the future of the dollar and china - radiant asset white paper

The Future of the Dollar and China: The Threat of Collapse and the Move

Towards a New Reserve Currency

Initially published October 27, 2009 Revised April 22, 2010

Prepared by: David Justin Ross Chief Investment Officer Radiant Asset Management, LLC

Radiant Asset Management, LLC P. 2

Introduction In their important book, This Time is Different,1 Carmen Reinhart and Kenneth Rogoff stress the role debt plays in causing financial crises:

[L]arge-scale debt build-ups pose risks because they make an economy vulnerable to crises of confidence, particularly when debt is short term and needs to be constantly refinanced. Debt-fueled booms all too often provide false affirmation of a government’s policies, a financial institution’s ability to make outsized profits, or a country’s standard of living. Most of these booms end badly.2

Debt has played an important role in the boom-bust cycles of the past decade. Both the stock market boom of the late 1990s and subsequent crash and the recent housing boom and bust were fueled in part by a too-loose credit policy by the Federal Reserve that was only half-jokingly called “the Greenspan put”. After the stock market crash in 2000, interest rates were kept very low in part because the Federal Reserve feared a deflationary cycle. Instead, the low rates fed inflation in housing prices and excessive accumulation of household debt. When the housing bubble burst and the worst recession in a generation hit beginning in 2007, the Federal Government began a spending spree (and debt accumulation) in an attempt to restore confidence. Today, that debt is fueling a slow crisis in the U.S. dollar. Each time, the seeds of the next crisis were planted by the efforts to ameliorate the previous one. And each time debt and credit played an important role. Today, public attention is increasingly focused on the burgeoning national debt. Some think unprecedented deficit spending on top of nearly one trillion dollars in stimulus money is essential to avoid a deflationary spiral and to lift the country out of the financial crisis. Others, growing in number, believe that the spending will lead to runaway inflation, a collapsing dollar, and a world-wide balance of payments crisis. Few commentators put the current situation in historical context or seek comparable periods for hints of what is likely to occur. Fewer still look at the investment strategies appropriate for the current era. This paper seeks to moderate the tenor of the current debate by putting the current spending in proper historical context. Facts may be less interesting than opinion, but they are more useful for making investments. To make good investment decisions in times of uncertainty, an understanding of what is happening and why is required. Only in the context of information and facts can thoughtful decisions be made. This paper looks at the current deficit in historical terms, how it affects the United States’ global relationships, where there is hope and justifiable fear and, most importantly, the likely outcomes and how to profitably invest accordingly. We look at the U.S. government’s true obligations, who holds U.S. government debt, and why they hold it. We discuss whether the debt holders are likely to continue to purchase the debt instruments and

1 This Time is Different: Eight Centuries of Financial Folly, Reinhart, Carmen M. and Rogoff, Kenneth S., Princeton

University Press, 2009 2 Ibid p xxv.


what happens if they stop. We shall see that, second only to the U.S. government, China will determine the future of the dollar, and through it, of the American Economy.

The Deficit and the Debt “Debts are like children: begot with pleasure and brought forth with pain.” – Jean-Baptiste Poquelin (Moliere) Let’s start by looking at the Federal budget during the past 70 years, with data from the Congressional Budget Office.

Chart 1: The Federal Budget, Current Year Dollars

Chart 1 shows the budget in current-year dollars. It should be noted that two estimates of out-year budgets are presented: the 2009 estimate and the 2010. This graph shows exponential growth, but because it does not adjust for inflation, it has limited utility. Chart 2 adjusts for inflation.

Source: CBO, http://www.cbo.gov/ftpdocs/108xx/doc10871/historicaltables.pdf Data as of Jan 2010 and is estimated for 2009 and 2010 as indicated.

http://www.cbo.gov/ftpdocs/108xx/doc10871/historicaltables.pdf


Chart 2: The Federal Budget, 2005 Dollars

Adjusting for inflation, the outlook improves some, but the trend is still disturbing. Current expenditures and current deficits overwhelm historical numbers, even those from World War II. Chart 2 gives the impression that the government is devouring a larger and larger share of the U.S. Gross Domestic Product (GDP). That impression, however, is wrong. Using Chart 2, it is easy to argue that there has been runaway government spending since the start of the Eisenhower Administration. What is deceptive, however, is that it fails to account for the growth of the economy. The following chart presents the data adjusted for that growth.

Chart 3: The Federal Budget as a Percentage of the Gross Domestic Product

Source: CBO, http://www.cbo.gov/ftpdocs/108xx/doc10871/historicaltables.pdf Data as of 1/26/2010

Source: CBO, http://www.cbo.gov/ftpdocs/108xx/doc10871/historicaltables.pdf Data as of 1/26/2010




Adjusted for growth, spending and the deficit do not look nearly as alarming, and in fact, are essentially steady. Ignoring WWII, total Federal outlays have risen from about 18% of the GDP when Truman was president to 20% at the time of George W. Bush’s second inauguration. Hardly cause for panic. The budget is not the chronic problem people commonly perceive. Instead, it is the anomaly of the current deficit that is worrisome: nearly three times the previous maximum of the past 60 years. It swamps the deficits during the Korea War, the Vietnam War, and the Cold War, and is exceeded only by those of WWII. The chart shows out-year budgets returning to normal, but how believable is that projected return? Chart 4 below focuses on the future and recent past and includes both the 2009 and 2010 estimates.

Chart 4: 2009 vs 2010 Budget Projections What a difference one year makes! The 2009 estimates for both current and out-years were consistent with historical norms. Current estimates, however, are not. The currently projected 2009 budget deficit is nearly five times as large as the estimate when the 2009 budget was assembled. Outlays are much higher and receipts much lower than what was projected only one year ago. Keeping in mind that the financial crisis was already in full swing when these estimates were made, how likely is it that the period 2010-2019 will play out as shown here? It seems more probable that this year’s deficit of 13% of GDP is likely to continue for longer than currently estimated. The next section looks in more detail at the U.S. national debt and its projected growth in the coming years.

Source: CBO, http://www.cbo.gov/doc.cfm?index=8917 Data as of 1/26/2010


The National Debt Increases in the national debt and budget deficits are only imperfectly related, largely because the U.S. government uses accounting methods that would make Enron blush. It is difficult to define clearly what constitutes the national debt. This is in part because the U.S. government has comparably-sized off-budget and on-budget obligations. Additionally, a large share of the debt securities is held by the U.S. government itself or by the Federal Reserve, making those holdings difficult to classify. If one part of the government owes money to another part, is that really debt? Chart 5, issued by the Treasury Department, shows the holders of the debt.

