Looming US dollar shortage could wreak massive damage
Yesterday the yuan fell to its weakest against the US dollar since late last year. In just the last couple of months, the Chinese currency has fallen 1.3 per cent. That's a big slide for a currency most people believe is locked into a long-term strengthening trend (see the first chart).
The yuan isn't alone. Over the last few weeks the currencies of Asia's emerging economies - the Korean won, the Singapore dollar, the Indonesian rupiah and so on - have fallen across the board against the US dollar.
And it's not just Asian currencies. In Europe, the euro has weakened as sentiment towards the single currency has darkened. Russia's ruble has fallen too, and in Latin America the Brazilian real has slumped by a hefty 18 per cent over the last two months.
Commodities have also taken a beating. Copper has fallen 15 per cent, while the price of oil has collapsed from US$124 a barrel at the end of March to just US$90 yesterday.
The conventional explanation for this general rout points the finger at Europe. As the euro zone's crisis has deepened, pushing its constituent economies into recession, European demand for Asian exports has dwindled. That's dented investors' enthusiasm for regional economies, hammering Asian currencies.
It's also suppressed demand for the raw materials supplied to Asia's factories, hitting both commodity prices and commodity-linked currencies such as the real.
Clearly there is a good deal of merit in this explanation. But, as always, there is another way of looking at things. And in this case the alternative view can help us form a clearer picture of some of the risks that may lie ahead.
To say that the yuan, the real, copper and oil are all falling is another way of saying that the US dollar is rising. Sure enough, if we look at an index of the US dollar's value against a basket of other major currencies, we find that the greenback has strengthened some 5 per cent since the end of April (see the second chart).
That may be just the beginning of a more protracted upward trend. Over the last 10 years we have got so used to the greenback as a persistent under-performer that businesses and investors around the world have adopted the US dollar as their funding currency of choice.
Companies have chosen to borrow in US dollars rather than in their home currencies, partly because of low US interest rates and partly because they believed the US dollar would continue to weaken, reducing the size of their local currency liabilities.
Similarly, investors and speculators have borrowed cheaply in US dollars to fund the purchase of higher-yielding assets denominated in other currencies.
As a result, foreign exchange strategist Hans Redeker and his colleagues at Morgan Stanley in London estimate that the world's private sector is now sitting on a net short position in the US dollar worth between US$2 trillion and US$2.4 trillion. That's a liability the size of the entire British economy.
The risk now is that the weakness of the euro - and hence the relative strength of the US dollar - will trigger a rush by businesses and investors to cover their US dollar short positions.
That, of course, would push the US currency higher still, exacerbating the liability-asset mismatch and prompting even more people to try to cover their positions in what could rapidly escalate into a classic positive feedback cycle leading to a global US dollar shortage.
If that were to happen, then the world's central banks would surely step into the markets. They have massive US dollar assets, offsetting the private sector's liabilities. China's central bank alone is believed to be sitting on US dollar assets worth almost US$2 trillion.
But the dislocation would be enormous. And Redeker and his colleagues warn that Hong Kong, with a financial centre heavily dependent on US dollar funding, may find it especially tough to obtain liquidity as the US dollar strengthens.
This could just be the start of something unpleasant.