ABU DHABI // Faced already with evaporating credit and export demand, cash-rich economies in Asia and the Gulf now face a growing threat from a new quarter: an erosion of the very savings they are counting on to cushion them. At the root of the concerns is the dramatic increase in the amount of money the US government will need to borrow for its financial rescue package. Also, with calls growing for a second massive economic stimulus package, economists say the US government's fund raising is likely to push down the value of the US dollar and with it the massive dollar holdings of central banks and sovereign wealth funds from Asia and the Gulf.
Some fear the ballooning US debt could even force Washington to go farther, asking creditors to accept delays or even reductions in its repayments. "At current run rates, this is inevitable," said Paul Schulte, the regional strategist at Nomura International in Hong Kong, who estimates the US budget deficit could exceed US$1 trillion (Dh3.6 trillion) next year. The prospect of getting lower returns on money they have lent the US, or of seeing the value of those holdings drop further, could put Asian and Gulf governments in a bind. Many governments are already dipping into their savings to offset the effects of the global slowdown.
Most of those savings are stored in central bank reserves and sovereign wealth funds. Much of that money is, in turn, invested in assets denominated in US dollars, including US stocks and government bonds. The notion that the US government might need a break on its debt is a radical one. US government debt has long been considered the lowest risk around, partly because the US dollar is the world's reserve currency. If America's debts become too large, the Federal Reserve can simply print more greenbacks to pay.
But either possibility - a massive increase in US borrowing or a flood of newly minted dollars - would eventually push up the price that Washington would have to pay creditors to borrow and push down the value of existing US bonds. The US economy is clearly getting worse. America's unemployment rate jumped in October to 6.5 per cent, the highest in 14 years, while consumer spending slumped to its lowest level since 2001.
The International Monetary Fund (IMF), meanwhile, is forecasting a recession in the US, Japan, the EU and the UK. The resulting downturn on tourism, trade and commodity demand is likely to hit emerging markets some thought to be insulated from the US economic cycle. In its latest World Economic Outlook, the IMF projected that growth in emerging economies would slow next year to 5.1 per cent, from 6.6 per cent this year.
Members of the Group of 20 developing nations (G20) responded at a meeting of their finance ministers this week in Sao Paulo by pledging to create a co-ordinated economic stimulus. Many have already been cutting interest rates, but some are planning additional fiscal measures like that announced on Sunday by China to spend 4 trillion yuan (Dh2.1tn) to stave off recession. "It represents a change of thinking at the top," said Andy Xie, an economist in Shanghai. "Until one month ago, the official line was still that China was doing fine despite the global crisis."
The Gulf is also not immune. With oil prices falling, the investment bank EFG-Hermes last week lowered its forecast for Gulf economic growth to 4.8 per cent next year, from 8.5 per cent this year. Global investors trying to cut their exposure to risky markets or scrambling to raise cash to pay off debts have pulled more than $40 billion out of emerging markets this year, according to Nomura International. The selling has pummelled emerging market stocks: in the past month, benchmark stock indexes in Dubai and Kuwait have tumbled roughly 20 per cent.
This exodus of overseas funds has also been punishing emerging market currencies, pushing some indebted countries to the brink of default. Iceland, Hungary, Ukraine and Pakistan have even been forced to seek help from the IMF. Richer exporting economies like the UAE are far from such straits. But revenues are declining with oil prices and borrowing costs are rising, forcing companies and governments in the region to reconsider whether to launch some new projects.
Governments like China and the UAE have accumulated budget surpluses and foreign currency reserves to keep money flowing into their economies. Governments like the US, however, will have to borrow - a lot. Washington already needs to raise the money to finance its $700bn Troubled Assets Relief Program (TARP). And now the president-elect, Barack Obama, has promised to pass a massive economic stimulus package when he takes office next January. "The US stimulus is negative for the dollar," said Mr Xie.
Why? Because the US government already owes over $10tn; to provide for TARP, Congress raised the debt ceiling to $11tn. A spending package will mean borrowing even more. The problem for Asia and the Gulf is that they already hold a sizeable portion of America's debt. China alone holds about $750bn of US Treasuries, according to Brad Setser, an economist in New York at the Council on Foreign Relations. Japan holds $595bn and the Gulf about $190bn combined, he estimates.
As the dollar depreciates, the relative amount foreign investors get paid back drops. Countries like those in the Gulf that peg their own currencies to the US dollar will receive the same in local currency no matter what the dollar does. But because their own currencies will depreciate with the dollar, the money they earn will buy less. Dollar depreciation is a sensitive issue between the Gulf and Washington. US Treasury Secretary Henry Paulson tried to allay concerns that the US might be intentionally letting the dollar slide when he visited Abu Dhabi in June. "The long-term health and strong underlying fundamentals of the US economy will shine through and be reflected in currency values," he said. "I wouldn't bet against the US or her economy."
Some say the dollar is still a good bet. The rout of emerging markets in recent weeks, for example, has been pushing up the dollar. That trend has bolstered Gulf currency reserves, according to Bahrain's Gulf Finance House. And some say that even if the dollar falls it won't make a significant difference. "The reserves are there essentially to facilitate the smooth operation of the dollar peg," said Simon Williams, an economist at HSBC in Dubai. As a result, "It doesn't matter where the dollar goes".
Sovereign wealth assets are diversified across currencies and asset classes, and so declines in their dollar holdings may be offset by rising values of their assets in other currencies, Mr Williams said. But not much is known about where sovereign funds have invested. The Abu Dhabi Investment Authority (ADIA) divulged in June that almost half of its estimated $500bn in assets were invested in North America.
With markets everywhere plummeting, analysts say sovereign funds have undoubtedly suffered big losses, no matter where they invest. Morgan Stanley recently estimated that sovereign funds may have suffered losses this year of up to 25 per cent. With the global economy slowing, moreover, exports will slow and with them the accumulation of new foreign currency reserves. Instead, developing economies will start dipping into their savings.
That may have the perverse effect, economists say, of accelerating the decline of their existing US assets. By slowing - or even reversing - their purchases of new US debt as surpluses fall, the US government will be forced to offer higher yields to borrow money. That will push down the prices of its existing bonds. All of which raises the question of why emerging economies kept so much of their savings in dollars in the first place. "The real issue is whether it makes sense for a central bank or a sovereign wealth fund to hold 60 per cent of their assets in US currency," said Alex Patelis, an economist at Merrill Lynch in London. "My answer is 'no'."