The recent history of the Dollar

China is the largest holder of the U.S. Dollar in its foreign exchange reserves at $2.45 + trillion. This is an impossible number to trade on foreign exchanges. So they're stuck with them until they can spend them. But, as long as the U.S. Dollar is the world's sole reserve currency, these reserves are useful to buy any asset in any country. It is vital that they retain their buying power. Buying power is defined by its exchange rate value and inside the U.S. relates to the inflation rate. A prime task of the Federal Reserve is to maintain price stability, i.e. buying power stability. So when China expressed concern over the value of the Dollar [and its buying power], we all became concerned. There are many reasons to be concerned about the future of the Dollar. We shall look at some of these in this article.

U.S. Government Deficit

Quantitative Easing is a technique the Fed used to fill the holes that the credit crisis created. Writing down of assets is essentially a reduction of money in the system. The consequences of this in the banking system meant that money disappeared off bank balance sheets and reduced their lending capabilities. The actions of the Fed allowed the money that disappeared to reappear again. It works nicely if the banks keep on lending. But if they don't the exercise is fruitless as they protect themselves by not lending, but investing back in government bonds instead.

That's happening today, because instead of lending money, banks are investing in Treasury and Agency securities. Their holdings of such assets increased to $1.57 trillion at the end of July, up 40% from $1.12 trillion in mid-2008. The government is borrowing in a rush, to shore up its deficit, growing fast at the moment. The projected 2010 deficit of $1.47 trillion will be a record, and equivalent to 10% of the economy. China and most other people expect such a growing deficit will lead to a significantly weaker Dollar.

At worst, such a prospect has the potential to deter foreign investment in the U.S., shoving up interest rates. If the U.S. Dollar Index falls below 80 [this Index measures the Dollar against a basket consisting of the Euro, Yen, the Pound Sterling, the Canadian Dollar, the Swedish Krona and Swiss Franc], the Dollar will fall quickly and heavily and further discourage investment in Dollar assets.

Deflation leading to accelerating Inflation

The longer the government delays in stimulating the U.S. economy again, the bigger the amount of new money needed to reflate the economy. As an economy deflates, money velocity slows and consumer attitudes become more and more thrifty. This makes efforts to return the economy to growth harder and harder. A fair analogy would be to compare the situation to retrenching an employee. To bring confidence and hope back to previous levels, two employees must be hired. The longer it takes to fire up the economy, the greater the stimuli needed to do so. Experienced investors are expecting new stimuli to lead to explosive inflation because the change from deflation to recovery becomes more and more mercurially uncontrollable the longer it is delayed.

The Trade Deficit

We do not expect to see a U.S. Trade surplus in the years to come, because of the structure of the U.S. economy. Every deficit means that more Dollars were exported. To date the difference between a recessionary economy and a growing economy is either a $30 billion or a $60 billion Trade deficit.

However, we do not think that U.S. foreign suppliers will dump their Dollars, but we do expect them to accept only the amounts that relate directly to the value of their U.S. trade in the future. Lowering the amount of Dollars they accept will allow them to reduce its role as the sole reserve currency over time.

Unless the U.S. restructures its economy so that the Trade deficit is eliminated, there is an immeasurable [but certain] time limit on its continuing as the sole reserve currency. As the power of the U.S. wanes, the clock is ticking. There are two events that will precipitate this hasty decline. Each of these has the power to accelerate the role of the Dollar in the global economy.

A change in the Oil price from the Dollar

Since Middle Eastern oil production began sales of oil have been priced in the Dollar. While there has been discussion on Dollar pricing, no change has been made to it. The Middle Eastern nations cannot afford to stand alone, they believe. The U.S. has guaranteed their security and shown that they are committed to doing this as seen in Kuwait and in Iraq. Such commitment now protects these nations from terror attacks as well. The House of Saud would fall quickly were it not for the protection they get from the U.S. Hence there is more to pricing oil in the U.S. Dollar than meets the eye. Until this advantage is either lost or replaced there is little enthusiasm to accept other currencies in payment of oil. Of late, though, we have seen Saudi Arabia increase its gold reserves and expect the rest of the Persian Gulf nations to follow suit, in time. We see this as them buying a small amount of insurance against the dangers facing the U.S. Dollar.

You may well ask why haven't they diversified their reserves into other currencies? Just as the Dollar is a reserve currency because of its 'oil backing', so oil in itself is instant international liquidity acting the same way as gold does. The need to have diversified reserves is lessened because of this. Consequently the dangers facing oil producers are not nearly as great as those who will have to rely on their gold and foreign currency reserves should they face a crisis. Gold buying by them is not for the benefit of the country, but for the sake of the reserves themselves.

China is up and coming and draining the power and wealth from the West. It is inevitable that a growing world won't rely on a waning Dollar, but will set up a system that immunizes them from the ailments of the Dollar. We believe discussions are well under way to globally use a basket of the world's main currencies as the benchmark for global trade. After all, the focus of U.S. Dollar policy makers is on U.S. economic performance, not on global economic performance.

A global reserve currency must reflect the overall global economy's state not just one part. It must also have the flexibility to reflect changes in the performance of different parts of the global economy. The 'basket' idea suits this role well.

The Internationalization of the Yuan

While the Chinese banking system is not yet mature enough to be a large part of the global banking community, they are moving fast to get there. At the moment the heart of Chinese manufacturing [the Guanchou area] is allowed to use the Yuan internationally. [It's a bit like a movie maker trying out the popularity of a film in one town] Once they have systems that are tried and tested they will be able to go global.

The advantages of pricing Chinese goods in the U.S. Dollar are huge, still. It's a currency used all over the world and by managing the exchange rate, the Chinese export industry remains competitive internationally. In the process China gains a huge level of surplus Dollars needed for its development in future years. So long as the Dollar retains its buying power internationally this position is fine. But it is clear to all that the U.S. Dollar may well not be able to retain its buying power at the current level in the not so far future. The day is already on the horizon when it would serve China well to gather the currencies of all its trading partners in its reserves rather than just the two main ones.

It will also serve the Chinese to have the Yuan become an international reserve currency, under their own management. Even as part of a global basket of currencies the advantages to China would become greater than they are in using the Dollar, particularly if they could buy oil in the Yuan too. The transition to an international Yuan would hurt the Dollar, but such pain may serve China better in the long run. After all if the Dollar did plummet, China would simply be another victim. We do not see them letting that happen and will act to forestall that. Even the Chinese see gold playing a part in the transition and beyond.

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