Global stock markets may have something far more ominous to worry about than the recent spike in oil prices, with one economist seeing a ‘Black Monday’ scenario in the making.
The United States has been running significant budget and trade deficits for the past number of years — spending more than it makes, and importing more than it exports — largely funded by private Asian investors through the purchase of U.S. securities.
The rationale for Asian investors’ support outside of making a profit is simple: the purchase of U.S.-dollar denominated securities keeps the U.S. dollar strong, which weakens Asian currencies and keeps products and services from these countries competitively priced.
If the buying stops, the consequences would be dire, and Morgan Stanley’s chief economist Stephen Roach has spotted a worrisome trend in who’s doing the buying, and it’s the same trend that occurred prior to the 1987 stock market crash.
“The funding of America is an accident waiting to happen,” said Mr. Roach in his weekly note.
“The day will inevitably come when foreign investors — already heavily exposed to dollars — will reassess risk-adjusted return expectations of U.S. securities. That’s what happened in the fall of 1987, and there are increasingly worrisome signs of a replay of that same ominous chain of events.”
At the crux of his argument is the fact that official buying (by foreign central banks and monetary authorities) of U.S. securities has picked up dramatically, rising to 35% of total net foreign purchases during the September, 2003, to June, 2004, period. This is double the long-term average, and four and a half times the 2000 to 2002 average of 7.6%.
This compares to the January to September, 1987, period when official purchases topped 47% or almost four times the 13% share of 1986, and according to Mr. Roach, history shows that official buying picks up in a “last-gasp” attempt to prevent sharp adjustments in asset prices and to “buy time.”
“There can be little doubt as to why foreign policy makers — especially those in Asia — have intensified their campaign to support the dollar: lacking in domestic demand and fearful that their external demand support would be eroded by stronger home currencies, they simply can’t afford to face the alternative,” he said.
Official buying of U.S. securities failed to prevent the Oct. 19, 1987 global stock market crash that saw the Dow Jones industrial average plunge 22.6% in a single day, for the largest one-day drop in history and the erasing of US$500-billion in wealth.
The 1987 crash was blamed on numerous factors including irrational behaviour and program trading.
The Bank For International Settlements noted in its June, 2004, annual report that a contributing factor to the 1987 crash was the sharp build-up of U.S. dollar reserves and the interplay of this with the U.S. current account deficit.
Foreign investors are currently funding the United States’ imbalances to the tune of roughly US$86-billion a month over the six months ended April, 2004. Meanwhile U.S. dollar-denominated assets have mushroomed to about 70% of the world’s official holdings of foreign exchange reserve, or more than double the United States’ share of the world gross domestic product.
This heavy reliance on U.S. dollar reserves makes for a greenback overhang, that Mr. Roach says “is increasingly ripe for a correction.”
If the Dow Jones were to suffer a fall of the same magnitude as 1987, it would drop to roughly 7,700 from yesterday’s close of 10,073.05, for what would mark a level not seen since the dismal days of October, 2002.
© National Post 2004
