior to that. The famous investor Warren Buffett has confirmed that the system can remain in such a state for indefinite time. A factor triggering the U.S. default may be just "a spark" that would cause a domino effect, like, for instance, treasury bonds withdrawal by a large international creditor. Crises are likely to start when there is a circumstantial evidence of something being wrong, and to be triggered by a spark, causing a further cascade of events, including those of a psychological nature. For example, while the global oil demand fell by no more than 5% following the recent crisis, the price of oil fell by more than 3 times. This is the psychology of the market.
If the U.S. declared a default, the world would suddenly lose trillions of dollars. International reserves denominated in dollar would depreciate, while international capital flows would plunge into chaos until the situation is resolved. Today, the probability of the U.S. default is small due to the fact that nobody is interested in it. For example, China is the largest holder of U.S. treasury bonds and could lose more than half of its foreign exchange reserves denominated in dollars. At the same time, we can observe China has actively started to invest reserves in real assets: gold and securities of companies around the globe. China Investment Corporation was created to manage a part of the international reserves of the country. During the ten months of 2010, China imported over 200 tons of gold, which is five times the volume of purchases of the precious metals made by the country for the full year of 2009.
The consequences for the U.S. in case it declares default would also be sharp budget shrink; social programs cuts and falls of living standards of all layers of the society, especially those who are financially dependent on the state. The dollar would be devaluated and lose status as a world currency; investment in the country would sharply decrease. Outbreak of inflation would be possible, and the U.S. would do their best to preserve national wealth, even at an expense of growth. But in the long run, America will survive. The future of the global economy is Technology, and the U.S. Technology will persist even in case of default. Thus, even if it had lost the status of the world monetary power, America would have remained the technological power. Such scenario would stipulate a launch of a new era in the U.S. economical and political development.
The recommendations to investors, holding assets in the U.S. dollars, are as follows:
• Monitor growth of the federal budget deficit and national debt of the United States
• Monitor the dynamics of demand for U.S. treasury bonds from major foreign creditors, primarily China
• Track yield on the 10-year U.S. treasury bonds, watching for the rates to reach 5% or more
• Make investment portfolio diversification; invest globally by buying stocks and bonds of U.S. corporations, looking for international companies with the U.S. sales share which does not exceed 25-30%.
