Monday, October 20, 2008

Will The Dollar Collapse?


(1) Lower interest rates. Finally US had decided to slash interest rates by 50 basis points to become 1.5%. The intention is to revive the US economy by the way of greater household spending. However, with lower interest rates on top of the current financial meltdown will further cause US to be a less attractive destination to save money. Wealthy foreigners & large fund management companies may look around other countries that offer better yields. With falling demand, dollar will fall

(2) Diverting to other growing economies. This has much to do with the loss of confidence on how the Congress is managing the crisis. Debt has been ballooning to more than $ 10 trillions lately, near to 70% of its GDP & there is a fear that US will run into repayment problem. Monies borrowed were not injected into the economy by developing infrastructures & human capital, but to buy toxic debts & part to finance previous debts. Economic confidence we have seen in earlier days has not return. Current account deficit is still large. Recession if not depression seems to inevitable. Investors may see US as a less attractive destination to park their money.

Existing investors could pull out by selling the holding of dollar assets. Meanwhile potential investors will shy away. Increasing supply of dollar accommodated by the fall in its demand are likely to cause dollar to suffer a free fall. There is a growing evidence that countries like China, Japan, South Korea, Russia etc had slowly diversified their portfolios away from dollar

(3) Current account deficit. The large deficit is caused by heavy imports while at the same time US' export is not growing much. Fortunately this trade imbalances is financed by the strong inflow of capital from OPEC oil-rich countries & emerging Asian economies. If this capital were to dry up as these countries no longer interested to hold dollar denominated securities, it means demand for dollar will fall. Dollar will depreciate

(4) Ballooning debts. US national debt is actually much larger than all of us thought, that is if we were to include all those future obligations such as pension funds, social insurance, Medicare, Medicaid etc. At the same time there is an immense pressure onto Congress to boost spending onto healthcare given the increasing number of retirees from the baby boomer generation

All this require huge spending too. So that means, in the future US are likely to borrow more to finance all these. The current crisis has already spark fear on the possibility of US to default on its debt. If it does materialise, there will be no countries that are willing to buy US debt & it may cause the dollar to fall. The impact will be exacerbated if in such a situation US begin to print more money to finance that debt (since they can’t find buyer). This will send the dollar to a free fall

Not likely,

(1) Self interest. China & Japan will definitely not let the dollar & therefore US economy to go collapse. Both have about the equal 20% share of exports to America, which means American consumers are important to them. Letting the greenback collapse, likely means sending Chinese manufacturing sector to recession & we may witness large scale of unemployment. To Japan, fall in demand for their exports will even give them more difficulty to bail themselves out of depression.

In fact, they are more interested to get hold of dollar by pumping in more Yuan & yen to make the dollar artificially high relative to their currency so that US will continue to buy from them. As for some claims of Asian currency shifting away from dollar, it could be argued that countries like China which is so cash rich are just diversifying their portfolios of investment, given that they already hold so much of US debts & securities

(2) Other currencies are likely to fall too. No doubt US economy is facing many problems due to sub prime lending & is on the verge of moving into a recession (or maybe another depression). Debt is standing at all time high. This somehow lowered the investors’ confidence on the prudent of holding dollar assets.

But don’t forget, Eurozone faces the same problems too. Many financial institutions are on the shaky ground. Government in each euro country has announced a series of measure to pump in more money to increase liquidity in their financial system. For instance, of the largest real estate companies in Germany such as Hypo was being bailed recently. To make things worse, Euro is also on the brink of recession. Their debt is high too & the interest rates had been slashed as well. This could mean that holding the dollar is as good as holding the euro. Other economy like Japan has high national debt standing at 195% of their GDP. The yen could be in problem too. However one can also argue that situation in Japan is much different, since their country has high savings rate

No comments: