Is the Changing World Order placing the US Dollar at risk?



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Is the Changing World Order placing the US Dollar at risk?

24.07.2009 14:31 Friday
The credit crisis has placed the BRIC and particularly China and Russia to the forefront of global policy decisions. Things have changed with China and Russia both now holding large amounts  of global  currency reserves which is in direct contrast to the US  which is  holding most of  the global  debt. As a result, we are seeing the BRIC flexing their collective muscles in the G20 and G8 meetings and making demands on the overall status of the US Dollar as the main global reserve currency.

This is a dependence that has created an uncomfortable position for the BRIC who are seeking ways of reducing this dependence going forward. The purpose of the article is to assess potential moves that may occur and how this may affect the US Dollar ultimately.

2007 saw the onset of the worst financial market crisis in living memory, with only the Stock Market crash of 1929 perhaps eclipsing the current crisis. The debate will rage for many years about the causes and the issues that led to such a disaster. We still though remain with uncertainty about whether the fractures in the credit markets have healed or whether there will still be aftershocks.  I believe that there will be many aftershocks for the US, UK and to a lesser extent Europe. The fact remains that those that have weathered this storm the best have been the BRIC who were the major beneficiaries of the credit explosion in the US, UK and Europe. This has been a blessing for these countries and has placed them in a far better position for the future than they could possibly have expected. Yet, for them, a crisis within the US Dollar  could still be a crisis too far and one that has not been examined as a potential source of a  future crisis or even as an aftershock event to the current crisis. Still it is clear that the BRIC are very aware of the largest systemic risk that they face is one of dependence on the US Dollar. It is this fact that is driving them to look at potential solutions to an impending crisis before it becomes a crisis.

Since the 1950s, Bretton Woods and the Marshall Plan, the US Dollar became the de facto global reserve currency. The pegging of the global currencies against the US Dollar ceased in the 1970s with the collapse of Bretton Woods and with it ushered in a period of free float currencies across Western Europe. The free float helped the global economy to better manage competitive advantages to trade and economic strife by using devaluation or even co-ordinated intervention to manage risk and systemic risk. This has been a system that has worked well and has provided a mechanism to adjust to specific economic conditions whilst not allowing imbalances to disrupt trade and cooperation. The advent of the Euro  further helped to  bring a stability to this important  functionality of  the entire market  structure and whilst technically a larger  trading Bloc than the US and an equal as a currency base, the US Dollar  maintained its overall base as  the global reserve currency. This came down to the fact that as the new emerging economies had entered the global economy, that the choice of the US Dollar as the desired pegging currency was a necessity to provide a stability and transparency to the entire extended global market place. Yet like previous pegging, in the Bretton Woods situation the collapse of pegging became inevitable, the question today is whether either pegging or ultimately free float is the solution.

It is important to understand the issues with pegging. Currently the main pegged currencies are Chinese Yuan, Russian Rouble, Indian Rupee and the Gulf States. It is this group which have the most concerns about firstly their exposure to the US Dollar and secondly the implications of the US Dollar devaluation, either implicit or policy created. Since the currency is primarily pegged against the US Dollar most trade and transactions are by default conducted in US Dollars. This is fine in a functioning economic environment where currency stability is the norm. Yet when we get into a position of fractured credit markets and huge fiscal and monetary stimulus, the problems to pegging become more exaggerated. This after all was why the Bretton Woods agreement ultimately collapsed. The pegging had the effect of stimulating inflationary pressures into the pegged currencies thus damaging the corporate competitive position of the domestic manufacturing industry leading to a protracted recessionary period that would exceed that of the base pegging country.

In 2007 the collapse of the strong US Dollar as a result of the impacts of the financial crisis had the effect of driving inflationary pressures into the pegged economies thus helping to drive further damaging impact of the global crisis. The use of pegging as a long term measure is never a path that is easy and one that is strewn with the bodies of failed intervention policy and fiscal policy as a result. The impact is to drive the pegged economies to issue new money to restore the equilibrium of the pegged currency as the printing presses are turned on within the base currency, in this case the US Dollar. This has the effect of driving up the cost base for manufacturers on a domestic basis driving inflationary pressures within the economy. The side effect is that monetary policy has to remain tight to combat these inflationary pressures which are the by-product of the process, thus creating a slowing effect on the pegged currency’s economy. Thus a lose/lose scenario unfolds for the pegged economy where the base economy is unable to tackle its domestic issues. The ability to devalue their own currency is not a function that is open to them, even though this would be able to permit a restoration of balance within the economy. Thus the imbalances within the entire economy are not conducive to stable economic base.

The recent developments within the US have added a further issue for the pegged economies which has not previously been a paradigm within a pegged economy before. Post Bretton Woods the US Dollar became the world reserve currency by default but at a period of minor trade and budget imbalances. Today the situation is much more dangerous in the fact that the trade and budget deficits of the US are deeply in the favour of the BRIC and there appears no easy way to negate these imbalances. This has created the real issue for pegged economies and most notably the BRIC. It is this point that has the ability to leave the currency markets in a state of flux and high volatility until resolution can be found.