Chart 5: Holders of U.S. Debt The total debt – that is, the total value of all outstanding U.S. debt instruments – is the “Public Debt”, shown in dark blue in Chart 5. What most people think of as the debt is the “Privately Held” portion. It need not be privately held at all – Chinese government holdings are in this grouping – it just is not held within the U.S. government. The difference between the “Public Debt” and the “Privately Held” portion are just the off-budget debts owed from one branch of the Federal Government to another. These “Public Debt” obligations occur when Social Security, for example, takes in money for its “trust fund” and the Treasury promptly takes that money and replaces it with bonds. Congress then equally promptly spends it. So they are real obligations of the Federal Government whether or not one is comfortable calling them debt. The “Privately Held” portion is further divisible into foreign holders (light blue), state and local governments, pension plans, mutual funds and insurance companies. In most of what follows we will

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Source: US Treasury, http://www.ustreas.gov/tic/mfh.txt Data as of 2/1/2010


observe the common practice and refer to the “Privately Held” portion as the debt. Its increase is the annual deficit. We will distinguish this from the total debt and its changes where necessary. The (almost) ever-rising debt As Chart 3 shows, running a surplus is not a common occurrence. There have only been two periods of protracted surpluses since World War II: the post-WWII return to a peace-time economy and the 1990’s “peace dividend” from the ending of the Cold War. The current U.S. national debt is around $7 trillion, approximately 60% of the country’s Gross Domestic Product. These unprecedented numbers are just a prelude to what the Congressional Budget Office estimates will occur in the next 10 years, as Chart 6 shows.

Chart 6: Projected National Debt The national debt requires the payment of interest to the holders of U.S. government bonds, notes, and bills. So shouldn’t we expect interest payments to be soaring? One of the many counterintuitive facts that comes from studying the debt is that while the debt itself is at record levels in dollar terms (and nearly so as a fraction of the GDP), interest payments are far lower (as a share of total expenditures) than they were twenty-five years ago. They are approximately 8% of current federal expenditures, while in the mid 1980’s they ranged from 10 to 15%. This is due to very low current interest rates. The average debt instrument currently yields 3.347% according to the U.S. Treasury, very low by historical standards. The problem will come when interest rates begin to rise3. Bad as Chart 6 appears, it only discusses the “privately held” debt, ignoring “off-budget” items. Chart 7 shows what the change in the debt looks like if Medicare, Medicaid, and Social Security (the last running

3 The effect of an interest rate rise will be felt quickly because the majority of current U.S. government debt is

relatively short term. The average duration of the notes and bonds sold in 2009 has been eight years, excluding the sale of substantial amounts of sub-one year debt. This keeps current interest payments low but sets up a problem for the future.


a current surplus) – all of which are off-budget items – are included. Note that even though there was a budget surplus in 2001, the total national debt still increased that year.

Chart 7: The Federal Deficit versus the Increase in National Debt Chart 7’s large growth in both the deficit and the increase in the National Debt in 2008 look positively benign when compared with what the Congressional Budget Office foresees for the next six years. It should be kept in mind that these numbers do not include the CBO-estimated $1 trillion expense of new government health care during this period.

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Source: US Treasury, http://www.fms.treas.gov/mts/mts0908.pdf Data as of 1/26/2009

http://www.fms.treas.gov/mts/mts0908.pdf


Chart 8: 2010 Budget – Projected Deficits and Debt Increases The large increases seen in 2008 are nearly same as the best case scenario going forward. The expected 2009 budget deficit – $1.75 trillion – is itself dwarfed by the actual debt increase of $2.73 trillion. The important lesson here is that the real debt increase is much larger than what is normally reported due to the outstanding “off-budget” items which still need to be paid. We learned, however, that looking at the budget, the deficit, and the debt in terms of current year dollars or even inflation-adjusted dollars can be deceiving. The important numbers are how these stack up against the GDP. Chart 9 shows the total debt (on- and off-budget) in dollar terms and as a fraction of the GDP. The chart is from the Congressional Budget Office.

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Chart 9: “Public Debt” The GDP for 2009 is expected to be approximately $14.4 trillion. The total debt by year-end will be $13 trillion, 90% of the GDP. This will rise to 100% of GDP next year and remain there as far out as the CBO projects. It is worth noting that in order to keep the debt at 100% of GDP while still increasing it at the 2010 rate of 9% per year, it is necessary to grow the GDP at 9% per year in current dollar terms. This means that if the GDP grows at 3% per year in real terms, prices have to inflate at 6% or else the debt will grow as a fraction of GDP. Even taking 2012’s estimated $950 billion increase in total debt and $16.5 trillion as standard, the CBO estimates assume a combined growth and inflation rate of nearly 6% per year. Off-budget items are not the end of the financial obligations of the U.S. government. The Financial Management Services of the U.S. Treasury estimated4 that the total obligations of the U.S. government exceeded $90 trillion. Table 1 reproduces that publication’s Table 6. The acronyms used are as follows: HI: Hospital Insurance, SMI: Supplementary Medical Insurance. Part B pays for physician and outpatient services, Part D for the prescription drug benefit program. OASDI is commonly called “Social Security”. This $90 trillion is not the same as the money borrowed from U.S. government Trust Funds by other government agencies. That borrowed money is taxes collected over the years and is supposed to be set aside for paying the obligations of the appropriate programs – Medicare, Medicaid, Social Security and others. But the collected money (which Treasury has borrowed and Congress spent) falls far short of what is required to fulfill the long-term obligations of those programs, even if it had not already been spent. Almost all of the $90 trillion are promised obligations with no established method of payment.

4 A Nation by the Numbers: A Citizen’s Guide, 2007.


Table 1: Total Obligations of the U.S. government

The long-term outlook is precarious at best. Let’s see what has happened with the debt this year. 2009 so far Despite the huge increase in their volume, U.S. Treasury sales have been moderate to good most of the year, with typical bid-to-cover ratios above 2.5. The following charts show four trends that have important consequences going forward. Chart 10a shows the percentage of U.S Treasury bond and note5 sales by duration. As can be clearly seen, they have been strongly biased toward short-term instruments6. Average duration for this year’s sales was 8.03 years7. Since interest rates are currently very low, this year’s very high debt purchases are particularly sensitive to rising interest rates at rollover time.

5 Bill sales, being less than a year in duration, are excluded.

6 Foreign purchases of US debt have also moved to shorter duration. In August, 2008, 12.6% of foreign purchases

of Treasury bonds, notes, and bills were bills. In August, 2009, 25.7% were. 7 A cynic might observe the coincidence of this duration and the length of two presidential terms.


Chart 10a: Duration of 2009 U.S. Treasury Issues

As the year progressed, U.S. Treasury sales accelerated dramatically, nearly doubling from January to September. Chart 10b shows this trend.

