The Credit Card Bill Comes Due (International Version)

The nation borrowed from the rest-of-the-world when interest rates were low. But interest rates can adjust. So can exchange rates. What to think of our creditors re-appraisal of the “right” effective interest rate to lend to us?


Figure 1: Broad, trade-weighted value of the dollar. Source: Federal Reserve Board via FRED II.

From the Financial Times:

China voices alarm at dollar weakness

By Mure Dickie in Beijing, Krishna Guha in Washington and Peter Garnham and Michael Mackenzie in London

Published: November 19 2007 19:14 | Last updated: November 20 2007 02:19

China on Monday expressed concern at the decline in the dollar, joining a growing chorus of global policymakers alarmed by the weakness in the world’s main reserve currency.

Wen Jiabao, the premier, told a business audience in Singapore it was becoming difficult to manage China’s $1,430bn foreign exchange reserves, saying their value was under unprecedented pressure. “We have never been experiencing such big pressure,” Mr Wen said, according to Reuters. “We are worried about how to preserve the value of our reserves.”

China keeps the currency composition of its reserves a state secret, but some analysts believe that more than two-thirds are probably still held in dollars.

The dollar has dropped 16 per cent this year against a basket of major currencies.

Mr Wen’s comments came as top international economic officials spoke out in support of a strong dollar in the aftermath of the weekend’s Group of 20 summit in South Africa and Opec meeting in Riyadh.

Russell Jones, head of currency strategy at RBC, said: “Any respite in the dollar’s weakness is likely to be temporary. The dollar isn’t a safe haven at the moment, because most of the problems facing the world economy are coming out of the US.”

Ashraf Laidi, currency strategist at CMC Markets, said “the power in influencing the fate of the dollar lies increasingly with the oil producers as they struggle with a falling dollar.”

Mr Wen’s remarks are likely to fuel market speculation that Beijing might move to reduce the proportion of its reserves held in the US currency

And from the other side of the globe (Reuters):

UPDATE 2-UAE talks up FX reform, markets seize on Saudi shift
Mon Nov 19, 2007 2:43pm EST

By Daliah Merzaban and John Irish

DUBAI, Nov 19 (Reuters) – United Arab Emirates policymakers kept up pressure for a review of Gulf Arab dollar pegs on Monday and currencies rallied across the oil-exporting region on a signal that Saudi Arabia may be willing to discuss reform.

The Saudi riyal hit a 21-year high and investors bet on an appreciation of 2.4 percent in a year after a source familiar with Saudi policy told Reuters the world’s largest oil exporter could consider its first revaluation since 1986.

Although the source ruled out dropping the peg in favour of a currency basket, he signalled that Riyadh, champion of the Gulf’s fixed exchange rates, may respond to a dollar slide that has split a regional economic bloc and the OPEC oil cartel.

“That Saudi Arabia is prepared to admit in public that a revaluation could be one of the acceptable compromises, will increase pressure on Gulf currencies,” Marios Maratheftis, head of research at Standard Chartered in Dubai said in a note.

Investors seized on the news. Retail customers scrambled funds into UAE bank deposits. Hedge funds pushed Bahrain’s dinar to a 10-month peak and Oman’s rial to a month-high as Omani inflation data underlined the Gulf’s policy dilemma.

Saudi partners in the Organization for the Petroleum Exporting Countries are complaining the tumbling dollar is eroding export revenues. OPEC agreed on Sunday to discuss the dollar weakness after Iran and Venezuela pushed it to price oil in a currency basket.

See also Brad Setser’s commentary [1], [2], on this meeting.

In the years when interest rates were low, some people argued this would be the perfect time to borrow. If the terms at which one borrowed were fixed, then one might take this argument at face value. But it pays to think about why those low interest rates on dollar assets prevailed — it was argued that the depth and sophistication of U.S. markets made dollar assets particularly desirable.

A corollary of this view was that if the desirability of dollar assets were to change (perhaps because of changes in the perceived default risk of dollar assets (see e.g. [3]), or because of changes in the expected rate of dollar depreciation) then there could be a discrete change in either dollar interest rates and/or dollar exchange rates.

That is the portfolio balance model at work.

