US Federal Reserve Board chairman Ben Bernanke on Tuesday broke with a
long-held convention and discussed the Fed's concerns over the declining US
dollar (see also
Dead dollar sketch, Asia Times Online, March 4, 2008).
Typically, only the US Treasury, now led by Hank Paulson, is supposed to talk
about the dollar, but then again perhaps the Fed chairman was peeved with his
counterpart's lack of enthusiasm for pushing up the US currency. In any event,
the scuttlebutt in Washington has been that Paulson is too busy interviewing
for Wall Street jobs that may see him emerge as the head of a banking colossus
early next year; with time running out on the Bush administration he doesn't
have long before facing the risk of
joining the unemployment queue himself.
Going back to Bernanke's verbal intervention on Tuesday morning, seeing as it
was the Fed that was doing the talking up, the markets immediately responded by
buying the US dollar and driving it up against Asian currencies such as the
Japanese yen as well as against the euro over the day. Curiously, the stock
market was falling through this period, led by financial stocks as concerns
mounted that another investment bank - market speculation focuses on the
smallest one, Lehman Brothers - had to borrow from the Fed (denied by the
company) and would likely have to shore up its capital (not denied). On Tuesday
alone, Lehman saw its share price fall almost 10%, pushing overall financial
stocks down by 2% for the day.
Even bigger commercial banks such as Wachovia have fared poorly in the markets
of late, highlighting the shift in market concerns from the over-leveraged
investment banks to the wider financial system, as it confronts mounting
defaults from mortgage borrowers, and increasingly on consumer finance products
such as credit cards. All this bodes ill for the sector at large, suggesting
that the time for them to go around hat in hand for more capital (yet again) is
not that far away.
The combination of the Fed intervention and swooning financial stocks does not
in my mind present a coincidence. It appears quite likely that the Fed is well
aware of brewing problems at one or more investment banks, and seeing as these
banks would need to raise capital once again in the next few weeks the central
bank may well have seen the need to shore up confidence in the United States as
represented by its benchmark, the dollar. Think about it like this: a falling
dollar implies lower valuations for American stocks, but also higher investment
risks for anyone considering investments in US financial companies.
Lastly, given rising inflation in the US, the Fed has limited ammunition to
help its financial sector with further rate cuts. At the most, it could try to
push through one more rate cut, but with most of the world's large bond
managers warning about the poor value of US Treasuries at current yields, such
as a cut could have the perverse effect of increasing bond yields as markets
show dissatisfaction with the central bank.
It is believed by some in the markets that various sovereign wealth funds
contacted the US administration in recent weeks to ask about how serious
problems in the financial system were likely to become, and more importantly
about the outlook for the US currency.
In turn, the weakness of the currency has been the key driving force of oil
prices that have had the deleterious effect on inflation across Asia, for
example. To a large extent, the discussions may well have emanated from the
constant US prodding for Asia to change its currency policies to allow greater
appreciation against the US dollar.
Markets and inflation
This is where the story becomes a tad more complex, particularly for Asian
central banks still living in the previous century. There is still talk in the
region of "allowing" their currencies to appreciate, but most central bankers
in the region have lost this window in the past few weeks. Inflation reports
from across the region have been horribly high, with many countries showing
double-digit year-on-year increases, even after all the "adjustments" on
calculating inflation baskets. What you and I in plain terms would call lying.
On the other side of the coin, growth has been falling around the region as
well. This combination of higher inflation and lower growth is what is known in
economic circles as stagflation, and is clearly something you would want to
avoid as part of any legacy. However, I would argue quite strenuously that
Asians have missed the boat completely in terms of controlling the inflation
Additionally, the flow of hot money into Asia has been slowing dramatically in
the past few weeks, as shown in falling stock markets and rising interest rates
in regional bond markets. This presents a headache for governments, as interest
costs are rising alongside falling tax revenues, essentially pushing most
towards larger fiscal deficits for the current year. Meanwhile, rising oil and
commodity prices alongside falling export demand particularly from the US means
that current accounts for most Asian countries are also likely to tip towards
deficits by the third quarter of this year.
Vietnam represents a cautionary example for all Asian governments. The country
attempted to fight market attempts to push the value of its currency, the dong,
higher. This was "achieved" by strong-arm tactics, including the arrest of some
bankers, and pushing through drastic limitations on foreign investors. Stuck
with a number of their investments, foreign investors have pushed up Vietnam's
credit costs in external markets, by more than 100 basis points in the past two
weeks alone, essentially rendering any recourse to such financing untenable for
the country. Meanwhile, the loss of investor confidence has pushed stock
markets into a downward spiral, with the benchmark index falling every day in
May (absolutely unprecedented anywhere in the world).
This is the problem with traditional Asian responses to market forces, dictated
as they are by communist ideology rather than rational understanding. The
fallout from Vietnam is quite negative for smaller Asian economies, such as the
Philippines, as it shows the limits of market patience with such government
shenanigans. A rising US dollar would make matters worse for Asia in the short
run, by creating greater inflation and sharper declines in household wealth,
even as the concurrent benefits on exports fail to materialize thanks to a US
In such a situation of rising budget deficits and falling current accounts,
Asian governments will need to put their resources (and reserves) to better
use, namely to buy essential commodities as well as to stockpile food. This
would help to stabilize prices across Asia and ensure that there is no
consumption bust in coming months. At that point, relative economic strength
against the US can be used to argue for rising currency values, and therefore
falling inflation for the region. This does depend on the first steps being
successful, namely that inflation is brought under control.
The Fed would much rather that Asian central banks instead used their cash to
buy stakes in US financial firms, even if (or more likely because) that
guarantees billions in lost value over the next few years. Bernanke's Fed pines
for the near-distant past, when compliant Asians simply bought US financial
paper that helped to generate economic growth in the country and also provided
supplemental benefits for Asians in the form of rising exports. Unfortunately,
those days are well behind us.