Chart 10b: Accelerating U.S. Treasury Sales in 2009

The next chart needs more explanation. As we will see in the following section, approximately half the “privately-held” debt of the United States is held by foreign entities or individuals, a trend that has been increasing for several years. Chart 10c shows the percentage of the Treasury bonds and notes purchased by foreign entities over the year. For comparison, in 2008 just over 50% of debt purchases were foreign. This chart starts at 30% foreign purchases, reflecting the strong concern, sometimes very

Source: US Treasury http://www.treasurydirect.gov/govt/reports/pd/mspd/mspd.htm Data as of 10/15/2009


http://www.treasurydirect.gov/govt/reports/pd/mspd/mspd.htm



publicly voiced, of foreign governments over U.S. deficit spending. Public complaints peaked in April and May. Foreign purchasers appear to have become more comfortable as the year has progressed. Today, most discussion centers on moving away from the dollar as a reserve currency rather than on not buying U.S. debt. This development is discussed in a following section.

Chart 10c: 2009 Foreign Purchases Return to Recent Levels

Closely related to the return of foreign purchasers, the fraction of U.S. Treasury sales bought by the Federal Reserve as part of its System Open Market Activity (SOMA) has declined. This reflects a lower-than expected use of Quantitative Easing (otherwise known as printing money) by the Federal Reserve as the 2009 year has progressed. Part of the reason the Federal Reserve announced that it was extending its purchases of Treasury, Agency, and Mortgage-backed debt is that it had not purchased as much as originally planned and it wants to keep that arrow in its quiver if the economy turns downward again.




Chart 10d: SOMA Percentage of 2009 Treasury Sales To summarize the year so far: debt sales are accelerating, focused on short-term debt, and characterized by a return of foreign purchasers and a well-correlated decrease in Federal Reserve purchases. It is obvious from Chart 10b that unprecedented quantities of debt are being accumulated. How this burden will affect U.S. retirements and the lives of American children and grandchildren depends greatly on what happens in the rest of the world. The high percentage of U.S. debt purchased by foreign interests guarantees that importance. The next section looks at the relationships between U.S. debt and the rest of the world.




The U.S. and the Rest of the World “Great indebtedness does not make men grateful, but vengeful” – Friedrich Nietzsche

Chart 11: Foreign Holdings of U.S. Debt

The effects of U.S. debt on her citizens will be determined by the rest of the world because the rest of the world has majority status as holders of that debt8. As Chart 11 shows, Americans no longer “owe it to ourselves”. We will look at this foreign ownership in detail farther on. The United States among the most indebted countries in the world. Chart 12 shows where it ranks among the 40 most indebted countries.

8 This excludes the “debt” one part of the government owes another.

Source: US Treasury http://www.treas.gov/tic/fpis.shtmlData as of 2/1/2010


Chart 12: Debt as a Percentage of GDP – Top 40 Countries

Chart 12 uses the 2009 world figures from the International Monetary Fund and debt and obligation statistics from the Treasury Department. Including only on-budget items, the United States has the 37th highest debt load in the world, nestled between the Cape Verde Islands and Morocco (in green). Counting total debt, the US is 13th, between the Seychelles and Greece (in orange). Including unfunded obligations, the U.S. moves to 1st, well above Taiwan and Zimbabwe for the highest debt to GDP ratio (in red). U.S. total debt plus unfunded obligations total 625% of GDP. About $3.5 trillion in U.S. debt instruments are held by foreign nations, half the total publicly held debt9. Chart 13 shows the disproportionate role played by China and Japan, at 23% and 21% of the foreign-held debt respectively. The blue bars are as of August, 2008 and the red bars are as of August, 2009. The rankings are as of August, 2009.

9 As usual, talking about the debt is complex. China is the largest foreign holder of U.S. debt, but it is only the third

largest holder of the debt overall. Mutual funds are the second largest – at slightly more than $800 billion. The largest holder of U.S. debt instruments is the U.S. government itself. More than $4.7 trillion is held in intragovernmental accounts, primarily Social Security and retirement pensions, as discussed previously. The Federal Reserve currently holds approximately $500 billion in U.S. Treasuries in Federal Reserve banks, out of their total holdings of $1.56 trillion in U.S. Treasury and Agency securities and Mortgage-backed securities.

Source: IMF, US Treasury Data as of 10/15/2009


Chart 13: Non-U.S. holders of U.S. Debt Instruments Perhaps the only surprises here are the sudden rise in UK purchases – in a year when Britain was having substantial debt problems of its own – and the 5% held by “Caribbean Banking Centers”. These are places such as the Bahamas, Bermuda, the Cayman Islands, the British Virgin Islands, the Netherlands Antilles and Panama. Many are sites of large international hedge funds and other unregulated international finance organizations. Money has been moving there as Swiss banking has become less confidential. U.S. Treasury purchases made through these financial organizations are recorded as purchases by a Caribbean Banking Center, regardless of whom they are made on behalf of. The same is true of the UK, which is also a major banking center. It is possible – some would say likely – that China is buying additional debt through British and Caribbean agents. China is trying to accomplish two objectives that may appear contradictory: buy more U.S. debt and chastise the U.S. for what they see as reckless spending that imperils their already enormous holdings. One way to do both at the same time is to publicly announce you are cutting purchases while simultaneously increasing your confidential purchases through a third party. The major drop in Chinese purchases this year occurred in late spring, contemporaneous with their loudest criticism of American deficits. The fact that purchases by the UK and by private agents both soared in June10, while China’s declined, may indicate who was really buying the U.S. Treasuries11. With China purchasing such a large percentage of U.S. debt, it is critical to know whether the substantial purchases will continue. The next section examines demographic and economic reasons for believing China will do so for a significant period.

10

UK’s purchases in June were up $51 billion from May and private purchases were up almost $80 billion the same month. Net foreign purchases rose substantially that month despite the fall in China’s. 11

From August 2008 to August 2009 UK total holdings rose from $82.5 billion to $225.8 billion and Hong Kong holdings rose from $65.8 billion to $124.7 billion. If as much as half of the UK, Hong Kong, and Caribbean purchases were for China, then China has purchased $350 billion in US debt the past year and now holds $920 billion, excluding Hong Kong (and more than a trillion if Hong Kong is included).