The ready critique of this view would focus on the fact that interest rates on U.S. Government debt have not risen. Three month yields have definitely fallen, and even 10 year constant maturity rates have declined. But of course, these are the yields on default-risk-free assets. And as I’ve noted elsewhere, the spreads between dollar denominated risk-free and risky assets have been widening. Those are the yields we should be looking at in comparison to risky yields in other currencies.

I don’t want people to jump to the conclusion that the dollar’s role as the dominant reserve currency is over. A lot of these concerns are old news — but the new news is the confluence of events. So while there is a tremendous amount of inertia in a currency’s reserve role, what we might be seeing now is the interaction of cyclical factors (low U.S. interest rates and dollar depreciation) and structural factors (the strains on dollar pegs and consequent erosion of demand for dollar assets) which could lead to a substantial drop in the dollar’s value.

This would not be a disaster — in fact, it’s part of the adjustment process (as Krugman highlights here). But if the interaction leads to an abrupt decline in the demand for dollar assets, then we might very well see even more upward pressure on yields on risky dollar assets, and even more discrete downward moves in the dollar’s value. Arguably not an unalloyed good outcome

A final step in the course on which previous policies have set us on (see here [pdf]): to buy a single unit of foreign “goods”, we have to give up more units of U.S. goods. In other words, the terms of trade have moved against us substantially, reducing American GDP adjusted for that effect. That, too, is part of the adjustment process.

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9 thoughts on “The Credit Card Bill Comes Due (International Version)

  1. bsetser

    the funny thing may be that china is now buying more dollars than ever, despite the current talk (or rather, the current talk signals their discomfort buying what the world doesn’t want). the only way we will have a clean test of the portfolio balance theory is if china is transparent enough ex post that we can tell for sure that it has adjusted its policy — and if the econometrics are good enough to allow someone to tell the difference between putting something like .75 of a very large flow into $ (holding the $ share around .7 when the $ is falling means buying more $ at the margin) and putting .5 of a potentially larger flow into dollars. We now know that Russia diversified in q1/q2 2006 and subsequently has dramatically increased its euro purchases relative to its dollar purchases, though with the huge increase in Russia’s reserves it is still buying a lot of dollars. Has anyone tried to assess the impact of this policy shift?
    incidentally, the broad dollar (including the no longer minor currencies that don’t figure in the fed’s major currencies index) is at a level that should support adjustment …

  2. Stuart Staniford

    I’ve been thinking a lot about the issue of the dollar/euro exchange rate movement, which initially didn’t really make sense to me. However, I’ve been toying with the following hypothesis: the world is now in the grip of significant resource constraints (oil especially, many minerals, food – with the pressure from biofuel production). This places the resource owners, and by extension the lower levels in the manufacturing hierarchy (China, rest of Asia) in a strong pricing position relative to the global north.
    Europe and the US provide similar kinds of services to the rest of the world (holding place for financial assets, sophisticated financial and other services, platform brands and marketing expertise, a huge array of niche and luxury products). However, Europe is fundamentally more resource efficient than the US because of it’s more compact nineteenth century urban layouts, public transportation system, more efficient auto-fleet, etc, etc. There’s something like a factor of 2 difference in per-capita energy usage, for example.
    So if we are now in a sellers market for commodities, it might make sense to have a fundamental long-term repricing of the dollar/euro relationship, to cause the available services/unit of commodities to be more equal. That in turn will place differential pressure on the US to conserve more.

  3. Simon van Norden

    Great blog.
    I always find discussions of how exchange movements should affect interest rates to be tricky in practice.
    On the one hand, we have simple models that stress uncovered parity, which implies that those real interest rate differentials must compensate investors for expected depreciation. But expected depreciation is a notoriously hard to model and measure, esp. given the large degree of uncertainty surrounding estimated “equilibrium” exchange rates.
    On the other hand, we have widespread evidence that uncovered parity really doesn’t describe the data, at least not at short- and medium-term horizons. That leaves us the choice of predicting variations in expectational errors (a challenge, to say the least) or risk premia (particularly the price of risk, which isn’t much easier.)
    Given these modeling uncertainties, do you think it would be informative to give conditional forecast *densities* (instead of point forecasts) when assessing what we know about how a dollar fall will affect interest rates?

