There is a ticking time bomb under the dollar. It could explode at any time. Although it is not in anyone's interest for this to happen, that may not be enough to prevent it.
One lesson of recent years is that just because something does not happen immediately does not mean it will not happen at all. This was evident with the financial crisis itself, when a multitude of warning signs took some time to be proved right. Likewise, it took months for problems in Dubai to materialize and for concerns about the debt picture in Greece to surface. When they did, it was not a surprise.
The message is that economic fundamentals matter and if something appears unsustainable or out of line with reality, then it probably is. At some stage it will need to correct and the longer it takes, the more severe the correction is likely to be. This is a clear warning for the dollar. On fundamentals, the dollar is still overvalued despite its gradual depreciation over the last year.
Britain was once the world’s super power, with massive economic, political, and military might. However, long after the United Kingdom had lost its status as the world’s premier economy, sterling was still the world’s dominant currency. Eventually, even that role was lost. This is likely to happen to the United States and the dollar. What makes it likely is the ongoing shift in the balance of economic and financial power from the West to the East. This is the New World Order (NWO). This time, however, given the speed at which markets now react, the transition to a new global currency could be faster and more destabilizing.
A decade ago, Asia held one-third of global currency reserves. Now it holds two-thirds, the bulk in dollars. As a result of the financial crisis, more countries are likely to follow in Asia’s footsteps and accumulate reserves. These are likely to be countries from across the emerging world and they will accumulate reserves for two reasons: insurance and competitiveness. Countries will want to insure themselves against another crisis by building up their own reserves. Also, a number of countries will intervene to prevent their currency appreciating in an attempt to retain competitiveness, particularly against the Chinese.
Yet a change is underway already. Many countries do not want to put the bulk of their reserves into dollars. But they do not want to actively sell the dollar, lest it triggers the crisis they fear. Instead a process of passive diversification is underway with less of the net new reserves going into the dollar. A year ago about two-thirds of any rise in currency reserves went into dollars; now we calculate it to be about it two-fifths. This is a significant shift and one that is likely to continue. This behavior by central banks not only sends a signal to the private sector but also reflects what the private sector is already thinking. This passive diversification is a sign of things to come.
There are many reasons why countries may have tied themselves to the dollar in the past, whether directly though a peg or indirectly through a managed float. Uppermost was an aim to tie themselves to US monetary policy and thus the credibility of the US Federal Reserve. Whilst understandable, in the future this may be less of an incentive than in the past. I don’t doubt the independence and anti-inflationary credibility of the Fed, but it will be tested as a legacy of this crisis. Moreover, more countries are establishing their own policy credibility, as they develop monetary tools and institutions. As a result, in the future many countries will have less of a case for anchoring themselves to the dollar.
There are other economic reasons to expect a natural shift by the private, as well as the public, sector away from the dollar. The financial crisis has brought into vivid focus the need for a rebalancing of the world economy. The crisis was triggered by many factors, including the failure of the markets to heed the many warning signs, a systemic failure of the financial system, and by an imbalanced global economy in which savings flowed “uphill” from regions with high savings such as Asia and the Middle East, to fund credit binges and borrowing in the West, particularly in the United States. This allowed the United States, amongst others, to run large trade deficits. In the years running up to the crisis, Asia and the Middle East exported around $3.3 trillion of surplus savings, whilst the United States borrowed a huge $3.9 trillion from overseas.
This old model is now broke. Although it will take time for a new one to emerge in the form of a balanced global economy, the transition phase could spell big shifts in markets, including currency flows. In particular, international investors may be less tempted to fund US trade deficits as more attractive investment opportunities emerge elsewhere.
Rebalancing the world economy will require a number of significant changes. Economies in the West with large external deficits such as the United States and the United Kingdom will need to spend less and save more. The United States and United Kingdom will become relatively poorer, as their economies will need to grow at below trend rates. Regions with large savings such as Asia and the Middle East will need to change their long-term behavior by saving less and spending more. And currencies will need to adjust. In particular there is a need for a stronger Chinese yuan and a weaker dollar.
Achieving a fully balanced global economy may take time, but a shift in the balance of global economic and financial power is already underway. Although the West accounts for about two-thirds of the $61-trillion global economy, this share is falling, as emerging economies and regions experience stronger rates of economic growth.
There are many aspects of this shift in economic power. One in particular will be a key factor driving future currency flows. That is the development of new trade corridors that bypass the United States. Already we are seeing rising intra-Asian trade, with China at the center, and increasing flows between Asia and other regions such as Africa, Latin America, and the Middle East. The fastest growing trade corridor today is between Asia and Latin America, admittedly from a low base. These trade corridors might have once been called “South-South” trade, indicating increased flows among the world's emerging markets, with rising trade in goods and commodities and increased flows of people, remittances, portfolio, and direct investment. Also, Europe, not the United States, is Asia’s major trading partner.
Such flows across these new trade corridors are certain to increase, the only issue is the pace. The emergence of a rising middle-class suggests the pace could be rapid. Over the next decade, Asia, for instance, will need to generate 750 million jobs for its growing young population. If it does, expect increased inward investment from western companies as they seek to take advantage of both lower costs and to position themselves closer to the rapidly growing markets of the future.
It is not just Asia. Similar patters are emerging in the Middle East. There the outlook is dominated by the three Ds: demographics, diversification, and the dollar. The demographic factor is a rapidly growing young population. Diversification is driven by the need for the region to generate sufficient jobs for this younger cohort and thus diversify into areas other than energy.