Source: IMF


China – a Cautionary Tale

“Small debt produces a debtor; a large one, an enemy” -- Publilius Syrus, 1st Century BC “Politics is only slightly less important to you than your next breath” -- Robert A Heinlein Unintended consequences always loom large in international affairs. In 1979 the government of China decided to “encourage” urban Han Chinese couples to only have one child. Sometimes brutally implemented through forced abortions and female infanticide, the policy has been quite successful. The relationship between China’s one child policy, the U.S. housing crisis and U.S. solvency is discussed in this section. It can be seen how China’s One Child policy impacted the U.S. housing crisis. The relationship is as follows: The One Child policy, coupled with Chinese cultural preferences, produced shrinking families with a significant imbalance of male children. As time passed, increased competition for wives drove family savings rates upwards. Relative wealth increases a son’s attractiveness and hence, a son’s chance of finding a wife. The Chinese government, always alert to causes of civil unrest, knows it needs to keep the estimated 35 million unmarried young men occupied. This drives a full-employment policy focused on exports and keeps the Yuan12 artificially low compared with the U.S. dollar. The high savings rate lowers domestic consumption, leading to the same result – a manufacturing sector concentrated on exports and cheaper Chinese goods. The low Yuan, full production employment, and a high domestic savings rate (and low domestic spending rate) result in a significant trade surplus for the country – and a high trade deficit for the U.S. High savings rates and a strong inflow of dollars drive the Chinese hunger for AAA-rated debt, the principal issuer of which is the United States. This high demand has kept U.S. interest rates low – helping to trigger the housing price bubble of the mid-2000s – and to absorb current deficits. The effect of the One Child policy is presented in an important paper by Drs. Xhang-Jin Wei and Xiaobo Zhang of Columbia, The Competitive Savings Motive: Evidence from Rising Sex Ratios and Savings Rates in China. According to their data, in 1979 the Chinese gender ratio at birth was 1.07 males to females, not far from the norm of 1.05. This has risen largely without interruption to the current nationwide value of 1.22, and is as high as 1.36 in some areas. In 1979 China was 12th in the world in births per woman at 2.31. This was already down from 2.6 the year before and nearly six a decade earlier. By 2005, it was 1.81 and China was 130th in the world. Today, it is 1.713. Chinese families have become significantly smaller and significantly more male. Wei and Zhang’s thesis is that these two facts have combined to produce China’s extraordinary savings rate. In 1979 the savings rate in China was about 33% of the GDP. This was already high by world and even Asian standards. The world averages 24.9%, according to the International Monetary Fund. Today, the savings rate in China is 50%. Chart 14a, taken from Wei and Zhang’s paper, shows the savings rate changes during this period.

12

The Renminbi (the people’s currency) is the currency of the People’s Republic of China. The Yuan is the major unit of that currency. Often the two terms are used interchangeably, though technically the former refers to the currency and the latter to the domination. Because of the greater familiarity of the term, Yuan is used throughout. 13

1.3 in urban areas and 2.0 in rural.


Chart 14a: Savings and Investment in China

They combine this with the gender ratio offset by 20 years (the average age of marriage in China). They normalize both curves by subtracting the mean and dividing by the standard deviation. Chart 14b shows the comparison. (Y-C)/Y is the normalized savings rate.

Chart 14b: Gender Ratio and Savings Rate (normalize)

The fit is extraordinary, indicating a high likelihood that Wei and Zhang’s premise is correct – the One Child policy has driven a strong imbalance in the number of young males and this, in turn, has driven the sharp rise in China’s savings rate that took place during the same period.

Gross Savings (% of GDP)

Source: The Competitive Savings Motive: Evidence from Rising Sex Ratios and Savings Rates in China Date: June 2009 Data as of March 2009

Source: The Competitive Savings Motive: Evidence from Rising Sex Ratios and Savings Rates in China Date: June 2009 Data as of March 2009


But why should this be? Why should fewer children and a higher percentage of males drive more savings? Wei and Zhang point out that China has a very weak public safety net and that retirement and health expenses are borne primarily by families14. With one child per family, this means that one child must help support two parents and four grandparents or else the parents and grandparents must support themselves, encouraging substantial savings. Wei and Zhang further observe that the competition for wives and the desirability of relatively wealthier husbands encourages parents to equip their sons well financially for starting out in life. Finally, having fewer children means having fewer expenses, making high savings rates easier to bear. While the general outline presented here makes a great deal of sense, some caveats are warranted. The current 50% savings rate is at least in part driven by the global recession. Even the United States, which traditionally saves only 6-8% of GDP, is currently saving 14%15. Further, projecting the increasing gender gap of the past 20 years (remember Wei and Zhang’s data was offset by 20 years) into the future would require the Chinese to save more money than they make. That is not going to happen. Nonetheless, China has a very high savings rate and is the third largest economy in the world. This leads to vast amounts of money that need to be invested somewhere. Purchasing U.S. debt offers a secure investment for those bank deposits. Further, with the Chinese saving so much (and the Yuan kept weak relative to the dollar), domestic demand remains weak and Chinese goods remain inexpensive and targeted for export. Americans buy them, and the resulting trade imbalance drives further purchases of U.S. debt as the monies derived from trade are repatriated. Given the reasons for Chinese debt purchases, how likely is it China will continue buying at the current rate? That is obviously an important question for the sale of U.S. debt instruments. Answering it requires understanding of China’s alternatives.

14

During Treasury Secretary Timothy Geithner’s June trip to China he urged China to increase its safety net and increase its domestic consumption. Both would be aimed at decreasing China’s savings rate. 15

China, in dollar terms as well as in percentage terms, is investing more each year than the US. According to the World Bank, China’s gross capital formation this year is approximately $2.1 trillion to the US’s $2 trillion. This means that China has slightly more internal development capital available than does the US, even though their GDP is only 30% the size. Prior to the recent recession, which has driven up savings rates in both countries, China’s gross capital formation was about 25% more than the US in dollar terms, and approximately five times as high when adjusted for purchasing power.


