The developing world fails to enact structural reforms, cannot borrow in their currencies, and depends on the US dollar.
By Will Hickey*
In Biblical terms, original sin denotes the fall of man after Adam eats forbidden fruit from the tree of knowledge in the Garden of Eden. In economics, the metaphor refers to the developing world’s inability to borrow in their own currencies, as described by Barry Eichengreen, Ricardo Hausmann, and Ugo Panizza. Developing nations overleverage their economies to external foreign debt, most often, the US dollar, due to an optimistic perception of global monetary stability and low, long-term interest rates.
With dollar interest rates near zero for the past eight years, dollar indebtedness has soared in many developing countries, and the piper will soon call.
Many developing countries confront too many protectionist regulations and export fixated mindsets that prevent not only foreign investment formation but also preclude the development of real endogenous growth initiatives, including entrepreneurial innovation and domestic small business growth.
Hot money inflows with a low interest-rate dollar since 2007 and the global debt crisis have allowed developing nations to avoid undertaking economic reforms to structural and systemic problems. These structural issues encompass: too many people working for government in redundant jobs, a plethora of inefficient state-owned companies, backward-looking education policies, and layers of stifling regulations on small businesses at all levels.
Countries are undertaking many desperate headline-grabbing measures to avoid restructuring their current systems, lest political support be lost. Consider a few fiscal gimmicks:
- Quantitative easing or printing more money, as tried by most developing countries, including Turkey and Vietnam, to cheapen labor and exports.
- Tax amnesties, recently Indonesia and Argentina to bring back money held abroad.
- Issuances of dollar bonds, as in Zimbabwe, to shore up deficient foreign exchange holdings.
- Oil production cuts among OPEC members to re-boost petrodollar receipts as oil and other commodities are priced in dollars – pre-war Iraq used euros, and Iran, while under sanctions and now, tries using other currencies, but most sellers demand conversion into dollars.
- Meanwhile, India’s chaotic demonetization of 500 and 1000 rupee notes is a step towards economic change.
Such mechanisms, intended to restore money in legitimate economic systems, are not a panacea in lieu of much needed structural reforms. Put simply, a currency devaluation or any of its proxies are a method for balancing budgetary deficits due to a nation’s failure to enact deep structural reforms and expect sacrifices of citizens. All currency devaluations underway today are against the dollar only. Some countries, such as Ecuador and Zimbabwe have “dollarized” their economies, either via outright dollarization – that is, legal use of the dollar in all transactions – or via pegs, like Hong Kong. Both scenarios present an expensive economic straightjacket by importing US monetary policy that they can ill afford.
If any devaluation is ultimately recompensed against a baseline dollar value, then a zero sum game ensues in an atomized world of unfettered communication with instant market adjustments. In other words, devaluations are quickly observed by all, not just bankers and businessmen, as in the pre-internet era.
Devaluations can be both implicit and direct. Nigeria and Venezuela used implicit devaluations with official and black market exchange rates. Egypt and Argentina tried direct, telegraphing devaluations well in advance. All people seek to maintain a baseline value of their wealth against depreciation, and the dollar serves this function supremely. For example, in Indonesia, a lack of domestic dollarized investment vehicles hindered the repatriation of assets abroad returning freely as part of their recent tax amnesty.
Simply, few in the developing world trust their own currencies. The wealthy want dollars, and these nations have created de-facto dollarized economies.
The Chinese currency is pegged to the dollar, but on a sliding scale that has recently trended downward with what bankers have called “stealth devaluation.” Nonetheless the Chinese are not fooled and are so desperate to get their money out of China that property bubbles have emerged in cities like Vancouver or London where prices have increased by almost 50 percent since 2011. Another tactic is “smurfing,” or using another person’s bank account to evade government limits on transfers.
The communist response has been to clamp down harder on capital outflows while talking about eventually revamping the export economy in general terms, floating more government loans to non-performing state-owned enterprises. China’s priority is political stability at all costs, not the currency.
Effectively, a gigantic confidence game is forming, and the 2016 International Monetary Fund Special Drawing Rights reweighting only reaffirmed this trend with dollar preeminence barely unchanged at a plurality of 42 percent while the euro took the brunt of reweighting to make room for the Chinese renminbi as a new reserve currency. The move was political on the part of the IMF, deigned to fete Chinese nationalism, as the renminbi does not meet all conditions of a ‘reserve currency’.
Any reserve currency pegged to another currency, or basket of currencies via political “reweightings,” serves only to consolidate dollarization status quo, not minimize it. The dollar still serves as majority value.
Nonetheless, most nations are now levered to the US dollar, a currency with significant flaws in its own underpinnings, namely a $20 trillion national debt, expected to grow further with the Trump presidency and his infrastructure spending plans, not to mention a US Federal Reserve that seeks to raise interest rates beset in a world of zero and even negative rates. No other nation could survive economically with such compromised policies.
No one knows exactly how a dollarized world against a low-interest rate environment will eventually play out. Additionally, there are only so many physical dollars in circulation. A run on the world’s dollar supply by all countries in tandem could see a sudden unwelcome surge in the currency’s value, ruining many private and government investors who originally issued dollar debts but receive payments in local currency, ergo the concept of “original sin.” The currency gurus of Eichengreen, Rogoff, and Hanke each have their macroeconomic theories of what might happen. In truth, surprising consequences could be in store in 2017.
For example, a soaring dollar combined with a glut of global manufacturing capability in developing countries could quickly magnify events, as it could turn foreign export markets savagely competitive during a time of nascent economic recovery.
Dollar hegemony is here to stay, a form of neocolonialism, tethering the developing world, and increasingly the middle-income world, to US economic policy. Economies like those of Venezuela, Iran, Nigeria, Turkey and Indonesia are based on dollars for energy, infrastructure, trade and finance. The countries have little choice but to continue using a “too big to fail” foreign currency. The trends are being magnified by quantitative easing in the developed world as the euro reaches parity with the dollar, while the pound and yen slump. Countries seek to improve their economic lot against the dollar’s goalposts, and it is not in the interest of many – those pegged to the dollar, their elites or exporters – to weaken it.
The statement made by US Treasury Secretary John Connally in 1971 to other finance ministers – “The dollar may be our currency, but it’s your problem” – holds true today.
*Will Hickey is the author of Energy and Human Resource Development in Developing Countries: Towards Effective Localization, Macmillan, 2017.