A $7 Trillion Currency Catch-22

It’s been exactly two years since Standard & Poor’s did the unthinkable and downgraded the U.S. government’s debt rating.

The Financial Times appropriately dubbed it, “A contentious and historic move that highlights the weakened financial stature of the world’s most powerful country.”

And yet, it’s as if it never happened.

Credit-default swap prices, which represent the cost to insure against a U.S. default, dropped to 22 basis points recently. That’s down from a high of 55 basis points right after the downgrade.

More amazing than the drop in default risk is that it came in the face of steadily increasing debt levels – and the fact that there’s no end in sight to Washington’s borrowing ways.

S&P now expects the amount of general U.S. government debt to hit 84% of GDP by 2015, up from their previous projection of 79% at the time of the debt downgrade.

So America’s finances have only gotten worse, not better.

Against that backdrop, it’s even more unfathomable that the U.S. dollar has been on a tear.

The world’s most despised currency is up 11% since the downgrade, as represented by the U.S. Dollar Index. And so far in 2013, it’s on track for its biggest gain in five years.

Talk about the great American debt downgrade debacle that wasn’t!

So whom do we have to thank for the unexpected resiliency and strength? And in whom should we put our trust for the future?

A group of do-nothing elected officials.

Indeed, we’re on a crash course with another debt ceiling debate, which is precisely what precipitated the first debt downgrade by S&P.

When it comes to the fate of our currency, however, we actually need to look overseas.

Here’s why…

The United States of Asia?

In an odd twist of fate, our trust for the future of our nation’s currency should be put in Asian governments.

You see, in the aftermath of the Asian financial crisis in 1997, Asia’s central banks swore to never let it happen again. And their defense strategy couldn’t have been more straightforward: stockpile U.S. dollars.

After all, what could ward off financial calamity better than a surplus of the world’s largest, most liquid and most trusted currency?

Fast forward to today, though, and Bloomberg reports that Asian governments now collectively hold upwards of $7 trillion in currency reserves, with the majority parked in the troubled U.S. dollar via U.S. Treasury bond investments.

With so many dollar bills owned by Asian governments, it’s no wonder they haven’t asked for Mao’s face to be printed alongside Washington’s!

So what was supposed to be an asset has now become a staggering liability. And they can’t do a thing about it.

I mean, think about it: If China, the largest U.S. lender, decides to start liquidating its $1.3 trillion in dollar holdings, the dollar would plunge – causing the yuan to soar. And a soaring yuan would completely undermine China’s already-wavering economy, which remains heavily reliant on exports.

Or as Leland Miller, President of China Beige Book International, told Bloomberg, “They understand they have no option but to accept the hand they’re given.”

Same goes for the second-largest U.S. lender, Japan, with $1.1 trillion in dollar holdings.

Remember, Prime Minister Shinzo Abe came to power in December 2012 – with a clear directive to reinvigorate the Japanese economy by weakening the yen.

He’s succeeded, too. The yen is down about 17% since mid-November, and exports were up for four months in a row (through June). But by bailing on the U.S. dollar, he’d be throwing all that progress out the window. The dollar would tank, as the yen soars.

Ironically, the best thing for Asian economies to do is nothing different. Just keep loading up on U.S. debt.

Doing so holds down their local currencies, which keeps their exports competitive.

Of course, it also supports the U.S. government’s mounting debt addiction. But is there really any other choice?

Nope, which explains why the U.S. dollar’s share of global foreign-exchange reserves is rising. It’s up to 62% in the first quarter, from a low of 60% in June 2011, even though the fundamentals underpinning the currency keep worsening.

Bottom line: Long ago, Asian governments started banking on the U.S. dollar to protect against future financial calamity. They overdid it. So while it might not be their currency, it’s become their problem to keep it strong.

For our sake, let’s hope self-preservation remains their number one priority. Otherwise, the dollar is doomed. And there’s likely nothing our elected officials in Washington can do about it.

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