Sunday, October 18, 2009

The Demise of the US Dollar?

One Saturday afternoon in 2005 when just starting my MBA studies, a friend of mine told me of an argument he had had with another friend about the American economy. According to this friend, living in the UK at the time, and still does, spoke about how his friend had praised the American economy, and how there was no chance of any problem. My friend went on to describe how condescending his friend was during this argument. This was interesting in the sense that my friend’s friend went on to lose a ton of money. On the day of the crash, this person went on to lose a sum my friend described as “beyond the call of duty”. Oh, and before you ask, he has made a complete u-turn in his opinion of the American economy.

I distinctly remember calls many years before the crash from those in the know about how to avoid a major crash, and how to soften the blow for people should the crash arrive. Nevertheless, many economists and financial pundits from the likes of Bloomberg, CNBC, CNN, argued that there was no need to get worried and that the “economic fundamentals were sound”. We now know that the economic fundamentals were not sound.

This was a statement from one of our partners while discussing the American economy. How the mighty have fallen, you might say. It does not look too good for the American economy.

A massive bailout program went into action with governments across the western World throwing money at the banks to stave off a major collapse. Some institutions became too big to fail further heightening the drama. Many economists have argued that this massive bailout can only fuel inflation. Some have even said that the level of unemployment in the US has helped stave off inflation. As for that argument, we let you decide.

So what else is happening on the horizon? For one the price of Gold is rising while the dollar is falling. There is now the argument that the dollar is going to collapse due to the ever-increasing weakness of the US. So what do we believe? Is this really going to happen and if so how? Are we to accept that the collapse is inevitable? By the way, which other countries are going to go down with the sinking dollar?

It seems that the only game in town is the demise of dollar. This certainly has many a pundit hot under the collar. There are stories a plenty now especially on the Internet. The newspapers are also not too far behind either. The discourse on the dollar’s demise is interesting with different twists and turns. Here are just a few examples (please note that statements have been removed for relevance):

A Financial Times (FT) report of 4th October titled “Mighty Dollar turns a paler green” states the following:

Can anything good be said about the dollar? The greenback, the world’s reserve currency, is under attack from all sides.

Such is the dollar’s power that any discussion of the direction of any other currency still has to involve the US currency – it is one side of 86 per cent of all currency deals. Even if an investor had particular reasons for believing in the weakness of another currency, that has to be considered in the context of the dollar’s likely direction.

Just now, the consensus is very definitely towards further dollar weakness and the greenback is obliging the forecasters.

The dollar has been weakening fairly steadily since 2002. Measured against an index of big US trading partners, it lost 41 per cent of its value from then to its low in April 2008. After Lehman collapsed last year, fears about bank liquidity produced a scramble for dollars, boosting its trade-weighted index by 24 per cent in five months. But since then, the downtrend has reasserted itself and the index has traded back near its lows of last year – and is expected to weaken further.

The FT goes on to give reasons for the continued demise of the dollar:

There are a number of reasons for the dollar’s slide and the expectations of further weakness. The most immediate one is excess liquidity.

“If the dollar’s huge rally at this time last year was the result of a dollar shortage, the recent weakness is driven by a surplus of the currency,” says David Woo at Barclays Capital. While other countries have similarly easy monetary policies to the US, none seem to be having quite the same currency effect. Analysts believe much of the extra cash is being parked in US Treasuries, where in spite of the stock market rally, yields have been falling – and faster than those on comparable 10-year German Bunds, leading potentially to selling of the dollar for euros.

As further evidence, a fellow weakling currency is sterling, whose poor performance has been helped by the UK, which has the most similar policies to the US in terms of pumping in extra liquidity through quantitative easing.

“It’s difficult to see this state of affairs changing in the near term, at least not until the market is assured the end of QE [quantitative easing] is near,” says Mr Woo.

Until then, the dollar is also likely to come under pressure from its role as a funding currency for carry trades. The deals were popular in the boom years as investors borrowed in low-yielding currencies to reinvest in ones with higher returns and are now returning as yield-hungry investors ready to take the risk once more.

As mentioned earlier, there are many opinions floating about. Here is an excerpt from the Independent Newspaper’s Middle East Correspondent Robert Fisk (Mr. Fisk includes some of the political implications for the de-dollarisation of the oil market):

The plan to de-dollarise the oil market, discussed both in public and in secret for at least two years and widely denied yesterday by the usual suspects – Saudi Arabia being, as expected, the first among them – reflects a growing resentment in the Middle East, Europe and in China at America's decades-long political as well as economic world dominance.

Nowhere has this more symbolic importance than in the Middle East, where the United Arab Emirates alone holds $900bn (£566bn) of dollar reserves and where Saudi Arabia has been quietly co-ordinating its defence, armaments and oil policies with the Russians since 2007.

