Thursday, July 17, 2008

SWF's Flee US Dollar



The US Is Losing Support
One of the Persian Gulf's biggest sovereign wealth funds has cut its US dollar-denominated exposures from 80% one year ago to 60% today, the London Financial Times' Henry Sender reports.
This may not seem like a big deal, but it has to be seen in the context of just how much money the rest of the world has effectively lent to the US. As recently as the last twelve months Middle Eastern sovereign wealth funds have been investing, some might say naively, in beaten-down US commercial and investment banks and mortgage lenders in what they thought at the time should have been a bargain-hunting trade. The sovereign funds received some pretty impressive interest rates, but any coupon now seems irrelevant in the face of ongoing losses in US financial institutions.
Sovereign wealth funds have lost a lot of money.
While the Gulf states contemplate going elsewhere for their investments, China's State Administration of Foreign Exchange (SAFE) has been actively looking to undertake deals with private equity firms in Europe as part of an attempt to mitigate the risk of their US investments. SAFE holds the majority of China's US$1.6 trillion of foreign currency reserves in US dollar instruments and has not been as quick as other government authorities, such as Singapore's, to diversify currency exposure.
The Qatar Investment Authority has suggested the outlook for the US dollar is a significant issue for investors contemplating US-related investments. Behind the scenes at SAFE, Sender reports, fund officials are questioning the credibility of the Fed and US Treasury in defending the US dollar and maintaining US stability. Last year long term US ally Kuwait cuts its currency peg to the US dollar, sparking a concern about the intentions of other Gulf states. This is unlikely to occur as long as the UAE stays pegged, but rumblings at the world's largest sovereign wealth fund - the Abu Dhabi Investment Authority - suggest dissatisfaction with having to import US inflation.
The ADIA is the world's biggest investment fund. The world's tallest building is in Tapei at the moment, but it will soon be in Dubai. The largest publicly-listed company is in Beijing. The world's biggest oil refinery is currently being built in India. What's wrong with this picture?
The largest movie industry is not in Hollywood, it's in Bollywood. The largest shopping mall in the US would not even make it into today's top ten. Only two of today's richest people are American.
The Barbarians are at the gates.
The world's two largest mortgage lenders remain, nevertheless, American. They are Fannie Mae and Freddie Mac, which between them control some US$5.3 trillion of US mortgages. Merrill Lynch analysts in the US warned yesterday that the US could face a "financing crisis" within months as the full consequences of the perilous state of Fannie & Freddie spread through the world.
The US is currently running a current account deficit (it is a net borrower) of some US$700 billion, mostly financed by Asia, Russia and the Middle East. When the Nikkei bubble burst in the early 1990s, Japan was forced to deal with the problem internally and cut its interest rate to zero, where it has pretty much stayed ever since. However, the heavily-borrowed US could not afford to do this without losing all support from its creditors. Things are already bad enough at 2%. And the world is pointing, with hindsight, to the folly of Alan Greenspan's 2004 level of 1%.
Brian Bethune, chief financial economist at Global Insight said yesterday, as reported by the London Daily Telegraph's Ambrose Evans-Pritchard, "This is not the time for [US] policy-makers to underestimate, once gain, the systemic risks to the financial system and the huge damage this would impose on the economy. Bold, aggressive action is needed, and needed now". Bethune suggested the US Treasury has only days to put real money, not just promises, behind Fannie & Freddie or face a dangerous crisis that could spiral out of control. Arguments over "moral hazard" are only holding up the solution.
While the increased dividend from Wells Fargo last night may have sparked a short-covering rally on Wall Street, on Main Street the queues only get ever longer outside IndyMac branches, and small depositors are beginning to heed the media's warning to take anything above US$100,000 out of any other bank account, as it will not be insured by the FDIC.
Evans-Pritchard notes that to acknowledge Fannie & Freddie as making up almost half the US$12 trillion US mortgage industry is still to understate the vital importance of these institutions. Fannie & Freddie are currently acting as a lender of the last resort to the battered US home loan market, providing 80% of all new mortgages. Some US$1.5 trillion of Fannie & Freddie AAA-rated debt is held in foreign hands. How patient will these investors be if the US dollar continues to slide?
Hiroshi Watanabe, Japan's chief regulator, yesterday urged Japanese banks and insurance companies to treat US agency debt with caution. But most of it is held in the Middle East, Russia and China. Were these countries to decide it was no longer in their interest to do so, their withdrawal could cause a run on the US dollar and "bring the United States to its knees", Evans-Pritchard warns.
It is unlikely they would do so, as the ramifications would be self-defeating. However, a mere slowing of dollar-denominated investment (and diversification away) could still cause major problems.
Merrill Lynch noted that aforementioned foreign governments had acquired US$241 billion of US agency debt in the past year alone as their own foreign currency reserves exploded. They now own US$985 trillion, which is estimated to include US$400 billion in China, US$150 billion in Russia, and another US$200 billion in Saudi Arabia and the other Gulf states. Rampant inflation in Asia and elsewhere is forcing interest rates to be raised as the US has cut, drawing more capital away from the US. (The interest rate spread between Australia and the US is now 5.25% and the Aussie dollar is pushing towards parity as foreign money flows in).
The survival of the US is thus in the hands of tenuous Middle East allies, Russia - from which Premier Putin has often stated that his country is now in a new Cold War with the US in reference to proposed European missile sites - and China. China is the country which has recently drawn a US hate-campaign over dodgy imported products and a new protectionist movement in Congress over trading imbalances.

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