Dollar’s privileged status safe — but for how long?
Foreign central banks have never been more important as buyers of Western government debt. But as fears grow over the direction of major currencies and interest rates, markets will have to think twice about the drivers of official sector demand. Taimur Ahmad reports.
In November, Lee Chuan Teck, head of reserve management at Singapore’s central bank, urged official sector investors — particularly wealthy Asian central banks — to take advantage of a generalised flight to safety into Western government bonds by shifting foreign exchange reserves into riskier assets.
His comments, while provocative, followed a series of headline-grabbing remarks by foreign central bankers in recent months about the need for reserve diversification, born primarily out of fears over ballooning Western government fiscal deficits — and the official sector’s role in financing them.
Korea’s central bank last month reportedly signalled its intention to restructure its foreign asset portfolio to reduce the proportion of dollar denominated assets in its $254bn reserves stockpile, the sixth largest in the world.
Meanwhile India recently switched a further portion of its reserves into gold. And China — with $2.2tr, the world’s largest foreign exchange holder — is also mulling holding more of the precious metal.
Western governments will have noted such developments with some concern, as their own financing needs reach unprecedented heights. Over the past decade, advanced economies with sizeable fiscal deficits had managed to keep a lid on domestic interest rates by tapping foreign savings from emerging market central banks, oil exporters and sovereign wealth funds.
But if foreign investor appetite retreats on concerns about rich country long-term fiscal sustainability, interest rates on government securities will almost certainly shoot up. And rising yields would hamper efforts to keep borrowing costs low for businesses and consumers — and could have far-reaching economic ill-effects.
Still going strong
Yet despite the rhetoric, central bank purchases of G7 sovereign debt have hardly diminished. On the contrary, by September, official sector purchases of US Treasury securities, for example, had shot up by 19% to $2.37tr, from a year earlier, according to the latest Treasury Department data.
Total reserves held by central banks have reached roughly $7tr, according to the IMF, of which the global stock of dollar-denominated assets is roughly around $4.4tr, up from about $1.6tr at the end of 2002.
"In the short term there’s significant amount of demand coming from the official sector — let’s call a spade a spade, basically from China or because of China," says Arnab Das, head of strategy and market research at RGE, the research and advisory firm founded by economist Nouriel Roubini. "In fact the rate of official buying [of US Treasuries] seems to have accelerated — it’s running at an annualized rate of about $1tr now."
Doomsayers had long predicted an investor revolt against US assets that would trigger the downward spiral of the dollar and sharp US rate steepening. Yet barely a few weeks after the collapse of Lehman Brothers, government bonds ended up being boosted by a global flight to safety; moreover, financial deleveraging ultimately favoured the US dollar along with other so-called funding currencies, including the euro and sterling.
Indeed, the fact that the US dollar has not collapsed in spite of the enormous spending and borrowing of the US government is partly due to the continued health, at least on the surface, of the US Treasury market.
The biggest and most obvious shift by central banks this year has been out of US agency debt — namely holdings in Fannie Mae and Freddie Mac, both now in US government conservatorship — and further into sovereign bonds.
However, as John Nugée, managing director of the official institutions group at State Street Global Advisors, points out, they did so not by selling their agency holdings but largely by holding them until maturity and then using the proceeds for Treasury purchases.
And central banks continue to pile into government securities, principally US Treasuries, but also the vast number of dollar and euro denominated bonds issued by other advanced economies this year.
All this is welcome news for debt-burdened Western sovereigns, for whom the official sector has become an increasingly vital investor base.
Chris Tuffey, managing director and co-head of credit capital markets at Credit Suisse in London, notes that a sharply improved market environment has changed the funding outlook for sovereigns since the start of the year.
"A year ago we were staring economic depression in the face," he says. "But things have changed dramatically over the year. Broadly the market was overly pessimistic in the ability of markets to fund borrowers."
Official sector demand for sovereign paper has bounced back, having ebbed at the height of the crisis, notes Tuffey. "What we’re seeing from Asian and Middle Eastern central banks is very strong support for European sovereigns. There’s a lot of money to be put to work."
Sean Taor, head of SSA syndicate at Barclays Capital, says: "[Central banks] are back to being an extremely important and large buyer of other governments’ bonds. Percentage-wise their participation in order books was smaller in the earlier part of the year, but they are now a much larger and extremely important investor base. Generally speaking, demand is twice as high as in the first half of the year."
Central bank participation in dollar and euro-denominated sovereign bond deals shot up in the first three quarters of 2009, from an average of 25%-30% early in the year to 45%-55% for more recent deals, according to Barcap.
Soaking up supply
The surge in borrowing in G7 economies over the last year is widely considered a necessary response to the financial crisis and the deep recession across advanced economies. Yet the question remains whether markets will continue to absorb record levels of debt supply; after all, advanced economies will need to sell some $12tr of sovereign bonds to plug the fiscal gap over the next year.
