Despite the debt deal, the US dollar is on the nose in developing countries

Like other “dollarised” developing economies, Timor Leste will feel the pain of a US dollar decline. AAP

Although the US debt ceiling crisis has been resolved for now, the saga has obvious implications for developing countries.

Yet, as is often the case, political conflict is obscuring the persistent and deeper elements of this crisis.

Ultimately, a default by the US on its debt is less of an issue than the inexorable “structural adjustment” that is ongoing.

Whatever the short-term outcomes of President Obama’s conflict with Congress – which will continue despite this week’s deal – we will see continued devaluation of the US dollar, some discounting of US bonds and greater “real economy” impacts on countries with strong economic links with the US.

The initial impact will be in the US itself. The country’s post-2008 recession will deepen, with contractionary belt-tightening, assisting the slide in its international financial and monetary pre-eminence. Greater protectionist measures will be demanded.

Despite recent uncertainties, the Washington establishment broadly agrees on the need to stabilise its expanding debt by slowing borrowings and containing spending.

The US public debt of US$14.5 trillion will be expanded by 2 or 3 trillion, at the same time as spending “cuts” of a few trillion are implemented. Exactly how this should be done is contentious.

The strong US dollar, held up artificially through its role as the world currency from the 1940s, helped the US invest abroad and carry out numerous interventions.

However, a strong dollar has also been an important element in creating the country’s chronic trade deficits: US exports became too expensive for other countries to buy. US authorities are therefore not opposed to a steady devaluation of the dollar.

The US also benefited from the large amount of foreign reserves deposited in US dollar denominated bonds, and often in New York banks.

Yet, in recent years diversification of reserves has followed diversification of trade currencies. China, after 2008, finally joined the ranks of creditors “diversifying” away from the dollar.

By late 2009, the US dollar represented only 37% of new reserves, compared to a 63% average over the previous decade.

While some US economists are trying to resurrect the idea of IMF Special Drawing Rights as a new world currency, this seems unlikely.

China, India and Russia and Brazil are unhappy with continued US and European dominance of the IMF. Russia, Venezuela and Brazil say they want to see a more “multipolar” world, with a greater variety of reserve currencies.

Within the US, the issue is taxation and spending cuts. The US military consumes about 20% of Washington’s budget, and payments on debt are similar. Yet with the powerful financial-military-media oligarchy, attention will be deflected to social spending.

Developing economies are looking to diversify away from US dollar-denominated assets. AAP

In developing countries, the impact will be most powerful in small Latin American countries like El Salvador, with a “dollarised” currency and reliance on remittances from the US (worth US$2bn per year, before the 2008 crisis) and on trade with the US (about 75%).

Ecuador and Timor Leste were also persuaded to adopt the dollar, in recent years.

“Dollarisation” was supposed to add stability, but it now means that these countries cannot buffer themselves – by a central bank buying up local bonds, for example – from volatility in the US system.

This is not an easy situation to turn around. Ecuador’s President Rafael Correa says he regrets his country’s adoption of the US dollar (in 1999), but will not make any change until the new regional currency (the SUCRE) is better developed.

The presidents of Brazil and Argentina recently discussed the implications of the US debt crisis. Brazilian President Dilma Roussef said the countries had to take “joint action” to defend themselves from “excessive liquidity which will artificially appreciate our currencies” as well as from “the avalanche of manufactured products which can’t find a market” in the wealthy countries.

Timor Leste seems somewhat removed from this, as it has few direct economic links to the US. However, the US dollar was adopted as the country’s official currency back in 2002.

Even more importantly, more than 95% of Timor Leste’s sovereign wealth fund reserves are held in US dollar bank bonds. A devaluation in US bonds will combine with the devalued dollar to degrade the value of the country’s $7 billion petroleum fund.

This foreign reserve dilemma is written into Timorese law. There are attempts to change this law, but they carry additional risk. Timor Leste’s Government, led by Prime Minister Xanana Gusmao, has a bill before parliament which removes most of the prudential controls on the Fund. Under the new law, up to half the country’s Fund can be handed over to foreign fund managers.

The oversight role of parliament will be largely abolished and transferred to ministers and investment advisors. The fund will be set up as collateral for debt instruments and its special status outside state finances will be removed.

Finally, the rate at which the fund’s revenues can be withdrawn by the government will be opened up. Removal of these prudential controls will expose the nation’s finances to potential losses in volatile stock markets, as well as opening the door to corruption.

One important lesson for developing countries is to anticipate the “big picture” changes in the global monetary and financial system, and to pay less attention to the centralising logic of the big powers.

They might study how to participate more effectively in financial diversification and to accommodate the steady shift towards a multi-polar world.