As a result, at the April G20 and the July G8 meetings, it was the BRIC with particular focus on China and Russia that are now seeking a move away from the US Dollar as the world reserve currency. It is clear that policy within these meetings is leaning toward the BRIC stance. It is important to understand that China holds more currency reserves than Japan in US Dollars and this is an important position to grasp. Their exposure like that of Russia is heavily US Dollar dependent. The Russians though did start to make the shift away from US Dollars and strengthen their holdings in the Euro from 20% to nearly 40% of reserve capital over the course of the last 12 months. This was a clear policy decision taken around the time of the BIS (bank of international settlements) meetings last July. The reality is that the global exposure to the US Dollar remains by default rather than design as there has been little attempt to move the fledging Euro currency into the spotlight as an equal world reserve currency to the US Dollar. Whether this would make any real significant change to the overall situation is unclear but it would certainly have helped move the systemic risks of the US away from the global economy in general.

The Chinese have taken a different stance to that of Russia by not reducing US Dollar holdings but with a significant difference. Where it appears that Russia is still a major US Bond holder in the US in the longer maturities, it appears that the Chinese have moved down the yield curve to the shorter maturities. They have been able to achieve this move thanks to the US Federal Reserve which has been a major buyer of their longer term securities through the quantitative easing program. Thus whilst the program is engineered to flood surplus cash into the system, it appears that the majority of this process has been used to deliver the Chinese an exit path down the yield curve and place them closer to a redemption positioning. These actions are normal within a currency that would be looking toward a free float rather than a retained pegged policy decision. Another key element that the Chinese have moved toward is creating a localised trading partnership agreement in Yuan for trade. This is confined for the moment to the SE Asia region with Hong Kong, Taiwan                                                                                                                                   and other regional trading partners who have a balanced trade balances with China.

The recent moves by both Russia and China with particular focus on the IMF long defunct SDR (special drawing rights) bonds has also been a warning shot across the markets bows. It is clear that SDR is never going to be a realistic option as its basket is still too heavily weighted toward the US Dollar and does not really address the needs of what these two major economies really require. Their need is a shift from US Dollar dependence not a surrogate for something that they can achieve themselves by capital reserve flows. It is normal for governments and central banks to send signals to the markets of potential or intended policy shifts. The real issue though is that the basket of currencies that compose the SDR is not a resolution of the real issue which is one that pegging against a single creates. Stability is still far from guaranteed and it is the stability of currency that will produce a more secure predictability for manufacturers and the economy in general.  Moreover it is one that allows competitive devaluation to protect the general economy and protect against enforced devaluation which appears to be the issue for the US Dollar currently. This is the burden that is dragging against the Chinese and Russian economies in particular.

The real answer would be a free float particularly for the Yuan, as this would open up the capital flows within the region and across the global trading economy. It would also help to place the Yuan as a potential basket currency with a largish weighting, perhaps as much as the Yen. This would then have the effect of moving the division of the Euro and the US Dollar to 50/50 in weighting terms. It is unlikely given the desires of the BRIC to move toward diversification of US Dollar dependence that they would expect or desire that the Euro US Dollar weights would remain with a disparity that currently exists. Within this is the argument for the Euro finally as a trading bloc and manufacturing centre for the West in general to take a larger role within the entire World reserve currency structures. Certainly the Russians have moved their holdings toward the 40% level which would require little alteration on a free float Yuan. This is because they would be sellers of US Dollar to facilitate a free float Yuan rather than taking a reduction in their Euro holdings. This perhaps suggests that a move toward a 50/50 weighting between the Euro and the US Dollar that a separate basket for commodity and world trade could be based off. This would help assist with an ultimately more stable commodity pricing structure. As we have seen the market has seen strong commodity prices driven off US Dollar weakness and conversely falling prices due to a strengthening US Dollar. If we took a 50/50 basket of Euro Us Dollar then the currency basket in terms of pricing would have remained relatively static as the Euro was a major gainer against the US Dollar within this process.

The interest of the BRIC is to see ways in which they can influence the overall World Reserve currency structures which would help them see a stabilised pricing mechanism for overall global trade but not force their own currencies into the limelight as too large an overall contributor to the pricing mechanism. This is perhaps why a Yuan  free float would be more desirable for the longer term pricing stability and also to a longer  term competitive advantage for the Yuan and China’s own manufacturing base. A currency structure that would allow more overall global balance in terms of price stability which should ultimately be more beneficial to stable global trade and global GDP growth with the ability to control inflationary pressures within the global economies as an added benefit.

The potential for the rouble to also be free floated is not a major priority but one of a backing the Chinese in a longer term goal which would assist the commodity centric Russian economy to see better stability of commodity pricing and clear stable visibility to revenue stream to Russia in particular which will ultimately allow it the freedom to free float.

The question was whether the changing global world order is placing the US Dollar at risk for the future. The assessment that I would make is that it is placing a degree of devaluation to the US Dollar as inevitability but one that should be able deliver with the G20 agreement to a shift to a Euro US Dollar 50/50 rating to ensure pricing stability to commodity prices and a more balanced global economy.  It is the vast global imbalances that are the real threat to the global economy in general and this requires a solution but one that has the scope to develop over the course of the years to come from a 50/50 base currency valuation to one that can eventually be expanded to accommodate one if not two other equal currencies within the overall structure. The risk is primarily focused toward the US Dollar seeing further devaluation to accommodate what appears to be a structured direction for the BRICs ultimate goal. A shift from a US Dollar dependence as a World reserve currency and a balance to a new pricing structure for commodities and global trade. Realistically this requires the US Dollar to become an equal partner rather than a dominate leader to the global economy.

Richard Morrish
Chief Market Strategist
MIG Investments