Where Can China (and Japan) Go? “If I owe you a pound, I have a problem, but if I owe you a million, the problem is yours” – John Maynard Keynes China’s gender imbalance is going to remain for at least another generation (the current gender ratio guarantees that), and the trade imbalance with the U.S. is likely to remain for a while as well. It is in the context of those two facts that China’s options must be weighed. Because of the size of their investments, the actions of China (and, almost equally) Japan toward the dollar and American debt dominate the issue. Together they hold nearly half the foreign-held debt of the U.S. (and a quarter of the total publicly held debt). While Japan has been relatively quiet, China has made it increasingly clear that they are worried that current spending levels in the United States – and the associated rise in the debt – are unsustainable and will weaken the dollar and therefore hurt Chinese Foreign Exchange holdings. This is not an idle worry. China currently holds more than $2 trillion in foreign reserves, approximately $1.7 trillion denominated in dollars, with more than $800 billion in U.S. Treasury obligations. A substantial and sharp decline in the value of the dollar – particularly a devaluation with respect to the Yuan – would damage China’s holdings significantly. How China avoids that while dealing with current geopolitical and demographic realities is the subject of this section. Below are some possible actions China could take. Do nothing Or at least do nothing about the dollar per se. Continue to worry about U.S. fiscal irresponsibility but realize that you are more or less stuck. Instead, institute moves toward a more consumption-based economy by convincing their citizens to spend some of their savings. It is likely that China will move this way at a slow but steady pace despite the aforementioned reasons for the high savings rate and the reluctance to spend. As domestic consumption rises, the Yuan will strengthen naturally as the trade surplus with the United States declines. A stronger currency will raise prices in dollar terms, further dropping the trade surplus. The pace, however, will be slow for several reasons: the reluctance of their population to spend, the need to preserve the value of their current dollar holdings, and the need to keep exports up during any transition. Change the degree of linkage of the Yuan and the dollar The Yuan and the dollar were linked until 2005 when China reluctantly weakened the link under considerable pressure from the rest of the world. Re-linking them would immunize the Chinese against the direct effects of a falling dollar and increased American inflation, but not from indirect effects such as devaluation of non-dollar-denominated foreign holdings of China. Alternatively, China could hasten the strengthening of the Yuan. It is unlikely they will do either. The following discusses why not. Chart 15 shows the number of Yuan a dollar buys. The linked rate was 8.28 Yuan and the current rate 6.84.


Chart 15: Yuan/Dollar

After the de-linking in mid-2005 and the one-time revaluation that took place then, the Chinese government slowly raised the Yuan until the financial crisis fully hit in third quarter of 2008. At that point, as U.S. bond yields plummeted, they stopped further floating. The rate of rise in the Yuan matches almost exactly the yield of the 10-year U.S. Treasury note (4.4% per year), and the cessation of movement matches the sudden drop in yield in third quarter 2008. It appears the Chinese, responding to pressure to strengthen the Yuan, are doing so at the maximum rate that does not hurt their current holdings. This may provide an indicator of their future actions. In particular, it may indicate that preserving the value of their current holdings is a major motivation for the government. Though they have effectively re-linked their currency to the U.S dollar since third-quarter last year, they are unlikely to formally link them again due to the extreme unpopularity of that move and the difficulty of sustaining it as the dollar weakens. They are equally unlikely to completely float the Yuan because of damage to current holdings and to employment in the export and manufacturing industries. Their most likely move will be to continue to float their currency at a rate that does not reduce the value of their current holdings but that does support their slow move to a more consumption-based economy16. Buy gold instead of dollars A common speculation is that China will replace their purchase of dollars with the purchase of gold. This is a favorite of those who worry the Chinese will do something precipitous that damages the U.S17. It is also, by far, the most unlikely. China may well supplement their foreign reserve holdings with more gold – the current rise in the price of gold indicates that both they and the Russians are doing so – but there is simply not enough gold produced in the world to cover more than a small fraction of Chinese needs. Chinese foreign reserve holdings are more than $2.3 trillion, 70% in dollars. At current prices, all the

16

The IMF estimates that the Yuan would have to rise approximately 4-fold to have purchasing power parity with the dollar. To close that gap without damaging their current holdings would take close to 20 years unless American interest rates rise sharply. The drive to make the Yuan a reserve currency, and the need to delink it completely in order to do that, probably argues for a faster revaluation, but is still unlikely to be precipitous, despite current panicked news accounts to the contrary. 17

And of those who sell gold.

Yuan

per D

ollar

Calendar Year End

Source: Exchange-rates.org Data as of 10/15/09


gold ever mined has a value of $3.8 trillion. Imagine the effect on the price of gold were China to try to buy anything close to the 45% of the world’s supply necessary to replace their dollar holdings. What about buying current gold production to replace the U.S. Treasuries they currently purchase? Chart 16 shows the current world production fractions. The total world gold production in 2008 was 2,356 tons or $56 billion at current rates. Excluding the $6 billion the Chinese produce themselves, this leaves a total of $50 billion in world gold production China could in theory consume18.

Chart 16: 2008 World Gold Production Share by Country

In the past 12 months, the Chinese trade surplus with the United States has been $248 billion. The Chinese purchase of U.S. Treasuries in the same time period has been, not surprisingly, $250 billion. Buying the entire world’s gold production would consume only 1/5 of the dollars flowing into China. Buying gold does very little to reduce China’s dependency on the dollar, though some such purchases are to be expected under the “every little bit helps” theory. Go someplace else There are several threads to be pulled apart in this potential strategy and they relate to some approaches previously discussed. There are two major threads: China could purchase the debt of other countries to replace their current purchases of U.S. Treasuries, and China could pressure for a reserve currency other than the dollar. These two approaches are interrelated but distinct. This section examines the possibility that China will purchase the debt of other nations, while the following section looks at a possible replacement for the dollar as a reserve currency that China has proposed. There is the issue of currency conversion and the problems associated with using U.S. dollars to purchase another debt source such as Euro-denominated debt. Ignoring these and the accelerated collapse that an extra quarter trillion dollars a year on the market would cause, the primary difficulty

18

Again, the effect on the price would be astronomical.

Source: British Geological Survey Data as of 12/31/2008


with China purchasing other debt is that such a high percentage of the world’s debt instruments come from the United States. Chart 17 shows the percentage of world debt for each country.

Chart 17: Percent of World Debt by Country

Even viewed this narrowly, China has a problem in diversifying away from the dollar, since the U.S. is 23% of the entire world’s debt market. The actual situation is even more restrictive. China, like most national purchasers, has a strong preference for AAA-rated debt. Only 16 countries have AAA-rated debt, and most are only a tiny part of the debt marketplace. Chart 17 shows the top twelve in red. They include the United Kingdom, which is at risk of losing its AAA rating. Japan, the number two debtor, has AA- rated debt (S&P) and Italy only A+. The United States provides the majority of available AAA debt. Chart 18 shows just the countries with AAA debt ratings. There is limited opportunity to go someplace else to buy debt, particularly if China wishes to avoid increased exposure to Japanese debt. For Japan the situation is of course, even worse, since it cannot buy its own debt. The most obvious source of non-U.S. debt instruments is Europe, but here China has the same problem as with the United States – its trade surplus is about $250 billion. That means that China has to absorb just as much money in Euros as in Dollars, making it very unlikely China will purchase more Euro-denominated debt than is required to repatriate its Euro surplus. To summarize: China cannot solve its balance of trade surpluses by purchasing debt instruments in quantities much out of line with the surpluses themselves. The only sure way China can move away from U.S. debt purchases is to reduce the trade deficit with the United States.

