Wednesday, August 25, 2010

The "why" and "why not" of the USD...

It's been long since I've blogged. However, after attending a series of lectures on Macroeconomics by Prof. Rakesh Singh, I decided to take up world economics as an active part of my blogs. In the last few days, we've seen a lot of policy initiatives from the U.S.; some of theses initiatives were targeted at Indian based firms benefited by outsourcing. Let me start off by evaluating the current state of affairs (especially in terms of currency in this blog-post), and where are we headed.

Reasons Why Dollar Could Collapse in the near future

1. Switching Reserves away from the Dollar.

The US is currently the world’s reserve currency. Central banks currently hold upto 70% of their foreign reserves in the dollar. However, as the US economy and finance sector looks very weak, it makes sense for countries to diversify out of the dollar. If countries were to switch from holding reserves in dollars to holding reserves in Yen, Euros or others, it could spark a free fall in the dollar.

Chinese banks have been told not to lend to American Banks. China in the past has threatened to bring down its dollar reserves. If China did sell its $1 trillion dollar assets, it would cause a devaluation in the dollar and also higher bond yield rates. Higher interest rates are the last thing the US economy need at the moment.

There is also the danger of OPEC oil exporting countries shifting out of the dollar or at least not using their oil surpluses to buy US securities.

2. US Debt increasing.

US debt currently stands at over $10 trillion which is more than 65% of their GDP. However, it is forecast to increase substantially. Some argue National debt could soon pass 100%.

The legacy of toxic debt could leave the US treasury facing unprecedented losses as it tries to bale out the system.

Long term spending commitments on health care and pension will increase spending. Although, this has gained less publicity, in the long term, it could be more expensive than the current financial bailout. The Ageing population will increase the debt burden.

The problem with the increasing levels of debt is that the growing concern that the US government may start to default on its debt. If this ever happened it would cause shockwaves throughout the global financial situation and people would sell dollars. At the moment, countries like Japan and China have shown a willingness to lend the US money (buy US Bonds) at relatively low interest rates. But, if this confidence falls, nobody would want to buy any more US debt. This would cause a fall in demand for dollars and the value would fall.

To finance the growing national debt, the government may also just increase the money supply because they can’t sell any more bonds. This would increase the money supply and inflation and also cause a depreciation in the value of the dollar.

3. Credit Crisis - Worst still To Come

The credit crisis and banking losses put downward pressure on the dollar because:

They are forcing the US government to borrow more.
Lack of Confidence in US financial markets which affects confidence in the dollar.

4. Current Account Deficit.

For several years, the US has been running a large current account deficit. This peaked at around 6.5% of GDP in 2006 (It has since fallen to 5% on the back of a weaker dollar.) Upto now the current account deficit has been financed by capital flows from abroad (mainly Asia and OPEC countries). If these capital flows were to dry up, as Asian countries no longer wanted to hold dollar securities, the dollar would fall.

5. Economic Recession and Low Interest Rates.

US interest rates are already low - less than 1%. However, if the economy was further pushed into a very deep recession (considering that the demand in the US had fallen considerably in the last quarter) then there may be pressure for further cuts in interest rates. This would make the US even less attractive as a place to save money. Therefore demand for dollar would fall.

Reasons Why Dollar Will not Collapse...

1. Fall against Whom?

The US economy is facing difficulties. But, so is the Eurozone economy, and Japan. It is not clear that any other country could cope with having a strong currency. US debt is high, but so is European debt (considering the performance of the PIGS countries). Japanese National debt stands at more than 100% of their GDP, it makes the US look positively, frugal. The point is that although the dollar looks weak, so do most other major currencies.

2. Dollar is already weak.

Using purchasing power parity, the dollar is already undervalued against the Euro and Yen. Europe is already struggling with a high value of the Euro. If the Euro was to keep rising, it would cause further problems as the Euro economy slips into recession. This is why Gold looks such a good investment at the moment (certainly better than the Dollar, Euro and the SDR) and India, China and other countries have been diversifying their reserves.

3. The Chinese don’t want to lose All their Dollar Investments.

Because the Chinese have so many dollar assets, they have a vested interest in preventing a depreciation in the dollar becoming a rout. Also, China is aware that their economy relies heavily on exports to America. They wouldn’t want that source of demand to completely dry up. Therefore China would like to avoid a collapse in the dollar - not out of altruism but self interest.

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