The Hand that Bites You

In light of the Dubai ports controversy, I have been thinking about how much longer the global imbalance can continue. The US Current Account Deficit means that similar deals are going to happen, unless the US reverses this huge deficit. On the other hand, the Asian export powers and the oil rich states can't exactly dump their dollars without consequences. Brad Setser has a great post on exactly that subject:

The US tells China (oops, CNOOC) that it cannot buy Unocal, even though Unocal's energy assets were primarily in Asia and Chinese firms have far fewer overseas assets than American firms. China responds by ... purchasing just as much US debt as before.

In January, China increased its Treasury holdings by $5.9 billion or so, its holdings of Agencies by $3.4b, and its holdings US corporate bonds by $2.7b - for a total of nearly $12b. Feeding the hand that bites you.

The US criticizes China's exchange rate regime. China gets annoyed that another country wants to tell it what to do with its exchange rate regime. But private investors start to think that China just might let the RMB move a bit faster, so money starts to flow into China. China has to intervene more heavily in the market, buys more dollars, and ultimately, buys more Treasury bonds. Feeding the hand that bites you.

... the big money in the Gulf isn't terribly happy that the US isn't willing to let Dubai Ports World operate US ports.

The Emirates is talking of shifting $2 b in reserves into euros.

They don't want to keep on feeding the hand that just bit them.

But I suspect, like the Chinese, they will find it is hard not to.

Suppose oil sheiks start shifting into euros, big time. Forget $2b of the Emirates $23b in reserves. $2b is chump change; it is two days worth of the oil states combined oil windfall. Saudi Arabia and Russia each add over $5b to their reserves (including all SAMA assets) each month. A real shift would imply that the oil states, who are now buying maybe $10b a month in euros, would need to start buying $20b a month in euros. Remember that the oil states now have roughly $35b a month, maybe more, that they have to invest somewhere ...

What happens if the oil states start buying euros? The euro probably rises against the dollar. A $120b swing is big, even in today's global economy. The Gulf states all peg to the dollar. So their currencies fall. And their citizens external purchasing power falls. The value of their existing stock of dollars falls (tough luck; what do you expect financing a country with a $950 b current account deficit?). And since their currencies fall, they will import less. Gucci ain't cheap, even with the euro/ $ at 1.20. And save more. And have even more funds to invest.

How can these countries stop financing the hand that bites them?

Spend more and save less, so they have fewer funds to invest abroad.

But for now, they don't want to change their currency regimes. China clings tenaciously to its (outdated) plan for a super-slow transition to more flexibility. The Gulf states don't even want to talk about the (even more outdated) dollar pegs.

And so they are all, in effect, opting to keep on feeding that hand that bites them.

... The US right now suffers from a bit of cognitive dissonance.

... The US doesn't think of itself as debtor in part because the United States' creditors have been so kind. Financing the US in dollars at low rates. Taking debt and not asking for any equity. And so on.

And since the United States creditors have been so kind, the U.S. hasn't felt pressure to be kind to them.

The only real question is whether those countries now financing the US are willing to change the policies that led them to buy $500b in debt from the US in 2005. Otherwise, they had better get used to feeding the hand that bites them.