Saturday, April 4, 2009

Top 6 Reasons Why Dollar May Collapse

At the point of writing, the direction of dollar against euro & sterling is just too inconclusive. There were several ups & downs. However, in the long run there are some evidence that the dollar rally may not last long


(1) Large current account deficit. This has been an ongoing problem with US economy & it becomes worse in recent years. The trade deficit is caused by growing appetite among Americans to consume imported goods. Imports grow relatively at a faster rate than exports. Also it was exacerbated during the era of Greenspan where interest rates were so low, which then leads to housing market boom that raise the economic growth. Such huge trade deficit means outflow of money is greater than inflow, thus creating downward pressure on dollar. People are selling dollars to get hold of Chinese goods

(2) Falling demand for US securities. All these while, US is able to sustain its current account deficit & prevent its currency from falling with the help of capital inflow. China is undoubtedly its biggest & most reliable lender thus far. The Chinese is very willing to help US partly due to the strong trade interrelationship. Letting Americans drown will not do any good to China, which rely on US as its largest export destination. However there is growing evidence that China & some other major economies like Japan are slowly substituting dollar to embrace euro. Since inception in 1999, world euro reserves have been growing at the expense of dollar

(3) Foreign central banks unwinding dollar assets. In the event of global recession, US economy is perceived as the safest haven. Therefore selloff hit many countries around the world, especially emerging economies. The reversal of capital flow has caused some currencies like rupee to depreciate. As such India’s Central Bank is forced to use its dollar reserves to buy home currency. Increase in its demand will raise the value

Another possible reason large budget deficit in oil gulf nations. Oil producing nations like Saudi Arabia has engaged in lavish spending these few years due to their ballooning dollar reserves. Most of it comes from the period where oil price was skyrocketing. Now it runs into budget deficit. One of the ways they are going to finance it, is by selling dollar assets. Again increase in supply will weaken the dollar

Countries like Russia, Saudi Arabia, India & Japan have around $2 trillion dollar holdings. It is expected that if situation worsens, these countries will likely ‘dump’ dollar. Interestingly, who will probably buy all these assets? (Probably …….you know the answer)

(4) US can’t raise interest rates now. It will be ridiculous if one suggests that US should raise interest rates now to attract inflow of foreign money. With such record low interest rates 0-0.25%, average Americans are still frugal & cautious in their spending. Any upward movement of rates will instantly kill the economy. Price deflation is the last thing we would like to see

(5) Quantitative easing. It was introduced as the traditional monetary tool has failed to revive the economy. Basically, it is somewhat like the modern day of printing money to buy US government bonds. Somehow, there is fear that US government could be too immature with this unconventional tool. The effect of quantitative easing could be stronger than predicted. If it were to happen, large increase in supply of dollar will erode its value

(6) Large budget deficit. Basically, when a government runs a budget deficit it means for a particular year, its total expenditure exceeds its total tax revenue. Due to this, it has to borrow by issuing Treasury bills & long term government bonds. The situation is very chronic for US. It has to fund the on going wars in Iraq & Afghanistan, increase the size of bailout for banks & auto companies & bigger stimulus package from time to time. Also it is worth to remember that they have the biggest commitment of all, which are social security & Medicare for the baby boomers. I’m very unsure to what extent they can borrow & to what extent foreign countries are very willing to lend

It has many repercussions. Even US’ closest trade partner began to doubt its ability in repaying all these debts. Recently, Chinese officials have suggested that yuan should be considered as an alternative to dollar. But what ever it is, if other countries began to sell dollar assets or demand for bonds fall, dollar may be slammed to its knee

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