Monday, June 1, 2009

Will US Dollar Collapse?

The issue of dollar going six-feet under is not something new since it was debated even back in 1990s. However, this topic seems to resurrect recently and once again provokes the interest of national policymakers and economists around the world in debating the survivability of the greenback. To be truthful, everyone seems to have a prophecy that the doom of dollar is imminent. It is not difficult to see why.

Reasons:

(1) Quantitative easing. The Federal Reserve has announced its interest in pumping about $1 trillion into the financial system by buying long term Treasury bonds and mortgage backed securities from troubled firms. Henry Paulson also added that additional liquidity may be needed if major strategic firms and banks continue to make inevitable losses and if the original objective is not met. Unfortunately, market participants and Central Banks around the world have begun to factor in this. Large quantity of dollar circulating in the financial system is expected to lead to the collapse of its value. As evidence, the dollar index has fallen by nearly 11% from March to 1st of June

There is another way to look at this. Sharp rise in supply of dollar will erode its storage value. The Americans will not hesitate to spend it off immediately before its purchasing power drops further. This will reckon the force of demand-pull inflation, which may immediately pull the US economy out of recession by early 2010, but into an inflationary one. Again people will want to spend their money immediately, thus creating a supply constrain which also explains for higher inflation. The cycle will repeat itself

(2) Never-ending borrowing. At the moment, US government seems to have endless commitment. It will have to continuously spend itself out of recession by building schools, hospitals, repairing roads and bridges which aimed at jobs creation. It has to increase the size of bailout for troubled car firms and banks, funding war and not to forget paying for social security benefits and Medicare for baby boomers. If we were to take into account all these simultaneously, the national debt would be much larger than 100% of its GDP

To finance all these, US will have to increase its borrowing by issuing more bonds. While China, Japan and Middle East countries are willing to lend, there could be a limit to what extend they can be of helping hands. As the level of debts is getting out of hand, it may trigger a crisis of confidence. Lenders will be suspicious of US ability to repay. Demand for long term bonds will fall and so is the dollar

(3) Very low interest rates. Wealthy locals and foreigners, pension funds and wealth management companies began to look for other places which offer attractive yield from savings. With such large economic contraction, it is highly unlikely that the Fed will announce any interest rates increase in foreseeable future. In this case, banks in UK and Euro-land economies could be a better substitute since interest rates from savings there are around 0.5% and 1% respectively. So, it is predicted that there will be long term outflow of money and given that US is now a less attractive place to hoard cash, demand for dollar is set to fall. That is why economists predicted that dollar will nosedive in value

Consequences:

(1) Increase in the interest rates of bond. The government has raised the interest rates of long term Treasury securities (maturity ranging from 10 years to 30 years). The increase in interest rates can be viewed from two angles. First, US government tries to create an incentive for investors or countries to lend them more money. Secondly, bond purchasers take long term view of the economy. As they expect inflation to be higher in future, they require for higher interest rates to compensate them for the anticipated losses in purchasing power

(2) Depressing housing market. Interest rates on 30-years fixed rate mortgages are tied to 10 years US Treasury Notes rates. In May both of these rates have increased and is expected to escalate further in the future. This is definitely not a good news for an already tumbled housing market

(3) Low capital expenditure. Increase in government borrowing will create a competing demand for money by private sectors. As such higher interest rates on government bonds will act as a signal for firms to equally raise the interest rates on corporate bonds. This will however ultimately dampen corporate plans to make capital expenditures, thus prolonging recession. It is also called the crowding out effect

Why the dollar will not collapse?

