Reasons Why Dollar Could Collapse1. 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.
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.
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.
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 Collapse1. 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.
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.