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 Alarming bouts of volatility in world financial markets over the
past 12 months have been rooted in a fear of what happens when a
world with its highest-ever peacetime debt pile faces even a hint of
higher interest rates.
Despite a constant narrative about U.S. households and banks paying
down debts ever since the global credit crash eight years ago, any 'deleveraging'
that did happen was more than offset by higher government, corporate
and personal debt around the globe in Europe, China and across
emerging markets.
In fact, aggregate world debt is now far higher than it was before
the 2007-08 crash.
"The saga of debt is far from over," says a report from Morgan
Stanley. It goes on to explain why Morgan Stanley expects
demographic-led shifts in savings and investment to soon push
interest rates higher and transform that debt mountain into
additional deadweight on world growth over next five years.
But the role of the U.S. dollar as the world's main reserve currency
denominating large chunks of that debt pile is showing up as
complicating factor that's added to risk of instability.
The first U.S. interest rate increase in almost a decade in December
- just a quarter of a percentage point - was enough to trigger a
convulsion in world markets that led to the worst start to a year
for global stocks since World War Two.
Underlining 'cause and effect', the subsequent recovery only came
about once the Federal Reserve hastily made clear it was pressing
the pause button precisely because of seismic events in world
finance.
Few doubt a growing U.S. economy that's near full employment can
absorb some normalization of interest rates from near zero, and a
higher dollar goes hand in hand with that.
But the rest of the world clearly can't.
The Bank for International Settlements estimates that while U.S.
dollar dominance means it accounts for almost 90 percent of all
foreign exchange transactions and some 60 percent of hard currency
reserves. But crucially it also accounts for about 60 percent of all
debts and assets outside the United States.
And if the rest of the world goes into shock because of the higher
cost of servicing and paying back those dollar debts, the boomerang
effect on U.S. exporters, commodity firms and the wider economy just
ends up tying the Fed's hands in ways made crystal clear this year
already.
AMBIVALENCE
No surprise, then, the U.S. central bank has no deep love for the
dollar's prime reserve currency status - even though it's been
described by Europeans and others over the years as an "exorbitant
privilege" that ensures the world lends to the U.S. Treasury in its
own currency at low interest rates regardless of dollar strength.
Speaking at an event in Zurich on Tuesday on the dollar's global
status, New York Fed chief Bill Dudley said Americans should not be
perturbed if other currencies such as the euro or China's yuan
eventually eat into the dollar's share of reserves.
"If other countries' currencies emerge to gain stature as reserve
currencies, it is not obvious to me that the United States loses,"
he said, as long as it "is being driven by their progress, rather
than by the U.S. doing a poorer job."
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While that's far from wishing away dollar hegemony, it speaks to the
greater ambivalence among central bankers toward reserve status than
their national treasury chiefs - given how widespread use of the
currency can compromise domestic policy.
It's that tension that risks sowing instability everywhere.
If the Fed can't adjust monetary policy because of fears of
transmitting a self-defeating shockwave around the world via the
dollar, then there's understandable concern that artificially low
Fed policy just stores up even more debt and international
accounting imbalances and undermines the very currency that's
supposed to play anchor.
At the same event in Zurich, Claudio Borio, head of the monetary and
economic Department of the BIS, said the dollar's role could
potentially exacerbate instability by allowing the United States to
run larger and more persistent fiscal and current account deficits -
and to run looser monetary policy for longer.
What's more, a resulting Fed easing bias spreads to developed and
emerging economies as governments resist a weaker dollar for
competitiveness or financial stability reasons, Borio added.
"Easing begets easing," he said.
For Morgan Stanley, this is just leads to ever-higher debt, and
there are no painless ways out of a problem that will start to hurt
significantly over the coming years - only a series of "less
painful" options including the option of consolidating debts and
making them permanent or perpetual.
In the meantime, the U.S. bank said, the dollar itself will most
likely push higher again, if only because the U.S. economy is
probably the only one that can absorb a rising exchange rate in this
environment.
For Borio, a more 'pluralistic' system with many world currencies
sharing the reserve role doesn't by itself solve any problem,
either. There would then be no credible single anchor.
Hard-headed cooperation and joint decision making may be the only
answer.
"This means not just putting one's house in order, but also putting
our global village in order."
(Additional reporting by Jamie McGeever and Jonathan Spicer. Editing
by Larry King)
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