The U.S. dollar is generally thought to be an extremely safe asset to hold, which is why it has been the world’s main reserve currency since World War II. Developing country governments, in particular, view plentiful dollar holdings as a hedge against economic crises that might precipitate a run on their own currencies. In some developing countries, such as China and Thailand, dollars represent as much as 60 percent of reserves.
But a strategy that was once considered a source of economic stability is becoming more and more dangerous. The dollar has fallen sharply against other major currencies in the last two years, and because of massive U.S. current account deficits, it is almost certain to fall further in the years ahead. If that happens, the losses from dollar reserves for some developing countries may exceed 20 percent of their annual budgets.
The damage of a declining dollar could be extensive: If many developing countries were to sharply increase their exports in order to rebuild the value of their reserves, it could lead to a serious drag on world economic growth and possibly prolonged stagnation in much of the developing world. For multinational companies, this would be especially painful because the fastest-growing markets in Asia, Latin America, and Eastern Europe, which they are depending on for their growth, could be stopped cold.
The size of foreign reserves held by developing countries increased substantially after the financial crises of the 1990s, which hit Mexico, Brazil, Russia, and many Asian countries. These episodes, which were generally caused by a sudden loss of confidence in local economies, led to severe economic downturns as each country attempted extraordinary measures — most importantly, sharp interest-rate hikes — to shore up the value of domestic currencies as the value of dollar reserves dwindled.
When the gross domestic products of the affected countries began to bounce back, their governments took steps to protect themselves from future economic crises. At the top of the list of actions was a decision to accumulate large reserves, particularly U.S. dollars. The conventional wisdom in developing countries is that substantial foreign currency holdings are a signal to nondomestic investors of the strength of the local economy and therefore its protection against a run on the national currency.
As a result, the value of reserves in many developing countries now exceeds 20 percent of GDP. In some cases, such as China, which keeps the yuan pegged to the dollar as an economic defensive measure, that value tops 30 percent. The mix of reserve holdings varies by country, but the dollar is by far the predominant currency.
Reserve holdings always come at a cost (reserves are held in short-term deposits that pay almost no interest), but the price tag will be especially high if the value of foreign currency reserves declines, which is virtually certain to be the case with the dollar, as Federal Reserve Board Chairman Alan Greenspan noted at the end of 2004.
The U.S. current account deficit is running close to $650 billion annually, or 5.7 percent of GDP. Remarkably, this deficit has continued to increase even though the dollar has already fallen substantially against the euro, the yen, and other major currencies. Already, the net indebtedness of the United States exceeds $3 trillion. If the current account deficit remains constant as a share of GDP, it would imply that net indebtedness would reach $10 trillion in less than a decade, approximately the current value of the entire U.S. stock market. Few, if any, economists believe that such a debt level is sustainable.
There are only three ways to make large reductions in the U.S. current account deficit:
Accelerate rapid growth in the economies of U.S. trading partners.
Have a severe economic downturn in the United States.
Experience a sharp decline in the value of the dollar.
Although more rapid growth worldwide would be desirable, there is little reason to expect a major upturn in the near future, and no credible forecasters are predicting sustained high growth. But there are factors that could lead to a sharp downturn in the U.S. economy, most obviously a collapse of an overheating construction and real estate market. Still, the Federal Reserve Board and the Bush administration are not likely to accept a prolonged downturn. They would take aggressive action to provide an economic stimulus if conditions sour.
This leaves a sharp drop in the dollar as the only plausible correction mechanism for the current account deficit. In the third quarter of 2004, we calculated that a drop in the value of the dollar of approximately 22 percent would be needed to bring the U.S. current account deficit down to a sustainable level, or approximately 3.0 percent of GDP. The longer the decline is delayed, the more dollar depreciation will be needed to reduce the current account deficit. As of December 2004, the deficit was already $100 billion higher than the figures we used when we ran the above calculation.
A drop in the dollar of 22 percent would mean big losses for countries with large dollar holdings. For example, a country holding reserves equal to 10 percent of GDP would lose 2.2 percent of its GDP; this is more than 10 percent of the annual budgets of most developing countries. A hit this large could force a substantial economic contraction in most developing countries and could diminish the purchasing power of consumers who drive growth in these countries, and who are a new target market for multinational companies.
This simple arithmetic should demonstrate the urgent need for governments to diversify their reserve holdings away from dollars. As Alan Greenspan said in a slightly different context, anyone holding large numbers of dollars at this point “must be desirous of losing money.”
Dean Baker ([email protected]) cofounded the Washington-based Center for Economic and Policy Research. Dr. Baker is the coauthor of Social Security: The Phony Crisis (University of Chicago Press, 2000) and editor of Getting Prices Right: The Debate Over the Consumer Price Index (M.E. Sharpe Press, 1997), which won a Choice Book Award.
Mark Weisbrot ([email protected]) cofounded the Center for Economic and Policy Research with Dr. Baker. He is the coauthor of Social Security: The Phony Crisis.