(1) Vested interests. Since China, Japan and oil-rich countries have so much dollar assets, watching how the dollar is buried will be the last thing on their mind. The accumulation of dollar assets is as a result of large holding of American bonds and hefty trade ties between these nations with US. In short, these nations are being held as ‘hostage’. Like it or not, they will have to fulfil and finance the growing appetite for debts. Otherwise, run on dollar which may lead to the collapse of world largest economy will do them no good either. The Chinese economy will suffer from recession time bomb with negative multiplier effects that originate in Guangdong and Guangzhou, the manufacturing hub. The Japanese economy will gain its second title of ‘long lost decade’. It is equally bad for many oil rich countries which are not diversified economically such as Iran

(2) Commodities are quoted in dollar. The beauty of dollar is that it has automatic ‘immunity’. Even if the dollar were to fall, say against euro or sterling or any other major currencies, this implies that oil purchases will be cheaper. Demand for crude oil will go up, so does the demand for dollar as transaction is in dollar. Buying interest will send oil prices higher. Given that oil is inelastic in demand, even with higher price the demand will still be strong as we witnessed the last couple of years up to 11th July 2008, where it reaches historical high of $147 per barrel. So demand for dollar will have to increase and the cycle continues

(3) Fall against? Some suggested euro. Well I have to disagree on this. First, the euro currency is just about a decade of establishment and its long term ability to withstand economic challenges is yet to be fully tested. So, that means there is no evidence of its stability. Secondly, Euro has its own set of long-term problems such as diverging economies in recent times, declining population, very little monetary and fiscal flexibility and lastly lack of political unity. That explains for its slow growth in recent years

How about yen? Well, first it’s not commonly used in major transactions. Secondly, the Japanese economy is heading towards long term decline which suggests that its currency will also lose significance. More over investing in Japanese bonds instead of US bonds is hardly appealing since the interest rates offered is so low for such big debts (190% of GDP). Lastly, yuan is not fully convertible and has too long been pegged to US dollar to suddenly go alone.

It is also worth to take note that converting one world reserve currency to another always require decades of preparation. Sterling was replaced by dollar as the main reserve currency since 1945 although US surpass UK in terms of GDP 50 years earlier

In a nutshell, dollar may gradually weaken but obviously not collapse

2 comments:

Santosh said...

Its surprising to find no comment on this article in the last 3 and a half months.

Looks like, either no one realizes the severity of the problem or everyone already knows it. I cannot agree with the later one though.

Seems like, no one is thinking of the US Dollar collapse, but nothing can be further away from the truth.

And to counter reason to your "Why the US Dollar will not collapse", I have a few things to say.

You mentioned "Vested Interest".
Agreed. As of now that's the reality. But that reality is not going to last long. China has started to look for other venues for there reserves (mainly gold, natural resources, yen, yuan).

As far as the already treasury bonds purchased by China and other nations, yes that's a risk to those nations as of now if US defaults. But, US cannot hold any country as "hostage" and there is no binding on any country especially China to fund there debts.

US debts held by foreign countries is a little less then $3.5 TRILLION. Think about it, the current US recession has destroyed around $30-$40 Trillion.

Now, its such a simple math. Why the world just not allow the dollar to collapse once for all and maybe think of the treasury losses as the 'price' to believe in the currency called as the US Dollar and get going with their lives?

Will there be pain? Ofcourse.
Will there be global chaos? Ofcourse.
But revolutions happen only that way. And this is no ordinary revolution. Because this is going to affect each and every person on this planet, one way or the other.
And the more this truth is swept under the carpet the more the painful things are going to be.


Why the world should suffer because of one BANKRUPT country? Have you ever heard of something like this in the ENTIRE HUMAN HISTORY??

2) You said "Commodities are quoted in Dollars".
Agreed. But how long does it take the rules to changes, when everyone knows the KING is naked?
How long does it take to put up a new currency which might be a basket of many currencies and other parameters? If the world wants to bother of their survival they will come up with it.

3) "Fall against"... aaah good one. First of all we need to ask "Stand against?" What is that the US Dollar is standing (backed) against? No prize for this one.....NOTHING. The US Dollar is backed against nothing so there is no question of fall against.

Lastly, I heard a child from Zimbabwe saying, "America is Zimbabwe in the making"

Eudaimonia said...

You must also remember that much of the world's debt, both public and private, is denominated in dollars. Since credit is contracting faster than the Fed can print (or quantitatively ease) there is actually a shortage of dollars in the global economy. If social mood prevents the Fed from printing even more (i.e pissed off American citizens fed up with bail outs) the dollar could rally significantly unless credit becomes more easily available of which there is no sign currently.