Wednesday, August 27, 2008

Mortgage Crisis, the Dollar and its Future, Part 4

Various other countries, even those not hostile to the U.S., also seek to reduce their their risks by reducing their dollars. Over a year ago Italy, Russia, Sweden and the United Arab Emirates announced they would reduce their dollar holdings slightly. Sweden's 90 % dollar foreign reserve went to 85 %. The UAE said it would convert 8% of its dollar holdings to euros. Friendly Japan, the largest holders of U.S. treasuries, was a net seller of $46 billion in U.S. treasuries in the last 12 months, reducing its holding by 3 % in three years. South Korea sold $19 billion this past year.

U.S. citizens, like foreign governments, have been diversifying out of depreciating dollars. In the last two years, more than 200 internationally focused mutual funds have been launched in the U.S. When the dollar is weak, overseas gains are worth more when translated back into dollars. This is part of the reason these mutual funds gained 16.3 % last year compared with 5.2 % for U.S counterparts. In 2007 more than 95 % of net inflows of money into mutual funds went into internationally focused funds, compared to less than 10 % five years ago. This net outflow of capital adds to the underlying weakness of the dollar: mutual funds and other institutions sell increasing amounts of dollars to buy increasing amounts of currencies in which the foreign stocks are denominated.

An increasingly popular way for governments to diversify out of dollars is through so-called sovereign wealth funds. These are state-owned entities that invest central bank reserves in stocks, real estate, bonds and other financial instruments. They are typically created when central banks have reserves massively in excess of needs for liquidity and foreign exchange.

Back in 1971 the U.S. said foreign governments couldn't exchange their dollars in gold. Now they have been told they can't exchange them for certain other things either. The U.S. prevented the sovereign fund of oil-rich Dubai from buying a company that operates six U.S. ports. It also prevented a Chinese government-controlled company from buying Unocal, an oil company. The Chinese company withdrew its offer of $18.5 billion, “saying it could not overcome resistance from politicians in Washington,” according to the Washington Post.

Countries have to question the value of accumulating a currency they can't spend in the country that issued it. Fortunately for them, the credit crisis gave them another opportunity. Massive losses by U.S. banks and other financial institutions created a need for cash. In January 2008, Citigroup (formerly Citibank), the nation's second largest bank, reported a 4th quarter loss of $18.1 billion, in addition to a $6 billion loss in the third quarter. Merrill Lynch, a 94-year firm that is the world's largest brokerage, reported a 4th quarter loss of almost $10 billion after $16.7 billion in write-downs from subprime mortgages and CDOs. Morgan Stanley reported a $9.4 billion loss for the 4th quarter. UBS reported a 4th quarter loss of $14.45 billion, primarily from U.S. subprime mortgages. Sovereign wealth funds from China, Singapore, South Korea and other nations jumped at the opportunity to buy into these companies. Merrill Lynch obtained $6.6 billion in January from South Korea, Kuwait and Japan and $6.2 billion the previous month from Singapore. UBS received $9.75 billion from Singapore. China now owns 9.9 % of Morgan Stanley.

Mindful of the earlier problems of Dubai and the Chinese attempt to buy Unocal, foreign governments are well aware they may encounter further political obstacles to investing in the U.S., particularly if the current banking crisis abates. In any case, they are looking for other ways of diversifying out of dollars. Think gold. It is something they can buy without any government's permission. It has an unrivaled record of 5,000 years as a store of value. And it surely is more valuable than unredeemable paper currency. Last year Qatar tripled its reserves of gold in one month. That still was a small amount, but what if other countries with far larger dollar reserves start trading them for gold?

For more than a century, South Africa has been the world's leading producer of gold. For most of those years, it produced three-fourths of the world's output. But last year it was in second place. The number one gold producing country in 2007 was.....(are you ready for this?)......China!

Through centuries of political and economic turmoil, people in China and India have hoarded gold and silver jewelry and bars as a means of storing wealth. There were no large, organized markets; prices were determined by the haggling of local buyers and sellers. All that has changed. New opportunities have greatly expanded commerce in gold and made it much more convenient for the public, which has responded with enthusiasm. Investors can now trade in physical gold on the Shanghai Gold Exchange. Some new Chinese gold issues are traded over the internet. On January 9, 2008, China's first gold futures contract was launched, attracting thousands of investors. A spokesman for China International Futures said “about 90 % are individual investors, most of whom were moving assets after turning bearish on the stock markets.” As China's economy grows, people have higher incomes that raise the appetite for gold.