The Middle East, and the Gulf region in particular, will need to shift currency policy away from the dollar. Tying to the dollar and to US monetary policy was not appropriate during the pre-crisis boom as it led to interest rates far lower than needed for domestic factors. This was not the only issue in Dubai, but it did not help. Tying to US monetary policy will not be appropriate once we move into a stronger phase of the recovery. Though it's hard to predict precisely when, at some stage I expect a shift in Middle East currency policy. It will heat up the debate as to which currency commodities should be priced in.
Expect more countries to manage their currency against a basket of currencies from countries with which they trade. Indeed, if global currency reserves were held in proportion to trade flows, then $2.3 trillion out of $6.8 trillion reserves would shift out of dollars.
Of course the dollar has some factors in its favor, as we saw during the recent crisis. The size, scale, and liquidity in US financial markets was a positive for the dollar, and was in contrast to many markets elsewhere. But even this strength will be eroded in the future. For instance, at the annual Asian Development Bank meeting in the summer of 2009, members recognized that for Asia to rebalance its economy, it must strengthen social safety nets, help small- and medium-sized firms, and develop deeper and broader bond markets. In fact, one could go one step further and say the need is for deeper and broader capital markets. This would create an environment in which people, and the growing middle class across Asia, could borrow against future income and in which firms could replace the need to save as the first priority and instead raise funds from the markets to invest.
In the future, the deepening and broadening of domestic financial markets across regions such as Asia, the Middle East, and Latin America will also provide international investors with greater opportunities in which to invest; this will be in contrast to recent years when limited opportunity to invest in less mature domestic financial markets was a factor that worked in the dollar's favor.
The toppling of the dollar is not in doubt, only its speed of decline. It is possible that we could see bouts of dollar strength during its long-term decline. This speed of decline will also be influenced by how quickly credible alternatives to the dollar emerge. It seems hard to imagine that the Special Drawing Rights (SDRs) will rival the dollar even though the International Monetary Fund could issue sizeable amounts of SDR bonds in coming years, feeding increased demand. Even the euro, the immediate alternative to the dollar, lacks the credibility on its own, given the deep-rooted tensions within the euro system. Indeed, a strong euro adds to pressure on the weaker members of the eurozone.
What about the Chinese yuan? Its status is set to rise, helped by the on-going process of capital and financial account liberalization. However this is not going to happen overnight. China's approach is based on gradualism, both in terms of liberalizing its markets and in allowing its currency to appreciate. Yet the Chinese have, over the last year, undermined the dollar by raising questions about its role as both a medium of exchange and as a store of value. That will continue. Capital account convertibility of the yuan could happen sooner than the markets expect, although the Chinese will keep rigid currency controls in place. During 2010 it would not be a surprise if we see a stronger pace of yuan appreciation, mirroring the recovery in the Chinese economy. If so, it will be another green light to sell the dollar.
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If the renimbi is overvalued as well as the dollar, where on earth does this leave the Euro?
Posted 15 January 2010, 15:38 by Hilary Barnes
First, the market will determine which currencies are to be held as reserves or are to be used to settle trade transactions. Holding a diverse portfolio of currencies makes sense today. This is really a minor issue for the US, which faces much, much greater problems.
Second, the US (and the EU for that matter) does not have to ask the Chinese to revalue their currency to reflect a market driven valuation. The US and EU can simply implement a floating tariff on all Chinese (and other Asian) imports. China has unilaterally decided not to allow its currency to continue revaluing against the dollar; one unilateral decision can beget another unilateral decision.
The Chinese currency is overvalued, as can be seen by the devaluation of the dollar to the Euro. The devaluation reflects the fact that the US economy has been deteriorating for several years now. Not only is our fiscal policy unsound but our monetary policy has been quite unsound in so much as it was the fuel to this decade’s credit crisis. The monetary policy can be worked out over the medium term. On the other hand, the fiscal policy would require a major realignment in the role of government on the domestic front. A devaluation of the dollar vis a vis the Chinese and other Asian currencies, the resulting rise in the cost of consumer items and the inability of the US to finance its growing deficit in a sound, cost-effective and reliable way could stimulate such a major change amongst the voters.
As if this isn't bad enough, the biggest damage to the US economy is the absolute rise in the cost of doing business over the past several decades. Considering today's global options for businesses and investors alike, this absolute rise is compounded by the relative low cost of doing business in other countries. The American political preference for safety, broadly defined, has increased the cost of doing business in the US. There is an actual cost to each such preference, one that probably is not fully appreciated by the voters and political leaders. Without an economically attractive substitute, the result is capital flight and a loss of income and employment opportunities. First were the blue collar jobs and then the white collar jobs.
Technological innovation has filled most if not all of the loss of "traditional" economic activity. But if many of these ideas call for manufacturing or exportable services, it is likely that the economic value will either largely or materially be shared with people in other countries. Much of this recent innovation was in financial services, most of which turned out to be very bad innovations. One consequence will be a significant increase in regulation (with perceived safety as the driver), which will provide incentives to drive some financial activity offshore.
Unemployment and underemployment are the results. These are very likely structural, particularly considering ongoing policies that will further drive up the cost of doing business. Unless there are innovations that permit people to live without earning money and receiving government support, the alternative is to reintegrate some "traditional" economic activity into the country. That can only be done if the cost of doing business is driven down relative to the foreign alternatives. An alternative to producing exportable goods and services is to export labor that is not utilized (not so different than what Mexico and other countries have done). Perhaps the Asian countries can guarantee these Americans reasonably decent jobs if we reduce the proposed new FX-based tariff.
Posted 13 January 2010, 23:32 by Ken Foster
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