Source: CIA World Factbook Data as of 6/30/2009


Chart 18: Percentage of AAA-Rated Debt by Country

A new international currency Leading up to the recent 2009 G20 summit, Chinese central bank governor Zhou Xiaochuan called for a new international reserve currency based on the International Monetary Fund’s Special Drawing Rights (SDRs)19. This was quickly supported by Russia and Brazil. Perhaps more surprising, it was also supported by the United Nations Conference on Trade and Development (UNCTAD), France and (it is rumored) by several Gulf oil producers. SDRs were established in 1969 by the IMF to support the Bretton Woods fixed exchange rate system. In essence, SDR’s were to serve a “paper gold” for countries to use in stabilizing their currencies under the Bretton Woods agreement. With the collapse of the Bretton Woods agreement, the need for SDRs had diminished until recent calls for turning them into an international currency. Today, they are not a currency in themselves, but serve as intermediaries for exchanging local currencies as part of maintaining trade and transaction balances. Current SDRs are based on four currencies – the dollar, the yen, the pound, and the euro. Chart 19 shows the existing allocation. The allocation is based on the IMF’s estimation of the relative importance of each currency in international transactions. Chart 19 and Chart 20 show how closely the importance of a currency matches the GDP of the countries using it. Some additional importance is ascribed to the dollar due to its dominant use in international transaction settlement and to the pound which formerly held that position.

19

http://news.yahoo.com/s/afp/financeeconomyg20forexuschina

Source: CIA World Factbook Data as of 6/30/2009


Chart 19: SDR Composition by Currency

Chart 20: Share of SDR-group GDP by Currency China’s proposal for SDR expansion has two main components. The first is to expand the SDR basket to more accurately reflect the major economies (especially its own) whose currencies are not currently included. The second is to set up a settlement system for converting between SDRs and other currencies so that they could more easily be used for trade and financial transactions. Chart 21 shows the result20 were the Chinese proposal implemented and SDRs extended to include the top ten currencies (by GDP percentage of countries holding them).

20

Saudi Arabia, Kuwait, Bahrain, and Qatar have proposed a joint currency called the Khaleeji for the member states of the Cooperation Council for the Arab States of the Gulf (GCC). Oman and the United Arab Emirates have,

Source: IMF, http://www.imf.org/external/np/tre/sdr/proposal/2009/0709.htm Data as of August 28,2009


http://www.imf.org/external/np/tre/sdr/proposal/2009/0709.htm




Chart 21: Percentage of Top Ten Currencies GDP To determine the effect of such a move, two related factors need examination: debt holdings and foreign reserve holdings. The debt holdings are obvious – indebtedness certificates, generally of limited duration, issued by sovereign governments or their affiliates – and have been discussed above. Currency reserves, on the other hand, have a more fluid definition. Actual deposits of one currency in the central bank of another country are often turned into debt holdings of the issuing country. In judging the impact of one country’s holdings of another’s debt or currency, it is probably best to approximate the true holdings by the larger of currency reserves and debt denominated in the subject currency. Chart 22 shows the “allocated” foreign currency reserves of the world broken down by currency. “Unallocated” reserves are either unknown or are held in currencies that play little role on the international stage. The data is from the International Monetary Fund.

for now, opted out. GCC combined GDP is not sufficient for the Khaleeji to be on this list, even though it is rumored that they are interested in making it part of an SDR-based currency. The importance of the GCC comes from their half trillion in dollar reserves. Their interest in participating in an SDR-based basket may presage moving their holdings to be more consistent with the proposed SDR allocation.




Chart 22: Allocated Foreign Currency Reserve Holdings by Currency The world’s total foreign currency reserves are estimated to be $6.8 trillion. As Chart 23 shows, China alone holds 31% of the total. $2.68 trillion worldwide are in dollars, with approximately 60% of the dollar holdings being in China ($1.7 trillion). Japan is second at 15% of world holdings and roughly 30% of world dollar holdings. As in everything else related to U.S. finances, it comes down to China and Japan.

Chart 23: Foreign Currency Reserves by County






China is not very forthcoming on the exact amount or distribution of its foreign currency reserves, but Chart 24 shows the approximate amounts stated by various government officials at different times.

Chart 24: Chinese Foreign Reserve Holdings (approximate) Japan’s holdings are no easier to determine than China’s, but they are at least as skewed toward dollars. Chinese and Japanese holdings are consistent with the fact that approximately 2/3 of world trade is settled in dollars. Chinese reserves have risen sharply in recent years as China has been printing Yuan and purchasing dollars in the foreign exchange markets. This serves two purposes. First, it helps prevent the Yuan from appreciating too much against the dollar, keeping Chinese goods cheap for Americans to buy. Second, it gets more Yuan in circulation worldwide, bolstering China’s desire to eventually have the Yuan become a widely-accepted reserve currency, whether in its own right or as part of an SDR-based basket. It is worth comparing Charts 19, 20, and 22. Each shows the importance of each currency in a different way. Comparing 19 with 20 shows how closely the SDR basket reflects the GDP of the issuing countries of the four most important currencies. Indeed, the only real difference between them is the higher level of the pound in the SDR basket (and in foreign reserve holdings – see Chart 22) which reflects both the historical importance of the British Pound and the ongoing importance of Britain as a banking center. Extending this equivalence to a broader currency basket, the makeup of an expanded SDR basket might look a lot like Chart 21.




Chart 25: Currency Participation in Reserves, Debt, and SDRs

Chart 25 combines Charts 19 and 22 for the four most important currencies. The blue bars show their importance as a share of allocated currency reserves and green bars show the share of the current SDR basket. The difference in the numbers indicates a possible trajectory in world reserve holdings with a move toward an SDR-based currency. Such a change would require a substantial decrease in dollar-denominated holdings and a substantial increase in Yen, Pound, and, to a lesser extent, Euro holdings. Were the basket expanded to include additional currencies (as China would obviously prefer), the decrease in demand for the dollar would be even sharper. The real issue is not whether SDRs will become a true currency. As the “paper gold” they were designed to be under Bretton Woods, they provide a standard for international currency conversion and transaction settlement. Whether it is a “currency” or not misses the point21, rather, it is not whether bank notes are ever printed in SDRs that matters – it is what increased use of multiple currencies for international transactions means to the dollar and other reserve currencies. The major worry, and one the Chinese are certainly watching carefully, is a panicked flight from the dollar. As an increasing debt burden weakens the U.S. dollar, the move to a more stable reserve currency basket will gain momentum. Even without official action, more transactions will take place in other currencies. Currency reserves will be adjusted to be a compromise between the individual country’s trade position with the U.S. and the new realities of international transaction settlement. This shift in reserves will lower demand for the dollar and raise demand for the other important currencies, further weakening the dollar versus those other currencies. The major threat to the U.S. and China is that this movement becomes a run for the exits before either country is ready. Because of the joint threat, progress toward a broader-based reserve currency will be measured, in so far as either country can exert control. The wild card, of course, is how badly other factors, including the increasing U.S. debt, will cause them to lose control.

