By Andrew Sheng
I was at an IMF Conference on capital flows in Bali when the Japanese earthquake and tsunami occurred.
As the tragedy unfolded over the weekend, it became clear that the crisis was complicated by nuclear considerations. All of our sympathies and condolences go with our Japanese friends as they go through this terrible natural disaster, possibly larger than the Kobe earthquake. When the Year of the Rabbit ushered away the Year of the Tiger, there was a false spring in February when financial markets were buoyant as everyone thought recovery was in the air. Even the Nikkei stock market index reached a recent peak. The U.S. economy seemed to be on the upswing as unemployment numbers declined one percentage point. The earthquake shattered that illusion of recovery. Chaos theory is always introduced by the idea that the flutter of a butterfly’s wings can cause a hurricane on the other side of the world. We now see chaos theory in real life. A tsunami in Japan can hit the West coast of the United States, but financial markets immediately reacted around the world, as everyone tried to assess what the largest net foreign asset holder in the world would do. Would the Japanese sell off their foreign assets to finance their own post-earthquake reconstruction? If they did so, would they sell off foreign currencies and buy back yen, which would make the yen stronger? On the other side of the world, there was another earth-shattering pronouncement, not immediately comprehensible by ordinary investors, but very significant in terms of financial markets. In Oct. 15, 2010, PIMCO, the world’s largest bond fund manager, with probably US$1 trillion under management, announced that their Total Return Bond fund was cutting their holdings in U.S. Treasuries as a result of quantitative easing. Most retail investors probably did not notice that announcement. But on March 9 this year, the head of PIMCO, Bill Gross, announced that at the end of February 2011 the fund had sold off all their U.S. Treasuries and agency debt. To me, that is as significant as a tsunami in financial markets. I did not fully digest the significance of that event because I was traveling from Washington to Bali. But after I downloaded Bill Gross’s comments, available at www.pimco.com, I began to understand his thinking. He showed a fascinating chart on who was and will be holding U.S. Treasuries. In the past, the U.S. Federal Reserve Board only held 10 percent, the foreigners 50 percent and U.S. institutions and individuals held 40 percent. Since the beginning of QE2 (the second round of quantitative easing), the U.S. Fed has been buying 70 percent and the foreigners are buying 30 percent, whilst U.S. institutions are staying on the sidelines. So why are U.S. funds like PIMCO not buying? Part of the reason is that “Treasury yields are perhaps 150 basis points or 1-1/2 percent too low when viewed on a historical context and when compared with expected nominal GDP growth of 5 percent.” In other words, the U.S. dollar is violating the second of the three pillars which give it the most-favored-currency status, according to Barry Eichengreen, Professor at University of California at Berkeley, who has a great understanding of the special role of the U.S. dollar from the span of economic history. On March 2, Professor Eichengreen wrote an article in the Wall Street Journal arguing “Why the (U.S.) Dollar’s Reign is Near an End.” The three pillars are firstly, the depth of U.S. dollar-denominated debt securities, secondly, the U.S. dollar is the world’s safe haven, and thirdly, the U.S. dollar benefits from a dearth of alternatives.