Tuesday January 27th, 2015

What does the Triffin Dilemma, the Strong Dollar, the Price of Oil and the Rising Risk of Default have in Common?

We have always been fascinated with the Triffin dilemma:

Basically the Triffin dilemma says that under the Bretton Woods monetary system (a gold standard system) a country whose currency is the international reserve currency will need to run balance of payment deficits in order to supply its currency to the rest of the world. There was some dispute when the Bretton Woods agreement was formulated between John Maynard Keynes (working for the British) and Harry Dexter White (leading the US delegation) about using the USD in that role; history records who won that discussion. Interestingly, Keynes and E. F. Schumacher had formulated an alternative called the “Bancor” which was essentially a supranational currency; now 60yrs later, many in the economic world are reconsidering this idea due to the perceived turbulence that rapid changes in the value of the USD have had in international economy in the last two decades. The rise in the BRICs have also brought with it some questioning of the US’s use of the its reserve status privileges especially in light of the USD leaving the peg to Gold under Nixon in 1971.

Much has been written about the USD’s recent strength, but little has been discussed about the causes and the potential implications.

The Bretton Woods system failed, in part, due to the US’s need to fund the Vietnam war. The US was borrowing money at an unprecedented rate and foreign governments began asking for US gold due to the peg. As the supply of dollars was expanding Nixon correctly was advised to remove the gold peg and prevent the world from exporting the US’s gold supply — probably averting a crisis in the making. That said, any anchor the FED or the US government (or later governments with fiat currencies) had was once and for all removed. In hindsight, there was little doubt what the consequences were which would follow:

From the mid 70's the US began running current account deficits at ever expanding rates

By the early 80's the US was going full bore on a borrowing binge with only a brief respite occurring during the 1991 recession, but then it was full steam ahead and even with the great recession we haven't been able to rebalance the current account (and should not under the Triffin dilemma). It's little surprise then that the US has triple deficits in trade, current account and fiscal. Furthermore, with the gold window gone, there is no real economic “gate” to prevent the US from continuing down this path for decades, other than some systematic monetary event (which Keynes suggests will eventually happen). After all, virtually everything is priced in USD, from commodities to planes even many countries peg or use quasi pegs to the USD. Essentially this has opened the world up to economic “nirvana.” All central banks now have entirely fiat currencies which have no intrinsic value other than the full faith and credit of the backing government; say what you will, but the US still has the faith of the world and as a result the vast amount of trade is conducted in USD.

But returning to the USD, its role in international finance has not been without trouble. As noted by Keynes the world reserve currency would need to finance international trade (even without the gold peg) and would remain in great demand. So while possibly negative to the US, its current account deficit has financed the growth in Japan, China, Asia, Canada, Central and South America and Europe. We all know what this means, the US consumer seemed to have an endless appetite for foreign goods and services- the dollars of which get recycled back as foreign reserves—but in fact this was predicted by Keynes. This situation has created the largest supply of reserves on the planet but facilitated international trade to everyone's benefit (most of the time). The demand for dollars during expansionary times had created a massive demand for offshore dollar debt as well, both corporate and government. In essence, as Keynes predicted, the world has a need for the USD for the financing of international trade.

Will we ever learn…

Whenever the US has had to make abrupt changes it its own monetary policy it has impacted the offshore dollar world directly. In the 1980s, when Volcker was raising interest rates to fight US inflation the South American debt fiasco emerged as the USD rose due to higher rates due to FED tightening. As the foreign debt was priced in dollars and the national banks were in another currency (which devalued relative to the USD) defaults arose. It happened again when the loose monetary policies of the late 80s and the economic revival of the USD led to a massive credit bubble in Asia which was benefiting from US growth. But as Greenspan raised rates the USD followed a fast path up and capital flight occurred which nearly wiped out most of the Asian tigers reserves (Korea needed an IMF bailout) and Russia would ultimately default. It happened on the grandest scale of all in the late 2007 when the easy money policies under Greenspan in the years before led to a massive credit bubble in the US housing industry whose debt securities were exported around the world being rated AAA without regard for the risks inherent in these securities many of which were made by subprime borrowers. Is it any wonder then that over the last 5 recessions, the USD has appreciated either before, during or in the aftermath? Dollar liquidity is a key driver to international fiance and when the USD strengthens after prolonged periods of easy money, borrowers who are financing the debt in other currencies often are unable to pay (both due to increase debt service associated with the changes in FX rates and the higher rates required to refinance ongoing debt), leading to default.

The strong dollar is a function of changes in US monetary policy

The Easiest Monetary Policy Ever…

The Great recession has left its marks around the world. But the biggest has been the expansion of central banks monetary base with virtually every central bank acting out:

Switzerland, as one can see, due in part to its peg with the EUR was the latest Central Bank to go expansionary. The ECB will being €60tr/mo in 2015. China was the record holder but has been backing off since 2011, which may explain some of the slowdown in growth in China.

The success in these programs has been mixed. Japan is embarking on a printing mission that has the central bank buying virtually all the government issued debt. Switzerland accumulated assets in defence of its peg to protect the Swiss Franc from the devaluation of the EUR so it is likely the Swiss may unwind this expansion. The US has succeeded in increasing asset values, with housing recovering substantially since the Great Recession and the US stock market at record levels. While the program has at least succeeded (on some level)in the US, one wonders if the impacts on non dollar reserve countries will be the same? The experience in Japan is currently suggesting that it won't be; the JPY has lost more value than the gains in broad equity market, an experience the US was able to avoid. None of the really matters, because its USD liquidity which has the most impact due to global demand for USD.

