Monday, 13 December 2004

Why Asians support the US dollar

General Glut thinks that East Asian central banks' willingness to support the US dollar is because of their need for US military support (see his posts here and here post). It's an interesting point, although I think the main reason for East Asian support for the dollar is to promote exports and stave off deflation.

Yes, I know deflation looks like last year's topic. Strong economic growth and rising prices over the past year have caused most people to shift their attention to inflation instead.

But Asian countries still remember the financial crisis of 1997-98 that wrecked their economies. That crisis was induced by rising economic competition -- particularly from China -- as well as excessive debt accumulation in the region. While the crisis pushed Asian currencies down, it was the fall in the currencies that eventually saved their economies by boosting exports. The Asian economies have had a proclivity towards weak currencies ever since.

And understandably so. The economic conditions that induced the financial crisis and threatened deflation in 1997-98 -- the competition from China and high levels of debts -- have not dissipated.

And yet, all this US dollar-buying may prove to be self-defeating if Asian central banks' reserves get wrecked by the fall in the currency, while the authorities in these Asian countries fail to do enough to restructure their economies to promote domestic demand to compensate for a potential fall in exports.

Indeed, Brad Setser thinks that central banks may be "fools" for buying US dollars. In The Global Test", he warns that this may not go on forever:

Japan...probably should be running a current account surplus and building up external assets that it can draw down on once its population starts to shrink -- but it also probably should be financing emerging Asia, not the US...

What could cause the system to break? A US that seems oblivious to the global test. A decision from China to take losses now rather than bigger losses in the future, no matter how painful. A US current account deficit that keeps on expanding on the back of consumption growth fueled by low interest rates beyond the amount of financing that is available from China and those countries that feel compelled to match China to keep their own currency from appreciating.

This is no way to run our global economy...

I have more comments on the US dollar in "The falling US dollar and rebalancing of the US current account".

For more of my past comments on deflation in Asia, see the following:

Deflation in Japan keeps yields low

Fight against global deflation must involve Asia

Stocks rise amid deflation confusion

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