If the US dollar is now a refuge, what is the yen?

The dollar rallied a bit last week, but nothing like the yen.

The Wall Street Journal’s Mark Whitehouse conflates – at least in my view -- deleveraging with safe haven flows.   

Deleveraging means that you borrowed dollars to buy something else and now need dollars to repay your debts.   Folks who borrowed yen (and dollars) needed to buy yen (and dollars) to pay their creditors back.   Safe haven flows by contrast imply that you own assets denominated in another currency and, in times of stress, would rather hold dollars.

I would interpret the dollar’s rally against most emerging currencies and the euro is a sign that the dollar was, along with the yen, a rather popular “funding” currency for a host of carry trades.   The dollar was just in the rather strange position of being a destination currency for some yen carry trades even as it was a funding currency for a host of other trades. 

The headline of the Journal’s story consequently seemed off to me.   Saying “Foreign investors view the dollar as a refuge currency in times of stress” suggests that there was a surge in foreign demand for US assets from investors who hadn’t previously borrowed dollars to buy other assets.   I am not sure that was the case.   

The defining characteristic of the US credit market last week was that there simply wasn’t any demand – whether foreign or domestic – for a host of US dollar-denominated bonds (Treasuries are an obvious exception).   That is why the Fed cut the discount rate, and why some hedge funds may give their funding banks bonds to exchange for cash at the discount window. 

So where did the demand for dollars come from?   My guesses would include:

• Investors who borrowed dollars and invested in higher yielding currencies were forced (or opted) to cut back on their bets.
• Investors with profits on their bets on emerging market equities wanted to either lock in their profits or raise cash – cash that they needed to cover losses elsewhere or to meet potential redemptions (see Jenny Anderson of the New York Times)
• European banks who had set up conduits and SIVs (think of them as minature credit hedge funds) couldn’t roll over their dollar denominated commercial paper, and had to borrow from their parents.   If they borrowed in euros, they needed to trade those euros for dollars to repay their dollar denominated liabilities.

I wouldn’t characterize any of these flows as classic safe haven flows.   

Indeed, with a host of US markets frozen, foreign investors who held dollar-denominated bonds likely found it rather difficult to sell their bonds for cash.  That, in turn, likely made it hard to “flee” the US.  Though I guess foreign investors stuck holding an illiquid CDO could still have hedged the currency risk … 

I also wasn’t completely satisfied with the two theories Whitehouse introduces to explain the United States ability to finance its large deficit with relatively little trouble.   Whitehouse writes:

“Economists offer at least two competing -- and overlapping -- explanations for the trend in the U.S. current account. Some put the emphasis on the profligate behavior of U.S. consumers and government, faulting America's appetite for foreign televisions and foreign wars for getting the country perilously deep into debt. Others see the U.S. as providing a necessary service to the rest of the world, offering the only financial markets large and resilient enough to safely absorb all the savings flowing in from countries such as Russia and China. As of 2005, the total value of the U.S. debt and equity markets stood at about $41 trillion, about twice the size of the comparable euro-area markets, according to the International Monetary Fund.

In the latter case, often called the "Bretton Woods II" view after the global system of fixed exchange rates that lasted from 1944 to 1971, the current-account deficit can be sustained as long as there are countries with excess savings to invest and as long as U.S. financial markets remain the best place to put the money. Recent worries over tighter accounting standards and the longer-term health of the U.S. economy have challenged the dominance of U.S. markets, but the latest market action suggests their reputation remains largely intact -- and offers some support for Bretton Woods II.  (Emphasis added)

The “profligate” US story is hard to square with (still) low global interest rates.  “Profligacy” – as Dr. Bernanke suggested a while ago – implies that the US borrowing should put enough pressure on global savings to push up global interest rates.    High rates in the US in turn suck in capital from the globe.   That story fits the early 80s better than the past few years. 

But the story that the US offers “the only financial markets” able to absorb Chinese and Russian savings – and particularly the argument that the US offers “the best place” for Chinese and Russian money” – also seems off.     Private Chinese and Russian money is quite happy to be in China and Russia.  It certainly isn’t financing the US deficit.   The US deficit is financed by the Bank of Russia and the People’s Bank of China.   

That point always needs to be emphasized.  And they clearly aren’t financing the US because the US offers the best returns, or even the best risk-adjusted returns.   Over the past few years, foreign equity markets have done better than US markets.   And the dollar has slumped v most currencies …

The strange thing is that foreigners have been willing to finance the US even though it hasn’t offered very good (financial) returns – and doesn’t really offer attractive risk-adjusted returns going forward.   In at least my view, foreign central banks finance the US because they peg to the dollar and want to support their export sector, not because they believe in US markets.   Think “Vendor financing.”   The service that the US has supplied the world is demand for their exports -- not large financial markets that offer a good store of value for the emerging world's savings.

Whitehouse doesn’t ignore global reserve growth, but he also doesn’t emphasize the extent to which the United States recent slowdown has left the US incredibly dependent on central bank financing.   If you want to explain why the US is (still) able to finance a large current account deficit, all you really need to do is to explain why foreign central banks added (my estimate) at least $600b to their reserves in the first half of 2007 …

Low returns certainly haven’t dented Mike Dooley’s faith in the dollar. 

“The fact that the U.S. still produces by far the best assets in the world will, as things settle down, be very good for the U.S."

And, well, Mike Dooley’s 2005 forecast certainly looks better than mine.   Back then, I doubted central banks willingness to finance large ongoing deficits.  He didn’t.    He was right.  

I presume by best assets he means the assets central banks most want to buy.  But even there, I have some doubts.   Treasuries don’t offer returns large enough to compensate for the risk of dollar depreciation – that, presumably, is why recent troubles don’t seem to have dented China’s risk appetite.   

The problem: the higher-yielding assets that the US financial system has produced recently currently don't look so good.   Once things settle down, I personally suspect that it will be a bit harder to convince the rest of the world – even previously generous official creditors – to finance the US on quite the same terms.    

UPDATE: I have thought about the Whitehouse aritcle a bit more, and I think it basically combines two puzzles in a way that, ultimately, confuses rather than clarifies.

The first puzzle is why the dollar rallied in the face of the subprime crisis.   Personally I would put more emphasis on delevaging than safe haven flows, but it is a real puzzle.  Certainly a crisis in the risky parts of the mortgage market didn't prompt a mad rush out of all US assets -- while most emerging market crises are defined by a rush out of all the country's assets, not a rush from CDOs to Treasuries.

The second puzzle is why the US has been able to finance a large current account deficit at relatively low interest rates for a long period of time even though the dollar has slumped and returns on investment in the US have lagged returns on investments outside the US.   That also is a real puzzle, but it puzzle is ongoing investor demand in a sinking dollar -- not an unanticipated rise in the dollar.   Bretton Woods 2, at least to me, is interesting because it offers an interesting explaination for why some investors (foreign central banks) have bought a lot of US dollar-denominated assets even though the US hasn't offered world-beating financial returns.  Apart from 2005, even "safe" US assets generally have underperformed "safe" European assets.

I am not sure that it is possible to look into both puzzles effectively in a single short article; they are fundamentally different puzzles.