Sunday, September 25, 2011

Some Thoughts About The Future Of The Dollar

              According to Peterson Institute for International Economics, “The US dollar is not the world’s key currency by policy design, just as English is not the leading global language by policy design. It is the evolutionary outcome of practice and experience. It would take both a major shock to the dollar and a viable alternative to dislodge it from widespread use”. For decades a large number of people as well as nations use the US dollar as an accepted currency for exchange, in fact, “most of the world’s foreign exchange transactions directly involve the US dollar” (PIIE).  What have been witnessed lately after the recent mortgage meltdown in the United States, new emerging markets, the turmoil in the Middle East and the surge in oil prices,  more investors are seeking safe heavens. Usually this would translate to great news to the United States dollar, instead the Swiss Franc and the Yen have been viewed as the new safe heavens for investors (CNBC).
According to Benjamin J. Cohen, for almost a century the United States dollar was viewed as a top currency in international exchange which made it a highly convenient instrument for trade. In the recent decade, however, the confidence in the US dollar has declined due to the steep deficits and sheer debts the government has incurred. In addition, due to the recent US housing market collapse in 2007 many have viewed the time for the fall of the US dollar had neared. Low interest rates as well as slow job growth and stagnant home sales have also fueled the wary. The recent surge of violence in the Middle East and toppling of some leaders in the North African Arab countries in Tunisia, Egypt and the still ongoing clash with Qaddafi’s government in Libya have put inflationary pressures on the US dollar due to the rise in oil and other commodity prices.
            According to Kelly Holland, the Swiss Franc as well as the Yen value has been pushed upwards due to recent economic and political events in the Middle East.  “Investors are focusing on countries with stable outlooks and tighter-money policies, or at least some indication that they might raise rates” (CNBC). This has not been witnessed before as the United States Currency has always been viewed as a top save heaven for investors in tough economic time.
            To understand the future of the dollar it is also important to understand why it became a dominant currency and what it is meant when we say the dollar is strengthening, weakening, rising, or falling and why this is important. According to Barry Eichengreen, three main reasons contributed in making the dollar a dominant world currency. The first one comes to the “availability of derivative instruments with which to hedge dollar exchange-rate risk is unsurpassable” which made the dollar the most,”convenient” currency for businesses, central banks, and governments. Second, investors fled to the dollar in economic slowdown which made the currency exceptionally liquid and safe in times of financial crisis. Third, the dollar in the past have benefitted from the lack of other alternatives even with the existence of other countries in the world with a reputation of stability.
            When we say the dollar has weakened, strengthened, these are usually relative terms in the world of foreign exchange according to Federal Reserve Bank of Chicago. The terms indicate a relative change the currency has changed from a previous level. When the dollar rises, or falls, this also indicates that the dollar’s value has either rose or fell in relation to a different currency around the world.  When the US dollar falls or weakens relative to another country’s currency, “prices of good and services from that country rise for U.S consumers. Because it now takes more dollars to purchase the same amount of foreign currency to buy good and services.”At the same time a weaker dollar makes U.S products less expensive in foreign markets, benefiting United States exports. For example the European auto manufacturer, Volkswagen Corp has invested in Chattanooga TN. That was a result of an appreciating Euro against the dollar which made the American goods and labor less expensive for the European corporation. This investment will “generate nearly $500 million dollars in income each year, create more than 11.000jobs, and produce $55.7 million in state and local tax revenue each year.”(UTC)  On the other hand a stronger dollar hurts U.S exports by making U.S good and services more expensive to foreign markets. At the same time a stronger dollar benefits imports as this will make foreign good and services less expensive to U.S consumers.
            According to Congressional Research Service in 2008, the value of the United States dollar in the international exchange has been in decline since 2002, a total of 29% by the end of 2007. On average the decline has been ranging from 3%-4% annually accelerating to 10% decline from January to Dec of 2007.  This problem of a declining U.S dollar is increasing the wary of a dollar crisis. The biggest fears stem from a continued decline in the value of the currency and an acceleration of the weakness from 15%-20% which would certainly give a huge negative shock to the currency affecting the U.S and the global economy.
            The United States is suffering from a huge deficit and this is definitely hurting its currency as well as its future economic prospects. According to the Economist article, The passing of the buck? The current account deficit in the United States “is now being financed by foreign central banks and short-term money. In the year to mid-2004, foreign central banks financed as much as three-fifth of America’s deficit. The recent purchase of reserves by central banks is unprecedented.” The amounts of capital inflows into America are not actually going to finance production and real investments except most of it goes to support the huge spending in the country.  The Economist article explains that, “America’s imports are 50% bigger than its exports, so if exports and imports simple grow at the same pace, the trade deficit automatically widens.”  The dollar with its position as a dominant currency encourages inflows of capital and investments into America. However, this is not always great news as it encourages more spending, increased borrowings, and widening deficits which could push investors to be more cautious to continue to finance, “future deficits at current exchange and interest rates.”
            With the evolving economic problems rising from the United States deficit, sluggish economy, and the increased pressure on the declining U.S dollar, the new question that emerges is, What other currency could emerge as a new dominant reserve currency?  The Japanese Yen? Euro?  The Chinese Yuan?
            Economist Nouriel Roubini, in his article, The Almighty Renminbi? Japan and Switzerland are not major powers, and their currencies remain minor reserve currencies. He also argues that there are still lots of concerns about the Euro and the viability of its Monetary Union. Mr. Roubini contends  that China, a creditor country with, “large account surpluses, a small budget deficit, much lower public debt as a share of G.D.P than the United States, and solid growth, is already taking steps toward challenging the supremacy of the dollar.” He explains that even with all the steps taken to undermine the role of the dollar and compete with it, the Chinese currency is still facing lots of problems that it has to solve in order to be considered ready for a reserve currency status. China has lots of restriction on the inflows and outflows of capital entering and leaving the country and that its currency is not ready to be, “fully convertible for such transactions.” In addition Chinas bond market is not as liquid as it is in the United States. Mr. Roubini argues that the decline of the U.S dollar and the loss of its position as a reserve currency, “could happen even sooner: if the United States does not get its financials in order.  He calls for the United States to rein on its spending and borrowing, and pursue policies of growth such as investing in infrastructure, alternative and renewable resources, and productive human capital rather than “toxic financial innovation.”
--Michael Helou--

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