21

Though a walking, quacking fowl is likely to be Anas Platyrhynchos.




Implications for Investing Two principles drive Chinese behavior: a strong desire to be respected and influential in the world and a stronger desire for internal stability. Indeed, the former is largely driven by the latter. Note that wherever the two conflict – such as at Tiananmen Square – China opts for stability. These two principles and their relative importance can guide us in determining China’s actions. The details of what follow are doubtless wrong but the broad outline is probably correct. As events unfold, keep in mind that the Chinese government is not usually reticent about saying what it wants, at least as far as finances are concerned. But remember the caution at the end of the last section – matters may get out of their control if the dollar is debased too much or too rapidly. There is an inherent contradiction in China’s printing Yuan and buying dollars for the dual purpose of increasing Yuan in circulation worldwide and keeping the currency weak. Increasing the currency worldwide bolsters the effort to make it a reserve currency (other countries cannot use a currency to pay obligations unless there is plenty of it to go around) but controlling the currency’s exchange rate (a major reason for the printing) inhibits progress toward it becoming a reserve currency. Many are becoming increasingly uncomfortable settling accounts in a currency whose value is seen as being set by political winds. Resolving this conflict will take time. We believe the most likely trajectory is that China will get more Yuan into world circulation while gradually floating it with respect to the dollar. That flotation rate, in accord with the first principle of internal stability, will only take place at a rate that does not seriously impact the value of their existing reserves and debt holdings. In the meanwhile, China will probably lobby for greater consolidation of the world’s reserve currencies – initially not very different from the way they are currently proportioned. Whether or not an actual world currency is adopted, existing currencies will be used in ways more in line with their economic importance and additional currencies will achieve reserve status. As we have seen, the proportions in external debt, Gross Domestic Product, reserve currency participation, transaction settlement, SDR participation, and Chinese holdings of foreign debt and currency are all roughly in alignment. Insofar as it depends on them, China will only adjust that alignment at a speed they can manage. In time, China will move toward an economy based more on internal consumption. In addition to the reasons cited above, a country that undergoes rapid economic growth often finds its saving habits lag that growth and only slowly adjusts to the new prosperity. As the Yuan floats, Chinese goods will become more expensive on world markets and consumption shift toward the domestic as trade surpluses begin to diminish. China will likely slowly and eventually reverse both its foreign debt purchases and its holdings of foreign currency. In part, this will probably happen naturally as trade surpluses diminish – so there is less foreign cash to repatriate – and as the Yuan is floated there will be less need for its oversized foreign currency reserves. None of this will take place quickly, however many pronouncements are made by their Finance Minister. The One Child policy continues as part of the current Five Year Plan, ensuring that China’s gender imbalance will continue for a long time. The desire to keep the overly plentiful young males occupied will continue to drive China as a manufacturer and protract the slow floating of the currency and preserve trade surpluses with the United States. An early sign of change in internal focus may be a drop in the trade surplus China has with the rest of the world as China begins moving toward an economy more balanced between manufacturing and consumption.


We face a world that will, over perhaps the next dozen years, carry on trade and transaction settlement based on a basket of today’s reserve currencies and the currencies of rising nations. This will result in diminished demand for U.S. debt and for U.S. dollars. If it happens too quickly, the U.S. risks both stagnation (from rising real interest rates) and inflation (from rising commodity prices). As demand drops for the dollar, its value in the world will drop. Imports will drop and exports rise in importance in the U.S. economy. Whether this stimulates or hinders the U.S. economy depends on the relative speed of the two changes. If imports rise in price while maintaining their importance in the economy, growth will stagnate. Since China will likely continue to support domestic manufacturing over its own imports, it is more likely that U.S. export business will grow faster than its import business falls, but it will be something of a balancing act. Domestically, from the mid 1980’s until today the U.S. has benefitted from the benign feedback loop of lower interest rates resulting in lower payments on the debt and a decreasing share of both the GDP and the Federal budget going to interest payments. If the market or the Federal Reserve brings on a rising interest rate cycle, a negative feedback loop may result. As entitlements and other unfunded mandates grow, high interest rates will mean either substantially higher taxes or a budget that is nothing but interest payments. This means the government will be highly motivated to raise taxes, keep interest rates low, and inflate its way out of the debt. It also explains why stagnation and inflation are the primary risks. As demand for U.S. debt instruments falls, government spending will decrease, taxes will rise, interest rates will rise, or the Federal Reserve will buy more debt to compensate. The first is unlikely; the next two will depress the economy; the last will heat up inflation. Given the current levels of deficit spending, it is much more likely the U.S. government will opt for inflating and growing its way out of the debt and keep interest rates low. Under such a policy, what will be the likely inflation rate? Regression against past data indicates that all else being equal (it rarely is), current deficit levels with no increase in interest rates should produce inflation of 5-7% in two or three years. Chart 26 shows the budget deficits since 1940 (horizontal axis) and the inflation rate two years later. Though the data is noisy (and raising interest rates prior to the onset of inflation can prevent it), the risk is obvious. As pointed out earlier, the 2010 debt increases cannot be sustained without a combined GDP growth and inflation rate of 9% per year. If the economy grows slower, or the inflation rate is lower, then the debt burden will grow as a fraction of GDP. Given a 3% real growth rate in the GDP and the implications of the 2010 deficit, projecting a 6% inflation rate does not seem overly alarmist.


