A warning for the US; reassurance for China

It is often asserted (eg in Brad Setser’s blog http://www.rgemonitor.com/blog/setser) that:

(1) The growing US foreign debt is manageable because it is denominated in dollars

(2) China will sustain a loss on its reserves when the dollar inevitably depreciates

The chart below suggests that such thinking may be unwise. It shows the logged dollar return on high-quality short-term debt (ie representative of reserves investments) in the US and UK (FRBNY discount or Fed funds rate and Bank rate respectively) from 1914 to 2006. 1914 is chosen as the start date because it marks the outbreak of the First World War, which arguably began the process by which the US dollar supplanted sterling as the main global reserve currency.




















Although, as would be expected, the dollar appreciated against sterling over this period, from nearly five dollars to the pound in 1914 to about two now, the consequently higher interest rates required to retain debt capital in the UK fully compensates for this depreciation, despite the existence of exchange controls in the UK until 1979. It seems that uncovered interest parity (UIP) approximately holds in the long run. In fact, if anything, sterling debt has provided a slightly higher return, presumably reflecting the risk premium of holding a declining currency managed by a weak central bank.

Although sterling debt lost ground from 1914, the interest rate penalty was sufficiently large that sterling had caught up as early as 1925. And a similar pattern was seen after successive sterling devaluations, including those of 1931 (the suspension of gold convertibility), 1949 and 1967.

To conclude, easy money and dollar neglect can delay, but not reduce, America’s debt burden. While China may report a mark-to-market loss on its dollar reserves over the next decade or so, this is practically irrelevant, because, assuming that China will not want to actively reverse its exchange rate policy for the foreseeable future, its reserves are stuck in dollars for a while anyway. And, as evinced by Zhou Enlai’s 1972 comment when asked about the impact of the French Revolution – “it’s too early to tell” – the Chinese are famous for taking the long-term view!