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How Asia can protect itself from a dollar default
Conventional Keynesian policies - fiscal and monetary expansion on a national basis - cannot solve the problem but will make it worse.
The Financial Times

How Asia can protect itself from a dollar default

By Yu Qiao

Published: April 1 2009 03:00 | Last updated: April 1 2009 03:00

President Barack Obama is set to urge leaders to boost government spending to save the world economy. European Union countries are expected to focus on fixing lax financial regulatory systems. For Asian countries, however, the key agenda issue is the safety of their assets denominated in dollars, as they look ahead to a devalued dollar from rising US sovereign debt.

Most of Mr Obama's stimulus spending is devoted to social programmes rather than growth promotion, which may exacerbate America's over-consumption problem and delay sustainable recovery. On top of this, the unprecedented fiscal stimulus, with the Federal Reserve's move to inject money into credit markets, contains selfdestructive seeds. The US risks ending the dollar's role as the reserve currency, especially considering there is already $10,000bn (€7,535bn, £7,009bn) in US Treasury debt, and much more in liabilities from the costs of social security, healthcare and financial institution bail-outs.

The provision of stable, reliable and viable dollars may be subordinated to short-term US interests, posing a risk to global monetary stability. In the long term, America may seek to resolve its economic mess by devaluing the dollar at best and a default at worst. This is depicted in a Chinese proverb: "Drinking poisonous liquid to quench thirst". History points to examples such as the collapse of the Bretton Woods system in the early 1970s. It is the foreign holders of US obligations denominated in dollars that would end up paying.

Analysts have warned of the dangers of the US Treasury bond bubble that developed in late 2008. Although insurance against sovereign debt default may reduce credit risk, it is unable to safeguard the real value of dollardenominated securities. If this bubble burst, east Asians would be victims. Their economies directly hold more than $1,600bn of US sovereign debt, or 25 per cent of the total held by the public. Including direct holdings, Asians may hold half of the outstanding public-owned Treasury bonds. China, by some estimates, directly and indirectly holds more than $1,200bn of US Treasury bonds. If the dollar collapsed, the consequences would devastate Asians' hard-earned wealth and terminate economic globalisation.

No other international monetary system offers a viable alternative. However, we can make the main reserve currency power more accountable by creating an instrument to help manage the global crisis.

The basic idea is to turn Asian savings, China's in particular, into real business investments rather than let them be used to support US over-consumption. While fixed-income securities are vulnerable to any fall in the value of the dollar, equity claims on sound corporations and infrastructure projects are at less risk from a currency default. But Asians do not want to bear the risk of this investment because of market turbulence and a lack of knowledge of cultural, legal and regulatory issues in US businesses. However if a guarantee scheme were created, Asian savers could be willing to invest directly in capital-hungry US industries.

First, Asian countries could negotiate with the US government to create a crisis relief facility. The CRF would be used alongside US federal efforts to stabilise the banking system and to invest in capital-intensive infrastructure projects such as a high-speed railway from Boston to Washington DC.

Second, Asians could pool a proportion of their holdings of Treasury bonds under the CRF umbrella to convert sovereign debt into equity investment. Any CRF funds, earmarked for industrial commitment, would still be owned and managed by their respective countries. In return, Asians would hold minor equity shares that would, like preferred stock, be convertible.

Third, the US government would act as the guarantor, providing a sovereign guarantee scheme to assure the investment principal of the CRF against possible default of targeted companies or projects. Fourth, the Fed would set up a special account with the US government to supply liquidity that the CRF requires to swap sovereign debt into industrial investment in the US.

The CRF would lessen Asians' concern about implicit default of sovereign debts caused by a collapsing dollar. It would cost little and help the US by channelling funds to business investment. Conventional Keynesian policies - fiscal and monetary expansion on a national basis - cannot solve the problem but will make it worse.

The writer is a professor of economics in the School of Public Policy and Management, Tsinghua University, Beijing

How Asia can protect itself from a dollar default