The demise of the dollar
Having the world’s largest economy brings with it a privilege, namely, when nervous souls fret, yours is the safe-haven currency they run to. The US dollar has served as the world’s reserve currency for as long as anyone can remember. This privilege has allowed the US to pull off the greatest larceny in history. America has been running a net liability position for more than a decade. By economic fundamentals this is unsustainable, but has been overridden by the dollar’s status. Now the party seems to be coming to an end. The dollar index which comprises the world’s major currencies shows the dollar at a historic low. So, can the dollar fall even further?
The carry-trade, a practice whereby investors borrow money in a low-yielding currency (mostly Japanese yen) to invest the proceeds into a higher-yielding currency (mostly US dollars), helped explain the dollar’s strength during 2004-2006. This attractive carry-trade is now unwinding as the US signalled a formal end to its tight monetary policy by cutting rates by 50 basis points. More rate cuts are expected as housing troubles and the aftermath of the subprime crisis still loom over the economy. Meanwhile, the European Central Bank and the Bank of Japan are in a tightening mode. As the interest rates of the major economies converge, the benefits of the carry-trade are eliminated.
A second fundamental factor driving long-term currency movements is relative growth rates. America’s economy, for so long seemingly impregnable, is losing steam. The most worrying feature is the slump in the housing market, which if it turns nasty, will be the leading cause of a US slowdown. And signs of a slowing housing market are already starting to manifest themselves, as the S&P/Case Shiller index for the resale value of US family homes indicates. The index fell by 3.9% in the year to July for the first time in more than 15 years. Going forward, these figures can only get worse as the economy bears the brunt of the recent credit market turmoil. A large number of mortgage instruments which accounted for more than half of the debt instruments originated last year, have all but disappeared during the subprime crisis. Meanwhile Eurasia and especially, emerging markets’ growth rates are looking as strong as ever. Whilst they are not totally decoupled from America’s economy, they certainly are not as dependant on America’s growth as in the past. The bottom line remains, an economic downturn in the US will cause dollar demand to wane.
Lastly, even after the abolition of Bretton Woods whereby currencies were pegged to the dollar forcing members to buy and sell dollars to maintain parity, dollar status did not decline. This infamy allowed the US to become the biggest debtor nation in modern history as dollars were gobbled up by central banks around the world. The fairytale looks set to end badly. Asian central banks, one of the largest acquirers of dollars, are looking to diversify away from American debt. China alone is sitting on foreign reserves of $1.6 trillion, most of which is still denominated in dollars. A recent study estimates that a 33% rise in the Chinese yuan over the dollar would result in a politically humiliating loss equal to 15% of China’s GDP. Currency diversification away from the dollar could somewhat mitigate these risks. Finally, there is also a move to diversify petrodollars to spread currency risk more widely. There is even speculation that Saudi Arabia, the biggest oil-producer, may “unpeg” its riyal from the dollar. Whatever the outcome – the dollar is slowly but surely losing credibility as a safe haven.
These three trends indicate that we have yet to see the real bottom of the dollar. It is unlikely that the dollar will collapse and it may even recover some of its losses in the short-term, but longer-term, the dollar’s path seems to be set.
