Small Business Blog from Atlantic Canada

I am "CA" Atreya (PMP, MBA), the author of this blog. I help businesses in Atlantic Canada achieve their BHAG successfully. You may subscribe to this blog using a feed reader (RSS).

How would you react when you notice a bunch of sharks keeping their distance from a bloodied meal? Imagine in your mind’s eye: speculators and hedge funds (sharks) circling around the meat (the US dollar), but still apprehensive to go in for the kill. After all we are talking about the world’s largest economy, albeit a one on crutches. Why haven’t we seen a hammering of the US dollar as we have seen in past crisis across the globe?

During the 1997 Asian crisis I was in the Philippines and saw the ASEAN economies meltdown first-hand. The underlying fundamentals of that crisis were the similar to the current one – inflated real estate prices, heavy reliance on foreign capital. It started in Thailand and the contagion quickly spread. Thailand’s Achilles heel was heavy reliance on exports and fixed exchange rate regime. The ASEAN countries did not want to let go of the peg that had brought them economic prosperity and their currencies got hammered when exports fell off the cliff. I can still recall Malaysia’s Mahathir Mohammad denouncing George Sores and his ilk on their speculative trades.

So what’s keeping the speculators off this time? Up until the latter half of 2008, credit was freely flowing in 2007 and early 2008. Did it have to anything with the fact that the US dollar is a vehicle currency? [A currency which is extensively used by traders and bankers in international trade transactions; i.e. used as an international medium of exchange, is referred to as the vehicle currency.] International payments could be carried out using any currency. However, in practice, the US dollar is predominant in international trade even now. That position may now be under threat. So will the US dollar go the way of the British pound, or the Dutch guilder before that?

There is nothing stopping countries from trading in a different currency? For example, Canada and India can agree to trade in the Canadian dollar or the Indian rupee. But the problem is that the exchange rate between the Canadian dollar and the Indian rupee is determined using the US dollar. Here is what I mean:

1 USD = 1.24220 CAD and 1 USD = 50.5250 INR. So 1 CAD = 40.6738 INR.

This calculation is true for all currencies worldwide. Cross currency exchange rates are derived from their respective values to the US dollar. The last time I looked, no other currency is poised to take over the US dollar’s position as the vehicle currency. And I am quite positive we are not going back to the gold standard. Gold standard was perceived as being too limiting to growth. That perception still exists.

Being the vehicle currency, the US dollar enjoys dominant share in central banks’ reserve portfolio worldwide. While there are some countries who have reduced their exposure to the US dollar, no country has given up trading in the US dollar altogether. Also, despite the fact that the “peg” may not remain as the exchange rate regime of choice worldwide, I am not sure how countries will view replacing the dollar peg with another currency. They will need a stable and a more stronger currency to replace the dollar. Another issue is the availability of that currency for trade in all countries around the world. This means that everyone has to have confidence that the currency they will use as the vehicle currency will be accepted by everyone else.

Having a vehicle currency also means that it has to be strong and most, if not all, other currencies must be weaker than this new vehicle currency. This is a necessary condition since exporting countries will want to boost their exports. I see neither Euroland nor the Yen advocating a strong currency. Japan is heavily reliant on export for its growth. The Yuan does not want their beloved peg to go and hence they have financed the US economy with their billions. But I do not see the Yuan toppling the dollar as the vehicle currency. I do not see any other country even in the race for the vehicle currency. So that brings us back to the US dollar.

If we look back at history, the pound sterling lost its status as a vehicle currency after the Second World War when it became the net importer of capital. The US has been in a similar situation for number of years now. That along with the widening current account deficit is reason to believe that the days of the US dollar as a vehicle currency could be over. But can we say for sure? As any economist will tell you, at the best of times predicting exchange rates is a challenging exercise. These are not the best of the times. The strength of the US dollar over the last couple of months (before the Fed started printing dollars) has been something of a surprise to me.

I expected the dollar to take a hammering and investors’ flight from the dollar. But when we think it through, where will the investors fly to? In all the past currency crisis, the flight was away from a region to the US dollar. In 1997, it was flight away from the Bhat, the Ringett, the Peso, the Won, the Rupaih and the Hong Kong dollar to the US dollar. But where will the investors’ fly to after dumping the US dollar? With the Fed throwing money at the problem, the consensus was that the US was still the safe place for investment and everyone bought into the US dollar by buying government T-bills. They in-fact are funding the US government and its bailout initiatives in the short term. This is the reason for the strength of the dollar. But what will happen when the T-bills mature and the government has to repay the money?

It appears that the US government is working to stabilize the markets in the short term. Once confidence returns to the market, the American government could encourage an orderly devaluation. But what will happen with the dollar devalues? We’ll use Canada as an example. The Canadian economy is a net export economy; i.e. Canada depends on the US to make a profit. So it is in the Canadian’s manufacturer’s interest that the Canadian dollar is cheaper than the US dollar. A weaker Canadian dollar would make it cheaper for the American citizens to purchase from Canada. A stronger Canadian dollar will make it cheaper for Canadian’s to import goods from the US. Depending on the extent of devaluation, it will mean loss of jobs in those industries that depend heavily on exports to US as their main source of revenue.

If the US dollar devalues, it is a reasonable assumption that the cost of goods in the international market would increase. The rationale for that with a dollar devaluation, sellers will make less and hence will raise prices to compensate for that. That’s what happened in 2007 and 2008. The dollar not only steadily devalued against the Canadian dollar since 2007, but it also devalued against other major currencies. The appreciation of the Canadian dollar was due to fact that the Canadian economy was propped up by commodities – oil. Non oil exporting countries would either see their currencies devalue along with the dollar or appreciate if they have stronger economic fundamentals.

Going back to my previous point, with a US dollar devaluation oil spiked up, food prices rocketed and we saw its political fallout in many developing countries. It is inevitable that the US dollar needs to devalue. The Americans need to export more than imports to get their balance of payments in order. The question then, to ask is where is the market for American exports? An even more important question is where are the manufacturing units to be found in the United States? Are there any left? If not goods, then the services industry will need to pick up the slack and export services. If the US dollar devalues, will the countries with stronger fundamentals allow their currency to appreciate? If other countries devalue their currencies too, then we are back to where we started – a never ending round of devaluations.

One last thing: in order for the America to consume, I (an individual in Canada) need to save. Not only that, you non-Americans worldwide need to save to. Where else do you think the money to bankroll America is going to come from? Your savings will act as the investment dollars needed by your mutual fund company or your government to invest in American T-bills. How long this will last is anyone’s guess. Think of the day when the rest of the world will say, “Enough is enough! I am not going to lend more money to the Americans. Is the United States of America too big to fail?”

Maybe the shift to a non-US dollar trading & financial world may already be in motion. Maybe I am wrong and the US dollar will retain its right to the title of “vehicle currency”. [I hope I am wrong. The US dollar and the principle it symbolizes brought much prosperity, innovation and growth to the world. This is not the way I would like to see it end.] Whatever the case, we are going to see a very different world – politically and financially – on the other side of the 2008/2009 crisis. We also should be prepared to see the long march by the world to another vehicle currency. Who knows what ruins lay on that path?

Some different points of view that might interest you:

• Day of reckoning looms for the U.S. dollar
• Can the world Economy afford US Tax cuts? The International Dollar Standard Redux
• Morgan Stanley - Reassessing the reserve currency status of the USD
• Bank of International Settlements Working Paper No 38 - FX Reserve Management: elements of the framework
• EAM Capital Partners Ltd.

• Leadership in the era of economic uncertainty - ReviewLeading in the best of times has been a challenge....