  4. Emmanuel

    (1) Dr. Chinn, the “risk-free” Treasury rate has always irked me as I don’t think it’s justified, more so now as the US has run up $46.4T in total fiscal exposures according to the GAO.
    Macroeconomic models that have been used for determining credit ratings like Cantor-Packer typically use current macroeconomic data, not forward-looking data that accounts for future obligations. It makes sense to look at the latter IMHO as default risk is a forward-looking assessment that should be matched by future expected fiscal performance. Maybe you can come up with a credit rating model that incorporates future obligations. I’d have much use for it.
    Why does the American debtzilla get an AAA? It’s probably partly political-economic in that S&P and Moody’s are both American and the US would lose a lot of prestige if it were (rightfully) given a lower rating. If US Treasuries deserve a AAA, then my name is “Chuck Woolery.”
    (2) Somehow I don’t feel sorry at all for those who’ve hoarded dollars. Thou liveth life and maketh thine decisions. The Fed is tasked with maintaining price stability and full employment, not with shoring up the dollar’s role as a store of value. Insofar as inflation stateside hasn’t really been galloping as exporters have been willing to shoulder $ depreciation, the Fed is reasonably comfortable to cut, cut, cut away. With apologies to Buzz Lightyear, to $1.50 to the Euro and beyond!?

  5. DickF

    We can speculate about why the recent decline in the value of the dollar but the hard fact is that the nations of the world are so concerned that they are talking about dumping dollars.
    Right now China is betting that the FED will raise the value of the dollar and so they are buying dollars, but their rhetoric is clear. If the FED does not do something to stabilize the dollar they are prepared to take action.
    The dollar is sticky in its role as the reserve currency, but once the sticky begins to slide it will be a rapid loss to the dollar. China can not be ignored.

  6. Bryan S.

    Do you think that the falling dollar could result in an upcoming recession? Or do you think the FED will act before a recession hits?

  7. John Thacker

    The massive loss by Freddie Mac just reported, coming on top of the Fannie Mae report, suggests that it’s not just jumbo loans that they weren’t involved in securitizing that were the problem. You hear a lot of various suggestions about whether the problem was everywhere, or just in jumbos, or just in subprimes, or just in subprime jumbos, etc.

  8. Menzie Chinn

    bsetser: You’re absolutely right — we’ll probably never have a clean econometric test of the portfolio balance model. I don’t disagree, but I’ll note that we need not see any changes in flows when risk aversion and prices and returns change (although this seems unlikely). In other words, in theory valuations could change even in the absence of trades.

    I agree the weakness of the dollar could now could spur substantial current account adjustment, although I suspect a big chunk of the deficit reduction is due to retrenchment in consumption.

    Stuart Staniford: I think there must be an element of truth in your reasoning. In economic-ese, the terms of trade have turned more against the US than Europe, partly due to the greater energy intensity of the US. However, there are a lot of other effects also in play, including the cyclical factors (including interest rates).

    Simon van Norden: Yes, probably thinking of the entire distribution would make more sense than just the point estimates. I’m still looking for reaction functions and trying to measure expectations better, using survey data.

    Emmanuel: I agree that the shorthand of equating US government debt as the risk free rate is in some cases misleading. It would be better to say that this rate is the default risk free rate — and relative to other alternatives, it probably is the best measure (remember, the European countries and Japan face much more serious challenges associated with incipient debt burdens due to demographic changes. Returning to the US Treasury rate, it certainly isn’t totally risk free (since risk is measured in most theoretical models is a function of covariance with consumption).

    Bryan S.: The declining dollar will tend to reduce the probability of a recession (since it spurs exports and depresses imports), unless the drop is so precipitous that it causes a further financial crisis, or exacerbates the credit crunch.

  9. PrefBlog

    November 21, 2007

    Menzie Chinn of Econbrowser wrote a good piece yesterday reviewing the dollar’s decline, noting:
    So while there is a tremendous amount of inertia in a currency’s reserve role, what we might be seeing now is the interaction of cyclical facto…

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