"I would be surprised if it’s feasible to maintain the current rate of US Treasury absorption," says Ousmene Mandeng, head of Ashmore Investment Management’s public sector investment advisory.
For now, the market appears sanguine, buoyed in part by a pick-up in sentiment and as yet strong demand for government paper. Says Taor: "We’ve got through a very challenging year. If we can get through this year then hopefully, as markets continue to improve, we can get through next year."
Still, advanced nations are financing their borrowing on terms that seem hard to believe. Government bond yields have been at historic lows this year thanks to easy monetary policy, quantitative easing and a lacklustre economic outlook.
Longer term bond yields in Germany, Japan, the UK and the US have generally edged up since the beginning of 2009, on the back of improving economic and market conditions. In contrast, yields on shorter term bonds have been held down by market expectations of policy rates remaining at historically low levels for the foreseeable future.
Increasingly, analysts are raising the alarm that debt sales may push yields sharply higher even if inflation remains subdued — a prospect which itself is far from guaranteed in the medium to long term. Such large increases in deficits and debt could raise government bond yields through several channels, as the IMF notes in its 2009 Global Financial Stability Report.
First, concerns about fiscal sustainability and government solvency could push risk premiums higher, resulting in higher real yields. Second, bond yields could rise on the back of sharply increased government debt supply and rollover risk, given the increase in deficits and measures to support financial sectors in a large number of countries, along with a shortening of debt maturities.
Potentially higher inflation expectations, reflecting concerns about the ability of governments to service their debts, could also exert pressure on bond yields. Unease is particularly acute for the US, with its $12tr of fiscal and monetary stimulus, the world’s lowest borrowing costs and a record $4tr of government bond sales between 2009 and 2010.
A key question into next year is whether governments will urge their banks to keep buying their debt, thus providing some of the demand to soak up the supply, as part of new liquidity buffer regulations; another is the extent of the borrowing requirements over the medium term.
In the US, Federal Reserve debt purchases — $300bn in Treasuries and $175bn of agency debt by next April — have artificially reduced the supply of fixed income securities coming into the market; next year, there will be greater issuance with no such support — a result that could pressure rates. In the UK, the Bank of England’s quantitative easing programme has funded some 130% of the budget deficit.
"I have a suspicion that there will continue to be a market for government debt but not at such extremely low yield levels," says SSGA’s Nugée. "There will come a time when bonds need to offer more return to continue attracting investors, but I don’t think the yield curve is going to blow out."
Nugée notes that regulators could exert more pressure on commercial banks to hold government bonds. "Regulators are going to require higher levels of liquidity," he says.
Meanwhile, the debate over how aggressively to bring down deficits — in the US, UK and eurozone — over the next few years is growing ever more raucous. And investor anxiety over fiscal sustainability could push up longer term interest rates unless governments commit to policies that ensure medium term fiscal sustainability and anchor expectations.
Public debt burdens across high income countries are converging at around 80%-100% of GDP. "In the medium term there needs to be a fiscal adjustment in the US and that will make the debt once again sustainable in the long run," says RGE’s Das. "The politics is already pointing at the domestic pressure for fiscal adjustment on top of the foreign creditors saying: ‘you’ve got to watch out’.
"We’re heading for an explosion of public debt that becomes unfinanceable and moves to another crisis — if nothing is changed. We’re not there yet, but the risk is certainly rising. If there’s not a fiscal adjustment that train wreck will eventually happen," adds Das. "There will have to be an articulation of some sort of medium term fiscal adjustment strategy."
The point holds true for the UK and eurozone economies as much as the US, says Das, although "the long term relative prospects of the US versus the rest of the G7 are better — thanks to higher potential growth, better demographics, and a far lower initial tax burden."
Central bank mandate
While fiscal concerns are likely to hit official sector appetite for government paper — and therefore the direction of interest rates and major currencies — demand will also depend on what central banks believe their mandate is.
The financial crisis has split central bank reserve managers more clearly into two camps: those that believe they’re managing policy assets — namely traditional central bank reserves — and those that accept that they have an investment objective alongside their policy goal, says SSGA’s Nugée.
"Those that believe they’re managing policy assets and put security and liquidity as their main concerns have moved further into government bonds [since the start of the crisis]," he says.
"Those that believe they’re managing investment assets — the richer central banks and most of the sovereign wealth funds, have said ‘no, this is a buying opportunity, here are assets which are cheap and therefore we can afford to move out along the risk spectrum’."
For central banks whose objectives were mixed — neither exclusively liquidity management nor investment management — the crisis has been a moment of truth, says Nugée. "The central banks in the middle have had to consider which side of the fence they fall. You’re faced with a fairly stark choice: are you interested in liquidity at all costs — and it’s certainly expensive when USTs yield roughly 1% — or are you interested in investment, in which case there are buying opportunities like you’ve never seen."