Without going into great detail, one can show that the US QE programs and the expansion of the monetary base was mostly offsetting the fall in total credit experienced due to defaults and restructurings around the world related to the great Recession; hence despite the growth in the FEDs balance sheet it hasn't proven to be inflationary (yet). The same is true for Japan and the UK (and now the EU), but its far less certain in China who embarked on a massive program far exceeding the FEDs. All this loose money gradually eased credit risks/spreads and USD liquidity returned to international finance (due in part to the actions of the FED). The result has been $9tr of offshore debt issuance; coming on the heels of a change in FED policy — will we ever learn?

This loose monetary policy of the FED has resulted in falling volatility in equity and debt markets as well as record low interest rates and historically low spreads to junk credit. One of the side effects of this policy has been the use of debt to finance oil exploration projects around the world (not just in the US). Armed with cheap financing and Oil prices stabilizing in what everyone believed was locked in levels around $100/barrel banks and insurers around the world financed exploration projects in the arctic, shale (US) and offshore deep water rigs. Whether or not it was a bubble is unclear now, but what is clear is that the rates of interests do not appear to be anywhere near the risk creditors are undertaking and this has been due to central bank intervention in the debt markets in their attempts to drive asset prices higher; thinking the “wealth effect” would trickle down to economic growth. But Oil was/is just a small portion of total USD offshore debt so there are likely many other risks not fully identifiable.

In any case the mix of cheap credit and high oil prices created the opportunity to extract Oil at unprecedented rates from shale deposits. The shale revolution has become so exciting many in the US were prognosticating energy independence again for the US by extrapolating the chart below years out into the future.

What everyone forgot was that Central Bank monetary expansion was due to sluggish growth; and of course, with sluggish growth comes reduced use of energy. Adding to that the mix of cheap rates and stubbornly high Oil prices led to the global expansion of exploration and production (not just in the US). The mix was deadly; global Oil production began to outstrip demand. In just the US, lets look at what the reduction in US interest rates (and the availability of cheap financing), the high prices for Oil and the shale revolution did to the US trade picture.

As you can see in the chart above, the US trade deficit has been shrinking despite the expanding US economy; first dramatically due to the Great Recession, but steadily since 2010. Returning to the Triffin dilemma, the US needs to supply USD to the world for international trade (and finance). But the USD trade deficit was improving, sucking dollars out of global trade, at the same time, QE was expanding USD liquidity providing likely needed global supply. However, with the cessation of QE in 2014 that tailwind to international liquidity ended. At the end of 2014, the US hit record Oil production levels (which are expected to continue into early 2015). The impacts of the recent changes in the price of Oil will likely eventually slow new projects — but what is clear is that the shale revolution reduced US imports of Oil (a major component of trade) thus creating a tailwind to the reduction of the US trade and current account deficits. So is it a surprise that as soon QE ended and Oil fell in price, EM currencies most vulnerable (to the price of Oil) to reduced dollar liquidity (Oil producers) all saw the first hits to their FX rates? And is it also a surprise, as can be seen from the chart above, that the USD began to rise against virtually every currency in the world — demand for dollars was increasing due to a plethora of reasons ranging from reduced dollar liquidity (related to the cessations of QE and decreased imports of Oil by the US), risks associated with the EU break up and real concerns that the FED would be normalizing monetary policy due to the stronger US economy (thus raising interest rates in the US relative to the rest of the world). Just as we have seen in the last crisis US monetary policy, due to its internal needs (as Keynes warned) is putting pressure on the USD. When one considers the need for USD financing, which may well exceed the $9tr estimate, the risks of a strong dollar to the global economy are great — we have seen this picture several times before.

Putting it all together

The USD is both used domestically and in international finance, when the FED expands monetary policy it not only impacts the US economy but indirectly the rest of the world through the USD reserve status. The current situation where the US was distorting economics through the use of QE to force down both short term and long term rates (below market induced rates) caused imbalances that have lead to possibly a bubble in international lending in USD; even if not a bubble an excessive amount at rates not appropriate for the risk. The same situation is occurring in the EU with rates in some countries (Switzerland) negative out to 9 years (due to the lack of growth and rising risks around the world). These imbalances cannot continue. For example, presently Spanish and Italian 10yr government bonds trade at a discount to yields in US government 10ry bonds. Does that make sense in light of the risks associated with these bonds and the countries ensuing them?

If the US is to continue as the reserve currency of choice, it must continue to supply dollars to the international system, if not it risks times like today where its internal policy comes before the worlds needs for USD- and potentially leads to a strong dollar and increased and unexpected debt burdens on governments, companies or individuals borrowing in dollars in international markets.

Clearly the USD should not be the reserve currency for this very reason.

Nevertheless, the USD will continue to rise as long as the US is not increasing the supply of dollars to the international markets (either through QE or trade). As its unlikely the US will introduce any QE for sometime and the trade picture is unlikely to change much through 2015, so the risks of a rapidly rising dollar are great. If the FED raising rates while, for example, the EU and Japan continues to expand their QE policies it is likely the USD could have a further significant move upward. Moreover, the potential for EM currencies instability is seriously worrisome. Argentina, Russia and a host of other countries could face defaults or at least significant additional pressure. Who will default first is the real question, many countries are now in that zone (Ukraine, Russia, Venezuela, Argentina, etc..) and others may follow (some EU countries face defaults including Greece, Italy and Spain).

It remains to be seen if this dollar rally will be like the 3 of the last 4, but we wouldn't bet against a credit crisis reemerging from the lastest change in US monetary policy and the fast upward surge in the USD that has just begun.

The Answer?

The USD fiat reserve system.

This story was published from my blog at www.darinoliver.com

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