Monday, September 29, 2008

US Dollar Collapse?

Some commentators are suggesting that the current financial crisis could cause an unprecedented fall in the value of the dollar.

Reasons Why Dollar Could Collapse

1. Switching Reserves away from the Dollar.

The US is currently the world's reserve currency. Central banks currently hold upto 90% 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.
If China did sell its $1trillion 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. (By the way, markets think this is more likely if Obama wins election)

2. US Debt increasing.

US debt currently stand at $9 tn or 65% of GDP. However, it is forecast to increase substantially Some argue National debt could soon pass 100%. This is because
  • Financial bailout for subprime debt. If house prices continue to fall, if mortgage defaults continue to rise; 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. (Default by US Government is no longer unthinkable at Telegraph.)

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 - 2%. However, if the economy was pushed into a very deep recession (e.g. growth of -2%) 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. Japanese National debt stands at 195% of 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.

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

Because China 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.

Conclusion.

The American dollar isn't a good investment. The dollar has depreciated by 40% in the last 6 years; and with the ongoing credit crunch affecting America the most, I would anticipate this steady decline to continue into 2009 and 2010.

At the moment, I can't see the dollar collapsing, if only because the US is not the only economy facing real weaknesses. However, there is a real danger US government debt could get out of control and they respond by increasing the money supply, which would devalue the dollar.

5 comments:

Baz said...

Hi Tejvan,

Thank you for this excellent article. However, I do have a couple of question that I have to bother you with:

"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. (By the way, markets think this is more likely if Obama wins election)"

I'm just curious as to why that would be under Obama, since I'm not aware of the details of his economic plan.

"US debt is high, but so is European debt".

Could you perhaps elaborate on that or point me to articles that discuss European debt? Is it certain that European countries will slip into a recession (by classical definition, and if so, who will and how deeply)?

Also, you said that "Gold looks like such a good investment at the moment." How can you advise one to invest in Gold, and how can a person like myself start? Any links would be much appreciated.

Finally, speaking of confidence, once this mess clears up post-2010, what do you suppose will be different (eg, confidence in USD, its strength vs major currencies, Wall Street operations sans the 5 investment banks and other failed institutions etc) and could things return to normal anytime sooner than said year?

Thank you SO much!

Tejvan Pettinger said...

Thanks for questions Baz, will try to answer if time.

Tejvan Pettinger said...

I answered some here:
http://www.economicshelp.org/blog/economics/questions-on-dollar-collapse/


rest later

Eudaimonia said...

Remember also 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. There is no sign of that currently with banks still reducing limits and tightening lending conditions for consumers and businesses.

Anonymous said...

The U.S. federal government cannot allow high inflation. With 10% unemployment (really it is more like 17% right now, because they calculate it wrongly to make unemployment seem lower than it really is), workers have no ability to negotiate higher wages to keep up with inflation. Allowing high inflation will cause even fixed rate mortgage holders to default, and will ultimately lead to food riots and worse.