Economic Fragility and Global Concerns Part II
Japanese Intervention
If you haven’t heard already, the Japanese intervened last month in currency markets to boost the strength of their currency. They apparently did it again in the last week. This has more potential to be a really bad omen than the UK situation.
A few points to know.
(1) The value of a currency is what you can buy with it. Within your country, your currency’s value is what goods and services you can buy. With inflation, those goods and services are more expensive. That means each of your currency units (dollars in the USA) buys less and we say it’s less valuable as a result. “Inflation erodes the value of a dollar”.
(2) In world markets, what can your currency buy? For most currencies, the answer is “nothing”. I can’t take a British pound or Japanese Yen and buy anything in the United States. So, outside your own country, your currency can only buy other currencies. Then you use those foreign currencies to buy foreign goods and services. When my currency buys more and more of another currency, mine is getting more valuable. But it’s only relative to yours. And that’s the weird thing happening with US dollars today. Domestically they buy less and less and are losing value. Internationally, they buy more and more and are gaining value. It’s weird.
(3) All values of currencies are determined by supply and demand. If demand for a currency rises, so does its value. If the supply of the currency rises, its value declines. Works just like all other markets.
Most developed economies don’t intervene in currency markets. They let their currencies “float” which means, they can float around at the whim of the markets.
The reasons most advanced countries do that are many. But one reason is that to be able to intervene to influence your currency’s world value, your central bank must have a massive stock of other currencies to trade. That stock is called “international reserves”. If I want to increase demand for my currency, I have to buy it (i.e., demand it) in world markets. But what do I pay with? Answer: I pay with foreign currency. So I need lots of foreign currency. Essentially, I sell foreign currency in world markets and buy up my own currency. This raises the value of my currency.
For the US to do this, we have to hold international reserves of foreign currencies like Euros, Pounds, Yen, etc. For everyone else in the world to do this they have to hold (mostly[4]) one foreign currency: the US Dollar.
So, as the US dollar continues to strengthen, more and more countries will start to intervene to strengthen their own currency. That means they’ll dump US dollars and buy their own.
That’s not actually concerning to me. It’s the next piece…
When these banks hold huge amounts of foreign currency, of US dollars, they don’t generally hold it in cash. They hold it in “the world’s safe asset”, US Treasuries which are better than cash in many ways.
Now we come to my concerns about Japan. Japan is the world’s single largest holder of US debt. Period.
The Japanese government holds about $1.2 Trillion USD in US debt, mostly as international reserves. The second largest is China ($1.1 Trillion in US debt) then the UK ($0.4 Trillion).
Just before things blew up and Truss finally called it a day, there was a lot of speculation that the UK would intervene to prop up the British pound. After Japan did it for the Yen, speculation rose again about the UK.
There has been concern off and on over the years about whether countries would ever dump US debt. All in all, foreigners hold 33% of total US public debt.
There was political speculation that China might be buying so US debt just in order to dump it.
I never put much stock into those theories because there is no economic benefit to dumping it en masse. Its value would drop and the values of those currencies would shoot up. Those countries don’t want that because much stronger currencies hurt their ability to export and they live from exports.
But today with the USD strengthening so much against all major currencies, the calculus changes. The ever stronger dollar is really becoming a problem for many countries. More of them will need to intervene to prop up their currencies.
If Japan starts doing it and selling large quantities of US Treasuries, I’m not worried about the value of the dollar per se, I’m more worried about the value of US Treasuries. The US is still running massive fiscal deficits and needs buyers of US debt. If those international buyers of US debt are trying instead to sell it, it could be a problem.
The US hasn’t faced a situation like that. At least not to the best of my knowledge and certainly not in recent years. There’s been speculation about it before, but no real, likely scenario.
But I worry today that the stars are aligning, making it in each country’s individual interest to intervene and sell more US Treasuries. If it happens suddenly, persistently and on large enough scale it will be bad for the US economy. But that in turn shakes the foundation of the worlds “safe asset”, the US Treasury. It’s held for safety reasons all over the world. The foundation of every major financial institution would shake.
Now, I’m not an alarmist. I’m not predicting the next Great Depression. I’m just watching world markets and the Japanese intervention is more alarming to me than it apparently is to many other observers. I see it as a bad signal of things to come. If the UK intervenes soon too, that will be more confirming evidence that some changes are coming.
The first effect will be much higher world interest rates and quickly. This will be devastating for emerging markets that are already struggling to hang on. And that sets off a string of crises that pulls the whole world economy down.
The US Federal Reserve knows all this too. They might intervene and engage in swap arrangements (buying US debt from foreign central banks to maintain their liquidity). It doesn’t all necessarily mean the end right away. It just seriously complicates matters. A lot.
Every day the US dollar strengthens further against most major currencies, the pressure for them to intervene grows.
If the dollar stops strengthening so fast against many major currencies, that pressure to intervene will be alleviated.
So, let’s hope for a little weakening in the dollar or at least less strengthening, but let’s also watch for Japanese and UK interventions.
These are dangerous times we live in. We are skating on thin economic ice.
[4] That’s an exaggeration. An Asian country that trades a lot with China and Japan will also hold lots of Chinese and Japanese currency. They’ll still hold dollars. The key point, however, is that we call the US dollar the “world reserve currency” because it’s held by nearly all countries in international reserves and can be used to buy a wide range of things in international markets. That makes it unique.