Cheap dollars sow seeds of next financial crisis

After years of selling cheap goods to debt-fuelled Western consumers, China now has $2 trillion dollars of foreign exchange reserves. That's two thousand billion - a reserve haul no less 25-times bigger than that of the UK.

In a world of systemic instability, reserves mean power. Reserves mean you can defend your currency, stabilise your banking system and boost your economy without resorting to yet more borrowing - or, worse still, the printing press.

Over half of China's reserves are denominated in dollars. So when the dollar falls, China loses serious money. When you're talking about a dollar-reserve number involving twelve zeros, even a modest weakening of the greenback sees China's wealth takes a mighty hit.

In recent years, America has run massive budget and trade deficits, both of which put downward pressure on the dollar - so de-valuing China's reserves. Beijing has generally remained tight-lipped, worried less about diplomatic niceties than the financial implications of voicing it concerns. If the markets thought China would buy less dollar-denominated debt going forward, the US currency would weaken further, compounding Beijing's wealth-loss.

American leaders have relied on this Catch-22 for some time, guffawing that China is in so deep it has no choice but to carry on "sucking-up" US debt. But Beijing is now so worried about America's wildly expansionary monetary policy that the Communist hierarchy is starting to speak out, despite the damage that does to the value of China's reserves.

Last weekend, Cheng Siwei, a leading Chinese policymaker, said his country's leaders were "dismayed" by America's recourse to quantitative easing - or QE. "If they keep printing money to buy bonds, it will lead to inflation," he said. "So we'll diversify incremental reserves into euros, yen and other countries".

This is hugely significant. China is now more worried about America inflating away its debts than about those debts being exposed to currency risk. Economists at Western banks making money from QE still say deflation is more likely than inflation. As this column has long argued, they are talking self-serving tosh.

China, the whole of Asia - in fact the entire non-Western world - rightly sees serious inflationary pressures down the track in the US, UK and other nations where political cowardice has resulted in irresponsible money printing. Now the wielder of the world's biggest reserves and debt-purchaser of last resort to a host of cash-strapped Western governments is saying enough is enough.

Following Mr Cheng's comments, the dollar fell throughout last week, hitting a 12-month low against the euro. As the dollar's "safe haven" status was questioned, gold surged above $1,000 an ounce to an 18-month high.

The US currency could well keep falling. New figures show America's trade deficit grew in July at the fastest rate in almost a decade. Imports exceeded exports by $32bn last month - a gap 16pc wider than the month before. One reason was that as oil prices strengthened, so did the cost of US crude imports.

Oil touched $72/barrel last week. If the greenback weakens further, prices will keep going up. That's because crude is priced in dollars and global investors will increasingly use commodities as an anti-inflation hedge.

These forces could combine to send the dollar into freefall. US inflation would then soar and interest rates would have to be jacked up. Even if a fast-collapsing dollar is avoided, Fed rates may have to rise quickly anyway if China is serious about dollar-divesting and the US has to sell its debt elsewhere. Under both scenarios, the world's largest economy could get caught in a stagflation trap - enduring both recession and high inflation.

Beijing doesn't want the US to stagnate. China has too much too lose. But even if the Chinese and US authorities work together to avoid a meltdown scenario, the world's currency markets could provide one anyway.

The dollar is now being widely used as a "carry" currency. Traders are using ultra-low Fed rates to take-out cheap dollar loans, converting that money into currencies generating higher yields.

"Carrying" credit in this way is currently the source of massive gains. No one knows the true scale but the world has, of course, been flooded with cheap dollars.

This presents serious systemic danger. A dollar weighed down by Chinese divestment, than suppressed further by carry-trading, could easily spring back. Those who had borrowed in dollars would instantly owe more, while their dollar-funded investments would be worth less. This "unwinding" of the carry trades could send financial shock waves across the globe.

This is what happened in 1998, when huge yen carry-trades went wrong, causing the collapse of Long-Term Capital Management and ultimately sparking a major global slowdown.

So even if the Western world manages to fix its unstable banking system, the Fed's money printing could well be stoking up the next financial crisis. The dollar carry-trade. You heard it here, first.

DARLING FINALLY BROWNED-OFF

Having often berated Alistair Darling, this column would like to say "Hats Off". Our erstwhile "glove puppet" Chancellor has finally plucked up the courage to bite - or at least nip - the hand that once controlled him.

Gordon Brown drones on about "Labour investment versus Tory cuts". No matter that the UK budget deficit will be equal 12pc of GDP. So what if we're set to borrow a staggering £200bn, each year, for the next three years.

The Prime Minister's solution is to keep spending willy-nilly and paint anyone who asks questions as immoral. Yet it is Brown that is immoral. Our so-called leader is at risk of wrecking the UK's credit rating - a cataclysmic outcome that would result in genuine austerity budgets and annual debt service costs approaching what we spend on the NHS.

By racking up enormous debts, on top of those he created as Chancellor, Brown is not only hindering UK recovery. He's trying to scare us into stealing off our children and grandchildren, so he can use the proceeds on counter-productive policies designed to cover-up his previous mistakes.

The British public isn't fooled. The vast majority of us - even public sector workers - know we've been living beyond our means. Having taken his cue off Brown for almost his entire adult life, Darling is now finally speaking up. "We have to focus on the limits of what government can do and areas where we can step back," the Chancellor ventured last week.

As Darling broke new ground, George Osborne followed - pledging for the first time to provide "specific numbers" on spending cuts before the next election. The Shadow Chancellor also confirmed that lower spending, rather than higher taxes, would be the "focus" of Tory efforts to get our public finances under control.

It's all so incredibly timid, though. We desperately need a no-holds barred debate on fiscal constraint - and fast, before our creditors rebel. Yet Darling is still speaking in code and the Tories seem to think they can solve the biggest fiscal crisis in our peace-time history by culling a few civil servants and raising the price of a salad in the MPs canteen.

We can't spin our way out of this one. The UK needs to take very substantial steps to cut spending - and the general public knows it. If our top politicians got out more, and hadn't spent their entire lives in politics, they'd have grasped that already.

Liam Halligan is Chief Economist at Prosperity Capital Management