The State Bank of India plans to launch an exchange traded fund (ETF) this year that will enable investors to trade gold like a regular stock. Dubai also hopes to launch an ETF in gold this year. In August, 2007, the Osaka Securities Exchange in Japan began offering a gold-linked bond aimed at smaller investors. In January the Hong Kong Exchanges & Clearing Ltd. announced plans for ETFs and other gold-related investments.

Gold buying in the U.S. used to be a clumsy process. For decades, thanks to President Franklin Roosevelt's prohibition on owning gold, U.S. citizens could not even own the metal except for jewelry and coins classified as collector's items. After gold became legal again, the investment process was small-scale and cumbersome. Investors buying gold coins or bars were faced with varying—and sometimes hefty—commissions plus storage and transportation costs. Investing in gold became more convenient and efficient with the advent of ETFs. These allow investors to buy or sell shares of stock shares tied to the value of the underlying commodity. When people buy shares of stock in such a fund, the fund buys an equivalent amount of gold, which is stored in vaults. When shares are sold, the fund sells an equivalent amount of gold. The ease and simplicity of the process, with the same commissions as for regular stocks, has resulted in investors pouring billions of dollars into these funds on stock exchanges in the U.S., Paris, London, Australia, South Africa, Mexico, Singapore, and some other countries. The most active gold ETF is SPDR Gold Trust, which trades on the New York Stock Exchange. It holds more gold than the European Central Bank or China's Central Bank. Meanwhile, gold futures are trading robustly on the world's most important gold market, the Comex division of the New York Mercantile Exchange, and on the London Metal Exchange. Other gold plays include a five-year gold bullion CD from Everbank Financial, common stocks in gold mining companies, and mutual funds specializing in those stocks.

Both foreign governments and individuals are turning away from the dollar as it loses value. The dollar is in danger of losing its status as a reserve currency. The international monetary system that has existed since the post-World War II Bretton Woods agreement is coming apart at the seams. Recently Bill Gross, CEO of PIMCO, the world's largest bond fund manager, wrote, “What we are witnessing is essentially the breakdown of our modern day banking system.” Vladimir Putin has called for a “new international financial architecture,” a call that resonates with emerging economies such as China, India, Brazil. At an international economic forum in St. Petersburg in June 2007, Putin pointed out, “Fifty years ago, 60 % of world gross domestic product came from the Group of Seven industrial nations. Today 60 % of world GDP comes from outside the G7.” In view of this growing global economic trend, it is hard to see the current monetary system enduring when the linchpin of that system, the U.S. dollar, is continually undermined by the inflationary policies of its own government.

Regarding a recent hint from China about dumping a portion of its dollars, Judy Shelton, Ph.D., a professor of international finance and author of books and articles on monetary issues, said: “The prospect of such a shock to the U.S. economy in the midst of a housing slump threatens to bring the whole edifice crashing down. Throw in statements of support from oil-producers Venezuela and Iran, and you have the makings of a devastating dollar rout.” Incidentally, last July Japan agreed to pay for its oil imports from Iran in yen rather than dollars.

Even if China does not dump its U.S. treasuries on the market any time soon, the longer term outlook for the dollar is still bleak. It seems unlikely any of the trends that brought us to this point will reverse; more likely, they will worsen. Earlier I mentioned that the U.S. national debt is now $9 trillion. But that does not include unfunded Social Security, Medicaid and similar obligations. If those are included, the debt is $59 trillion. There is no way those future bills can be paid in terms of current dollars. As a “solution,” future administrations will simply employ larger doses of the same inflationary measures that created the problem. Because of structural changes in our government many years ago, which I discuss at some length in my book Makers and Takers, the system has evolved to favor the politicians who spend more and promise more. “A lot of people, including me,” said Paul Volcker, former chairman of the Federal Reserve, “have been saying that the country has been spending more than it's been producing, and that will have to come to an end. The question is: Does it come to an end with a bang or a whimper?”

The attempt to kick the problem down the road to the next generation and let them pay off future obligations with trillions of dollars worth a fraction of today's dollars will no longer work. As the dollar loses its stature as a reserve currency, as countries one by one defect from their formal links to the dollar, as U.S. dollars pile up abroad from financing our deficits, and as our borrowing becomes increasingly expensive, the monetary framework becomes ever more fragile. The danger of creating a run from the dollar could easily snowball like the run to gold prior to Nixon's action in 1971. The dollar may survive this crisis, or the next one, but there will always be one more, to which the U.S. will be more vulnerable than to the previous ones. Long before that $59 trillion debt comes due, the dollar will have lost too much value to be trusted any more. The end will not come with a whimper.

Edmund Contoski is the author of MAKERS AND TAKERS: How Wealth and Progress Are Made and How They Are Taken Away or Prevented (American Liberty Publishers, 1997).

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