Private Sector Cooling on the Dollar

Brad Setser, in one of his thorough and informative posts, parses the December Treasury International Capital report and finds strengthening of a trend he noted in the August TIC report: that the dollar purchases that fund our current account deficit come almost entirely from central banks and other government purses, and not private sector buyers:

A not-particularly-good TIC data release hardly even registered. But make no mistake – December capital inflows into the US were on the weak side. Net flows were only $60b, a bit under what the US needs to cover its current account deficit. Net long-term flows were only $45b.

The TIC data (found here) though did at least make one thing clear – in December, there really can be no argument about who financed the US deficit.

Central banks and sovereign funds supplied the US with $52.1b of financing, $35.8b in long-term financing and $16.3b in short-term financing.

Private investors supplied $8.4b (net).

And we already know central banks and sovereign funds supplied the US with even more financing in January than in December….

As I constantly note, the pattern of past data revisions suggests that the TIC tends to understate official inflows and overstate private inflows.

There is considerably more detail in the post.

Setser in an earlier post argued that concerns about a small decline in dollars as a percentage of total official reserves was misplaced. He believes that the dollar is in no imminent danger of losing its reserve currency status. But he is nevertheless acutely aware of the dangers of the US losing its privileged status:

The big issue facing the world isn’t the end of the dollar as a reserve currency so much as the overuse of the dollar as a reserve currency – the resulting accumulation of dollar reserves by countries that really have no need for reserves of any kind…

There also is — perhaps — a growing sense the enormous increase in central bank dollar holdings may reflect political decisions that make little economic or financial sense… The dollar hasn’t held its value…. And it isn’t likely to hold its value v. most emerging market currencies….

The US now relies on exorbitant privilege not so much to live well as to sustain the otherwise unsustainable – notably large private capital outflows from a country with a large current account deficit that isn’t attracting large private inflows. Without a lifeline from the world’s central banks, the US wouldn’t be able to finance its external deficit by selling under-performing financial assets. And if the US ever had to finance its deficit by selling financial assets that outperformed comparable assets, watch out. The US external position would deteriorate rapidly.

That leaves the United States in a position of intrinsic vulnerability.

The real risk though isn’t that the dollar will suddenly lose out to the euro. The real risk is that a bunch of already over-reserved emerging economies will conclude that it isn’t in their interest to hold even more dollars and euros – dollars and euros that they no longer really need – in their portfolio, and that this change will come before the US has weaned itself off its need for subsidized central bank financing….

There is, though, another risk – namely that China and a host of others won’t change, the continued availability of such financing will allow the US to sustain large deficits without producing assets that private investors want to hold, and the overhang of unneeded and in some sense unwanted dollar reserves will grow. The result: the United States’ dependence on the political good will of its creditors will only deepen.

Setser focuses keenly on the official data, which says our suppliers are still willing to fund our overconsumption habit, but the signs from the private sector are far less encouraging. This article from the Globe and Mail, “Is the greenback’s grip slipping?” cites a UBS study that found that companies that trade internationally are moving away from dollar-based invoicing and argues that private sector use of reserves greatly exceeds, and is therefore more significant than central bank reserves. However, the piece also says that the decline of the dollar is gradual:

The chief executive of jewellery giant De Beers SA made waves this week when he suggested the global diamond industry consider pricing the shiny gems in a currency other than the U.S. dollar.

That comment, from the head of the world’s largest diamond company, is the latest in a string of signs that the greenback’s glory days could be fading.

A UBS Investment Research report says that while it would be wrong to write off the U.S. dollar as the global reserve currency, its roughly 90-year iron grip on that position is loosening. “The use of the U.S. dollar as an international reserve currency is in decline,” said UBS economist Paul Donovan.

“The market share of the dollar in international transactions is likely to decline over the coming months and years, but only persistent policy error – or considerable fiscal strain – is likely to cause the dollar to lose reserve currency status entirely.”

The UBS report maintains that the gradual slide of the U.S. dollar is being driven not by the world’s central banks, but by the private sector, as individual companies increasingly abandon the greenback as their international currency of choice.

“The private sector’s use of reserves is more important than official, central bank reserves – anything up to 20 times the significance, depending on interpretation,” Mr. Donovan said. “There is evidence that the move away from the dollar as a private-sector reserve currency has been accelerating since 2000.”…

“We as the diamond industry should maybe think about a different currency than the dollar,” Gareth Penny, the head of De Beers, said at a diamond conference in Tel Aviv on Monday, according to a Bloomberg report. “Maybe it’s time to recognize the need for a different paradigm.”

Don Lindsay, the head of Canadian miner Teck Cominco Ltd., said Tuesday that given the soaring loonie, his company is no longer interested in investing in the diamond sector.

The U.S. dollar’s position as the global reserve currency means that it is held by central banks and other major financial institutions as part of their foreign exchange reserves, a situation which tends to draw the most attention.

In addition, the UBS report said that companies often use the U.S. dollar for international corporate transactions, which has created a private-sector greenback reserve.

Japanese companies have shifted to invoicing the sale of goods or services in the yen, particularly with deals done in Asia, UBS said. “This means, of course, that Japanese exporters have less need to hedge currency exposure today than they did in the past.” Aside from raw materials, the Australian economy is also relatively unlikely to pay for its imports in U.S. dollars.

Global trade data suggest the greenback appears to be declining as an international medium of exchange. “International trade growth has outstripped the amount of dollars in international circulation by some margin,” Mr. Donovan said.

A UBS “survey of our global equity analysts indicates that the dollar is not universally accepted as an international invoice currency.” The report listed global lodging and leisure as one sector where the dollar will play a declining role.

While most central banks have maintained their U.S. dollar holdings, the rise of sovereign wealth funds also points to a rising interest in portfolio diversification. “This diversification will place less emphasis on liquidity and more emphasis on returns, and thus could lead to a permanent reallocation away from the dollar,” the UBS report said.

The weakening of the U.S. dollar is comparable to the decline of sterling in the 1920s and 1930s. “Like sterling 90 years ago, the dollar is the most important reserve currency in the world, but it is no longer the only reserve currency – nor even the overwhelmingly dominant choice as a reserve currency,” Mr. Donovan said

Although the euro has generally been touted as the greenback’s replacement, the benefits “of reserve status are likely to be shared with a wider range of alternative currencies,” he said.