But while some diversification into riskier assets is taking place at the margins, this is hardly at the expense of core G3-currency — and especially dollar — denominated debt. "Clearly if central banks continue to buy G3 sovereign paper it’s because there aren’t enough alternatives," says Ashmore’s Mandeng.
While the rhetoric among many emerging market central banks may imply less than full confidence in the dollar as the dominant anchor of the international monetary system, their net purchases for now suggest otherwise.
The rate of central bank reserve accumulation, having fallen during the crisis, has surged in recent months, in most part because large emerging market central banks —most visibly the People’s Bank of China — are maintaining their formal and informal dollar pegs, notes RGE’s Das.
China’s attitude towards its dollar securities is doubled-edged. On the one hand, the government is openly worried about the eroding value of its estimated $1.6tr of reserves held in dollar assets; at the same time, it effectively pegs its currency to the dollar, perpetuating the very dynamic that leads to its accumulation of US assets.
"In the short term we don’t see a financing problem [for the US] because the Chinese and many emerging market countries and the dollar-pegged commodity exporters are controlling their exchange rates," says Das. "And so in the short term they’re financing the US and some other countries through reserve accumulation."
For all its talk China bought another $1.8bn of US Treasuries in September, bringing its total holdings to $798.9bn, according to the latest TIC data.
Indeed, the US benefits from the dollar’s unique role as global reserve currency, enjoying what former French president Valery Giscard d’Estaing once called the "exorbitant privilege" of being able to borrow abroad in its own currency. That insulates Americans from the danger of seeing their debts skyrocket in response to a sharp decline in the dollar’s value.
Says Mandeng: "The ‘exorbitant privilege’ couldn’t come at a better time for the US."
Yet while there is growing recognition that the dollar is likely to face downward pressure for the foreseeable future, the key question is whether the pace of depreciation turns into a rout that jeopardizes its reserve currency status and the accompanying privilege.
Most analysts are loath to put a timescale on the dollar’s possible demise. But Ashmore’s head of research, Jerome Booth, is forthright on the US currency’s weakness: "When we talk about the risk-free rate in US Treasuries that’s an abuse of the English language. It’s not true at all. The US dollar is one of the riskiest currencies there is."
Others, including SSGA’s Nugée, see it differently. "The dollar rallied as a flight to quality and now it’s giving up some of that rally," he says. "I really don’t think you should read too much into the long term role of the dollar as the world’s reserve currency from the value of the dollar at the moment. There is no real alternative."
While the dollar’s store of value may be in question, it remains an acceptable accounting unit and is still "the world’s most liquid transaction unit," he adds.
No way out?
The implication is that — short of a dollar crisis — the currency’s primacy looks assured for the foreseeable future. For foreign central banks, which lack meaningful alternatives, this means more of the same: investing reserves in the dollar, as well as in euro and yen at the core.
"Central banks may well stick to the G3 currencies and not much more than that," says Nugée. "When you move outside that where are you going to go?"
But one of the implications for foreign central banks of maintaining the status quo — which includes holding increasingly large amounts of US Treasuries as international reserves — is that it perpetuates the global economic order that many believe contributed the financial crisis: namely, the payments imbalances between saver nations and borrower nations. Says Mandeng: "The more they absorb [G3 debt], the more they exaggerate the imbalances they are committed to get rid of."
He argues that as a first step towards any global economic rebalancing, central banks should move beyond the status quo in the international monetary system and towards a multiple reserve currency system — incorporating leading emerging market currencies including those of Brazil, Russia, Indi and China.
"Many share the view that it is no longer desirable to keep on accumulating reserves in one or two currencies," says Mandeng. "But the institutional set up has simply not adjusted to the fact that central banks have emerged as managers of public wealth, not just liquidity.
"What we need is for central banks to rethink their mandates as they’re piling up billions of dollars in reserves. Most central banks agree that greater diversification makes sense — but there needs to be an adjustment in behaviour."
More of the same
Yet few investable alternatives exist. Moves are afoot to create such possibilities, including by the Chinese to gradually internationalise the renminbi. But by the same token, other large emerging economies — including Brazil, India, Indonesia and Taiwan — are trying to discourage investment in their currencies through capital controls because of overheating fears.
Says Das: "Right now, things are going in the opposite direction. At a minimum because of the weakness of the dollar, China and India are not going to lower their barrier to capital flows... This is taking us away from reserve diversification towards EM countries."
"These countries would have to live with the consequences of opening their capital accounts too soon," says Nugée. "More importantly, what is wrong with what they’re doing at the moment from their perspective?"
Moreover, on a deeper level Nugée believes that a fundamental shift in existing economic patterns is unlikely. "I can’t see either the market or moral mechanism to change what is happening. And that will mean saver nations will continue to have surpluses and will need somewhere to put them." And for now, the only feasible destination for that surplus is liquid markets.
"There is only one market in the world [where] you can put $50bn to work quickly without impacting the market," he says. "It’s the developed government bond market."