3 May 2008

Abandoning the USS Titanic

By Chan Akya

Yes, I know that the Titanic was not registered as a United States ship. The title though refers to the startling comparisons that can be made to the ill-fated vessel after it hit the iceberg in 1912, and the US today after it has hit the twin icebergs of the idiotic George W Bush presidency and the subprime mess in the economy. I am not suggesting that the two were linked, only that an ineffectual government frequently makes a cyclical problem much worse by its own actions.

US Federal Reserve head Ben Bernanke has taken on the role of the second in command whose job it is to scream "full steam ahead", even as it becomes wildly apparent that it is a structural problem in the economy, not a mere cyclical downturn. As a number of other commentators have written in Asia Times Online, including Julian Delasantellis and The Mogambo Guru, the problem with the US is that of excessive borrowing that has fed a consumption boom. Almost three-quarters of the US economy is consumption, compared with the more usual 50-50 mix considered "normal" in Economics 101 textbooks.

This excess of consumption creates the massive borrowing needs of the US, which are immediately supplied by a bunch of supplicants, be they Middle Eastern dictators or imagination-free Asian central banks. What many of us on this website have been writing about is that this edifice is cracking and quite likely to fall over.

Kuwait strikes

On Thursday (May 1), the finance minister of Kuwait, Mustafa al-Shiwali, suggested that Gulf Cooperation Council (GCC) countries were considering an idea to abandon their long-standing US dollar pegs. This is a minor news item to be tucked away in page 20 of the financial press, which it has been – but rather emblematic of a systemic shift.

For years, Gulf countries have held US dollars as an article of faith, with an almost religious fervor. These were the same countries that considered the same action in the 1970s, and indeed it was the Kuwaiti finance minister of that time who famously asked, "Why should we sell our black gold in exchange for unguaranteed currency notes [US dollars]"?

The aftermath of the crisis in the 1970s was greater US meddling in the region, propping up friendly dictators around the region and stoking the flames of war in Iran-Iraq that culminated in Saddam Hussein marching his forces into Kuwait in 1990. Perhaps that was America's idea of punishing the Kuwaitis, but we would never know that for sure.

Despite owing a debt of gratitude for getting their country back, it is interesting that Kuwait today is concerned more about domestic inflation that has run away to absurd levels, and less about kicking the US when it is down. Call that the new world, if you will.

The story though is complicated, because on the same day, the Kuwait Sovereign Fund announced it would increase its stakes in US financial firms Citigroup and Merrill Lynch, in effect continuing the trend for the rest of the world propping up the US financial system's malcontents.

The likely consequences of Gulf countries abandoning their US dollar pegs will be twofold. Firstly, their overall holdings of US financial assets, such as government bonds and shares, will have to fall dramatically. Financial analysts around the world assume that this will take the form of such investors in future buying fewer US dollar assets. I however think that it is more likely we will see actual selling of such assets, particularly the really dumb US Treasury bonds that offer yields roughly in line with official inflation and less than half of unofficial inflation figures.

The second consequence of Gulf states abandoning their dollar pegs is that they will increase the price of oil commensurately to ensure that their "local" income does not suffer. For example, if you pegged your currency at 100 to the US dollar and so were getting 1,200 in your currency for oil; and after de-pegging let us say that it rises to 75 on the dollar, you would need to bump up prices to ensure that you still get 1,200 in your local currency for oil. That means oil prices denominated in US dollars would have to go up some 30% to compensate.

The immediate impact of this on Asia would be quite nefarious, particularly for oil-importing countries ranging from Japan to India. Every one of them with an ability to allow their currencies to appreciate (and here I include only Japan, China, South Korea and India) will do so, in turn triggering the same first- and second-level reaction as suggested above from Gulf states' de-pegging, that is to sell US financial assets and raise prices of their exports accordingly.

It gets worse for weaker Asian states such as the Philippines and Indonesia, which don't really have the ability to push up their currencies. They will struggle to control inflation and failing that, embark on new rounds of government borrowings. This is the scenario I painted earlier in the year, which highlighted increased problems for smaller countries against the bigger ones in Asia.

The final consequence of the decline of US power is global in nature, namely a search for an absolute value reserve. That would be physical commodities including oil, copper and whatever have you. The easiest though would be gold.

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