It has been an unsettling few days in the world of finance and the bumpy period looks set to continue. A string of questions spring to mind about both the dollar and the euro. One obvious one is that if other countries distrust the ability of the US to fix its finances, why do they continue to hold so many dollars in their official reserves? Another is why are German government bond yields so low, given the uncertainty about the currency in which they are denominated? Still another is what on earth should people do to preserve the value of their wealth? Buying gold seems a bit of a cop-out.
Click HERE to view graphic (232k jpg)
So how might we look back on this period? One of the things that has been troubling me is how the world will replace the dollar, or rather build up the role of other currencies alongside it. It will take some months before the full consequences of the past week inCongress become clear. We don't know the US will lose its AAA credit rating. We don't know its medium-term fiscal plans. And we don't know the views of the main holder of dollars overseas, China.
Nevertheless, while some damage to the dollar has been done, the plain fact remains that US Treasury securities remain a safe haven for the nervous hot money scurrying around the world and the dollar remains the world's principal reserve currency. As of now there is nothing that can replace it.
If you look at the composition of official reserves, or rather the chunk of those reserves in currencies rather than gold, the dollar dominates, with the euro a poor second, and sterling and the yen relatively insignificant (see graphic). Both China, holder of the world's largest reserves, and Japan, number two, principally hold dollars.
Indeed one of the most striking things is how low the gold holdings are for both countries. According to the World Gold Council, China has only 1.8 per cent of its reserves in gold and Japan 3.1 per cent. By contrast the US is the world's largest holder of gold, with 75 per cent of its reserves in that form, while Germany, Italy and France all have roughly 70 per cent in gold.
The UK used to hold a substantial proportion of its reserves in gold but following the sales under Gordon Brown and his predecessors we now have only 17.5 per cent of our reserves in it – Portugal has more gold in its reserves than us.
So for the emerging world, gold is no substitute for currencies. It is almost as though our monetary authorities do not trust our own paper currencies and would rather hold gold, while those of the emerging nations do trust our currencies and pile them up in their reserves. The main reason for this, however, is not a delight in the dollar and the euro as such. Rather it is that the piling up of dollars is a by-product of an aggressive intervention policy on the exchanges.
Building up reserves is the counterpart to the current account surpluses that both China and Japan have generally run in recent years. Were it not for this intervention their currencies would have risen faster and they would have lost their cost advantage more quickly.
Were currency holdings to reflect trade patterns there would be much more significant holdings of the Chinese yuan and the Indian rupee. But these are not really suited to be in reserves as they are not fully convertible. Notwithstanding the projections that China will pass the US in economic output in about 15 years' time, the Chinese do not like foreigners holding their currency. Until they – and other large emerging nations – are happy for that to happen, the dollar and the euro will continue to dominate.
There is however something else happening that deserves notice. It is that if you want a store of value, there are physical alternatives to currencies and one of the best is iron ore and scrap. The graph at the bottom comes from the Bank for International Settlements annual report, and it highlights just how bad an investment in US shares has been relative to one in commodities in general or in coal. But as you can see, ore and scrap beat them both.
This creates problems for the real users, for as the BIS observes, the price movements of commodities do not just reflect supply and demand for the commodity itself. Their prices are behaving more like the prices of financial assets. You may simply want to put more of your spare cash in gold, but if you think gold is too high already you can always buy scrap.
We will, I think, see more diversification of official reserve holdings and much greater diversification of private-sector wealth holdings more generally. The issue is whether this transition can be managed in a gradual and non-destructive way.
The US dollar's inexorable decline
What is happening in Europe does not bode well. We are beginning to see a de facto two-tier euro. Euros are being withdrawn from Greek banks because there is a fear that the country might withdraw from the common currency. It would certainly make sense for anyone wanting to hold euros to place these in a German bank rather than those of any other country, for if there were to be a split in the eurozone there can be no doubt that the German chunk of it would be revalued.
There is no danger that the dollar will split. The de facto default of the dollar would take the form of a gradual whittling away of its value by inflation – not double-digit stuff but a steady decline of, say, 4 to 5 per cent a year in its real value, rather like the decline of sterling's real value at the moment. So what will investors do?
My guess is that the officials in China and Japan will go on doing what they have long done: put up with it. Gradually the dollar will be replaced, but this will be a 30-year process, not a 10-year one. But the private sector will move faster. Just as foreign investors in the UK have bought property and companies, so too will investors in the US and Europe.
Initially this will tend to be in prime assets but gradually secondary assets will be mopped up. We are accustomed to that in Britain; we accept that rich foreigners are richer than we are. But I am not sure how well the US will take to this. The more evident Chinese investors become, the more concerned Americans will feel: it is all right them buying up Treasury securities, but less so them buying prime homes on Long Island.
That will surely be the lasting effect of the events of recent weeks. Things will not change overnight but there will be a gradual switch from financial assets in the US, particularly those bonds now trading at very low yields, towards a wide range of physical assets. In the early stages of the switch the focus will be on trophy assets, as it always is: expect prime USA to be revalued. But the hunt for value will drive up the price of the second tier and beyond.
It is an unsettling period indeed, but one with opportunities too. In such times in the past the really solid assets have been the ones that have proved best value, even if they are denominated in dodgy currencies.