An interesting argument here from Richard Duncan, about the role of excess dollars in asset booms in Asia, and the subsequent surplus capacity and deflationary tendencies:
During the 30 years since the breakdown of the Bretton Woods International Monetary System, the global economy has been flooded with dollar liquidity. International reserves are one of the best measures of that liquidity. During the quasi-gold standard Bretton Woods era, international reserves expanded only slowly. For example, total international reserves increased by only 55% during the 20 years between 1949 and 1969, the year Bretton Woods began to come under strain. Since 1969, total international reserves have surged by more than 2000%. This explosion of reserve assets has been one of the most significant economic events of the last 50 years.
Today, Asian central banks hold approximately $1.5 trillion in US dollar-denominated reserve assets. Most of the world's international reserves come into existence as a result of the United States current account deficit. That deficit is now $1 million a minute. Last year, it amounted to $503 billion or roughly 2% of global GDP. The combined international reserves of the countries with a current account surplus increase by more or less the same amount as the US current account deficit each year. So central bankers must worry not only about their existing stockpile of dollar reserves, but also about the flow of new US dollar reserves they will continue to accumulate each year so long as their countries continue to achieve a surplus on their overall balance of payments.
With the depreciation of the dollar rapidly gaining momentum, Asian central bankers are scrambling to find alternative, non-dollar denominated investment vehicles in which to hold their countries' reserves. Consequently, this is a topic that is attracting considerable attention in the press.
First, it is clear that countries which built up large stockpiles of international reserves through current account or financial account surpluses have experienced severe economic overheating and hyper-inflation in asset prices that ultimately resulted in economic collapse. Japan and the Asia crisis countries are the most obvious examples of countries that suffered from that process. Those countries were able to avoid complete economic depression only because their governments went deeply into debt to bailout the depositors of their bankrupt banks. Second, flaws in the current international monetary system have also resulted in economic overheating and hyper-inflation in asset prices in the United States as that country's trading partners have reinvested their dollar surpluses (i.e. their reserve assets) in dollar-denominated assets. Their acquisitions of stocks, corporate bonds, and US agency debt have helped fuel the stock market bubble, facilitated the extraordinary misallocation of corporate capital, and helped drive US property prices to unsustainable levels.Third, the credit creation The Dollar Standard made possible has resulted in overinvestment on a grand scale across almost every industry worldwide. Overinvestment has produced excess capacity and deflationary pressures that are undermining corporate profitability around the world.
The affect on the economy is just the same as if the central bank of that country had injected high powered money into the banking system: as those export earnings are deposited into commercial banks, they sparked off an explosion of credit creation. That is because when new deposits enter a banking system they are lent and re-lent multiple times given that commercial banks need only set aside a fraction of the credit they extend as reserves.
Take Thailand as an example. Beginning in 1986, loan growth expanded by 25% to 30% a year for the next 10 years. Had Thailand been a closed economy without a large balance of payments surplus, such rapid loan growth would have been impossible. The banks would have very quickly run out of deposits to lend, and the economy would have slowed down very much sooner.In the event, however, so much foreign capital came into Thailand and was deposited in the Thai banks that the deposits never ran out, and the lending spree went on for more than a decade. By 1990 an asset bubble in property had developed. Every inch of Thailand had gone up in value from 4 to 10 times. Higher property prices provided more collateral backing for yet more loans.
An incredible building boom began. A thousand high rise buildings were added to the skyline. All the building material industries quadrupled their capacity. Corporate profits surged and the stock market shot higher. Every industry had access to cheap credit; and every industry dramatically expanded capacity. The economy rocketed into double digit annual growth.And, so it was in all the countries that rapidly built up large foreign exchange reserves: credit expansion surged, investment and economic growth accelerated at an extraordinary pace, and asset price bubbles began to form. That was the case in Japan in the 1980s and in Thailand and the other Asia cisis cuntries in the 1990s. It is also true of China today. Wherever reserve assets ballooned in a short space of time, economic bubbles formed. Unfortunately, economic bubbles always pop. And when they pop, they leave behind two serious problems.
First, they cause systemic banking crises that require governments to go deeply in debt to bailout the depositors of the failed banks. Economic bubbles always end in excess industrial capacity and/or unsustainably high asset prices. Banks fail because deflating asset prices and falling product prices make it impossible for over-stretched borrowers to repay their loans. The second problem economic bubbles leave behind when they pop is excess industrial capacity caused by the extraordinary expansion of credit during the boom years. The problem with excess capacity is that it causes deflation. Japan is suffering from deflation. Hong Kong and Taiwan have deflation. Even China, where an economic bubble is still inflating, has been experiencing deflation since 1998. The rest of the Asia crisis countries only avoided deflation by drastically devaluing their currencies and exporting deflation abroad. Think of the impact that the over expansion of Korea's semiconductor industry has had on global chip prices.
Source: Finance Asia
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