This does not indicate a trade war with America – not yet – but Arab Gulf regimes have been growing increasingly restive at their economic as well as political dependence on Washington for many years. Of the $7.2 trillion in international reserves, $2.1trn is held by Arab countries – China holds about $2.3trn – and the nations interested in moving away from dollar-trading in oil are believed to hold over 80 per cent of international dollar reserves.

Saudi Arabia's denials of any such ambitions were regarded by Arab bankers as a normal part of Gulf politics. The Saudis, of course, managed to deny that Iraq had invaded Kuwait in 1990 – even when Saddam Hussein's legions stood along the Saudi frontier, until the US broadcast the news of Iraq's aggression to the world.

Saudi bankers are well aware that in nine years' time – the current timeframe for a transition away from the dollar in oil trading to Japanese and Chinese currencies, the euro, gold and a possible new Gulf currency – China will have doubled its national income to $10trn (assuming a growth rate of 7 per cent), at which point the US might hold no more than 20 per cent of the world's gross income.

Such massive financial movements, encouraged by the de-dollarisation of oil, will have enormous political effects in the Middle East, especially if economic superpower rivalry between America and China comes to dominate the Arab world. Will American economic support for Israel remain as loyal in nine years' time if China and the Arabs are setting the pace in global financial markets? Indeed – perhaps with this in mind – some Israeli financiers have been expressing interest over the past two years in non-dollar Arab bank investments. Whenever a change of this magnitude takes place over a number of years, it has to be commenced in secrecy.

It seems from the blogosphere and other sources; Mr. Fisk’s article has caused quite a stir. Here is Mike Whitney’s take on the Fisk article titled “Dollar Hysteria” from the Information Clearing House website on October 6th:

Yes, the dollar will fall, (eventually) but not for the reasons that most people think. It's true that the surge in deficit spending has foreign dollar-holders worried. But they're more concerned about the Fed's quantitative easing (QE) program which adds to the money supply by purchasing mortgage-backed securities and US Treasuries. Bernanke is simply printing money and pouring it into the financial system to keep “rigamortis” from setting in. Naturally, the Fed has had to quantify exactly how much money it intends to "create from thin air" to placate its creditors. And, it has. (The program is scheduled to end by the beginning of 2010) That said China and Japan are still buying US Treasuries, which indicates they have not yet "jumped ship".

The real reason the dollar will lose its favoured role as the world's reserve currency is because US markets, which until recently provided up to 25 percent of global demand, are in sharp decline. Export-dependent nations--like Japan, China, Germany, South Korea--already see the handwriting on the wall. The US consumer is buried under a mountain of debt, which means that his spending-spree won't resume anytime soon. On top of that, unemployment is soaring, personal wealth is falling, savings are rising, and Washington's anti-labor bias assures that wages will continue to stagnate for the foreseeable future. Thus, the American middle class will no longer be the driving force behind global consumption/demand that it was before the crisis. Once consumers are less able to buy new Toyota Prius's or load up on the latest China-made widgets at Walmart, there will be less incentive for foreign governments and central banks to stockpile greenbacks or trade exclusively in dollars.

Within the cacophony of noise comes a different outlook to this whole situation. The World’s number one forecaster Gerald Celente has a different take on the overall matter. He (Gerald) does agree that the dollar is falling but he adds this important caveat (on the Jeff Rense Talk Radio Show October 7th):

There is a lot of glee going around the World, for example about the battered dollar and how the Arab nations and the BRIC nations, Brazil, India, Russia, and China are talking about number one not taking dollars for oil anymore, not basing it on petro dollars and establishing an alternate currency and or doing business in their own currencies. The World should not be happy about this because something much bigger is happening.

The United States of America the empire is collapsing. And when you go back to collapsing of great empires, and no empire in recent history not even the English empire had so much clout in terms of global trade as does the United States. When this empire falls, it is going to be like the fall of the Roman Empire in that the sense that a Dark Age followed. The reverberations are going to be felt worldwide.

All of these countries, China, Indonesia, Singapore, Vietnam, all these countries that ramped up production in anticipation of continued growth are going to be in for a big shock. So this isn’t going to be pleasant. And I say this because what happens, this country and others, we are going to see what we fear the most, is that if all else fails, and you (Jeff Rense) asked how they are going to prop it up, what they do is that they take you to war. And so as World economies decline, world war looms in the future.

For anyone who has followed Gerald’s work will know he is not the World’s number one forecaster for nothing. His accuracy in predictions has been uncanny. Are we to believe what he has described? Is this scenario possible? Many will remember how he predicted the fall of the economy way back in late 2007 when many claimed that no one saw it coming. One cannot ignore what he says nor take it with a “pinch of salt”.

For now, we cannot draw any conclusions, as it is too early. A lot can still happen especially with the Federal Reserve, who knows what stunt they pull next. Many had believed that the too big to fails would die a natural death, as they are no longer viable entities. Many also believed that the US would reign in its’ debt but it seems business as usual. We can only wait and see what happens.

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