Chart 26: Regression of Inflation Rate versus Deficit What are the investing implications? As always, it is vital to pay attention to what the markets are saying. Whether or not China uses part of its massive supply of dollars to buy gold, the metal should still be a good investment so long as the U.S. government pursues an inflationary path out of its debt burden. Gold, as well as other commodities, is therefore a reasonable longer-term hedge against all of the potential crises outlined in this paper. In the short term, however, we are at least a year, and likely more before inflation becomes an immediate worry. Whatever happens with the move from the dollar and dollar-denominated debt, it will be relatively slow if China and other debt holders have anything to say about it. While the above outline is only one possible scenario, if it plays out, long-term investment in Chinese manufacturers who specialize their domestic might be attractive. Most Chinese investment capital will, for the present and intermediate time, still drive their export market, however. Employment in the export market is a critical part of the Chinese internal stability plan, and one that will stay primary for some years. So long as new plants are built and capacity expanded in the export industry, it will be clear that China wants to maintain the status quo by running a strong surplus with the United States. For investing within the United States, the situation changes with the investor’s timeframe. In the one to two-year timeframe, we believe equity prices are likely to continue to rise, given the huge amount of stimulus money yet to be spent. This assumes that international bond sales continue to be satisfactory and interest rates are not driven upwards. Given that rising debt and easy credit mandate asset price inflation somewhere, it will be worthwhile seeking those particular areas, always being mindful of how such periods of asset inflation typically end. Stocks are one good candidate for near-term asset inflation. Others are commodities and the industries of countries that supply those commodities. As time goes on, exports will be more likely to grow than imports and industries highly dependent on foreign-bought goods (such as oil) are less likely to do well than those that do not. The speed with which this shift takes place will depend on how rapidly the dollar falls (as well as on whether there

Source: www.bls.gov/cpi/, www.usgovernmentspending.com/federal_deficit_chart.html Data as of 10/15/2009

http://www.bls.gov/cpi/

http://www.usgovernmentspending.com/federal_deficit_chart.html


continue to be large new finds of oil, such as the recent Brazilian discoveries). Another potential investment is American companies well diversified into countries with more stable currencies, particularly into countries that use one of the currencies against which the dollar is depreciating. We believe the most successful longer-term investment plays, however, are likely to be in bonds and currencies. The primary approach is to hedge against the weakening dollar and the move to SDR-based transactions, as well as the associated shifts in currency reserves (and the parts of those reserves held in debt instruments). In the bond market, until after there is a substantial and intentional rise in interest rates to restrain inflation, U.S. bond prices will probably fall. This may be erratic – the yield curve is still fairly steep by historical standards and there is no current inflation – but the main direction is down. Indeed, given that the floating of the Yuan roughly matches the yield of the 10-year U.S. Treasury Note (and has less potential to lose value as demand drops than the note does), investing in Yuan rather than 10-year U.S. Treasury Notes might make sense – or shorting the 10-year and going long the Yuan. The latter is the opposite of what China has been doing the past few years and would take advantage of their moving away from that practice. On the currency front, pay careful attention to moves toward SDR-based transactions. Some will be obvious – like the current pronouncements in support from China, Russia, France, and Brazil22. Others will be more subtle. Already some debts are discharged in local currency rather than dollars, particularly if that local currency is a candidate for the SDR basket (such as the Yuan, the Real or the Rupee). China (and Japan) moving to make their reserve and debt holdings more in line with the GDP of the countries behind the currencies (rather than in line with today’s foreign currency reserves) would indicate a behind-the-scenes movement to prepare for SDR-based settlement system. In any event, investments in the currencies of the rest of the world, particularly of currencies currently in the SDR basket or the most likely new members, may prove a good hedge against a falling U.S. dollar. Whether or not the world moves toward an SDR-based currency, the Yuan will play an increasing role in the world economy. This is driven by the simple fact of China’s size and growing economic clout. Hindering the rise in the Yuan’s importance is its linkage to the dollar and imposed weakness. China, out of self interest, will seek a dollar that sinks only slowly. At the same time, they will likely continue their support for using other currencies for transactions where appropriate. Their balancing act will be reflected across the world, because few would benefit from a precipitously-falling dollar. In the meanwhile, American debt will continue to grow sharply and, so far as the Federal Reserve can control them, interest rates will stay low. All else being equal, this will drive the U.S. dollar lower. The primary threat to the world economy therefore is a dollar that collapses precipitously. Domestically, such a collapse would result in a sharp increase in oil and other externally-supplied commodities, which would contribute greatly to an already-threatening inflationary spiral and to economic stagnation23. Because a collapsing dollar would lead to lower purchases of U.S. debt, the government would be faced with three unpopular choices: cut spending sharply, raise interest rates to attract purchasers, or have the Federal Reserve purchase more debt instruments to offset loss of foreign purchasers. The first two would likely trigger a sharp recession, while the latter would raise the threat of high inflation.

22

And the widely reported – and just as widely denied – Gulf States’ support of abandoning the dollar. 23

Exacerbating this would be increased taxes or import duties on such commodities.


Internationally, and particularly for China, the results of a collapsing dollar would likely be worse. A free-falling dollar would mean a rising Yuan and a sudden fall in the Chinese export industry. The resulting crisis would produce higher unemployment and underemployment and likely spur even greater savings among the Chinese, at least in the short term. This, in turn, could lead to a deflationary cycle that would be difficult to break. The threat of civil unrest, whether urban from unemployed young men or rural from a countryside that would be hit harder by a slowdown, should not be underestimated. With so much of the world’s reserves held in dollars, a sharp enough dollar collapse could trigger an exchange rate crisis and considerable trade disruption. Such crises have been historically difficult to resolve. These disruptions do not need to take place. Growth in the American economy and a modest rise in interest rates once that has been established, coupled with a return to more traditional levels of Federal spending can slow or even reverse the dollar’s slide without harming the economy and guarantee continuing foreign purchases of U.S. debt instruments. Accomplishing this will take fiscal restraint on the part of the Congress and the Administration and resolve on the part of the Federal Reserve. How likely that constraint and resolve are will not become apparent until inflation reappears at the one to two percent level when action will become necessary to restrain its rise. Hesitancy at that time would risk a crisis of confidence in the dollar internationally and spiraling inflation at home. Quick spending cuts and a rise in interest rates would give strong positive signals to the rest of the world that the U.S. does not intend a soft default on its debt through inflation. Whatever happens will not play out overnight, but the main factors are there for all to see – rising American debt, an unsustainable Chinese savings rate, an aging Chinese population, a politically compliant Federal Reserve, and a spendthrift Congress. In the long run, the markets and American good sense will doubtless prevail and find a new stability. But in the meanwhile, it may be a wild ride. With the right forethought, it can be a profitable one.


About Radiant Asset Management, LLC

This paper was written by Radiant’ Chief Investment Officer, David Ross, who has a background in applied mathematics and investment management with an emphasis on U.S. Treasuries-based stratgies. It was developed both as part of the research effort to understand the events surrounding U.S. debt and Radiant’ enhanced return U.S. Treasuries strategy. Mr. Ross previously has run three companies, holds nine patents, received a BS in Physics from Yale University, did his MS and PhD studies in Aeronautics and Astronautics at Stanford University and has an asteroid named after him for his mathematics work at NASA’s Jet Propulsion Laboratory in the Advanced Projects Group.

Radiant Asset Management is an alternative investment management firm formed on the belief that corporate fundamentals, investor behavior, and market dynamics drive performance. Original research and proprietary analysis set us apart. We seek superior absolute returns in all markets. If you have any comments on the paper, are interested in any further research or speaking engagements

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