Thursday, December 09, 2004

The Collapse of Dollar Economy??

Is the US$ - and the global dollar economy - heading for a collapse?

[This is continuation of a theme, on which I had twice written earlier: once, in April '03 about how the Iraq Invasion was/is a last ditch attempt to save US$[1], and then again, when a whole issue of Alternative Perspective in Feb'04[2] was devoted to this topic]

Even if the idea seems far-fetched, it is worth a serious thought.

Most such speculations focus only on the US Current Account Deficit, which has grown to disproportionate dimensions. It is true that US consumes more than it produces, imports more than it exports. Financing this deficit would require an inflow of $2.6bn/day... that, incidentally, is 80% of world's daily savings!!!...

In contrast, since lst year or so, US is able to attract only $1.7bn/day back into economy (Visit the U.S. National Debt Clock[3])

Perhaps a greater cause for worry should be the increasing cumulative US National Debt, which now is more than $7.5trillion, i.e., statistically, an average American child is born with $25,000 debt. 40% of this is foreign debt.

Interestingly, the US government's response to this impending economic disaster has been to keep increasing the permissible debt-limit.... This year in October, when US reached the $7.4trillion debt-limit set by the senate/congress, it just raised the limit to $8.2trillion. At the present rate of debt-accumulation, this is just postponing the debt-bubble to burst by just another 470 days... Given the present promises of the "foreign policy" - preemptive strike, regime change, "democratisation" of Middle-East, war on terror, etc. - this will keep on increasing.

Moreover, if one looks at the "hidden debt" - US Government's future commitments - the numbers are staggering. In 2008, when the 78mn baby-boomers start retiring, US will need more than $50 trillions to pay for the medicare, pension, social security, etc.!!!

It is not surprising that Stephen Roach (Chief economist of Morgan Stanely) predicts that America has no better than a 10 percent chance of avoiding economic "armageddon."[4]

So why is America, consciously and deliberately, continuing to slide down this path?

In my understanding, there are two mindsets/hope/assumptions behind taking these risks:

  • One can take economic risks, and bet on the future, because the anticipated future inflows - hopefully coming from "democratisation of middle east", cheap oil, new world order, PNAC, etc. - will offset the present trends (the only other economic entity which did this kind of accounting - i.e., counting its "pro forma" earnings to boost its present balance sheet - in the recent past, was Enron!!!)

  • We are in it together. Since so many economies are locked in to US economy, if US falls, so will the world economy... And that is true. So there is a chance that other economies will try helping US survive, so that they can also survive.... After all, countries like China and Japan, the central banks of most developed and developing countries, etc., with their huge investments in dollar assets and dollar-reserves, will necessarily do their best to keep dollar afloat... historically, this is similar to the "white man's burden" felt by the gentry in London in the beginning of 20th century: if we don't consume as much as we do, "poor natives" will die of hunger!!!

    However, given the required inflows, these assumptions do not seem viable in the long run (or perhaps, even in the short run).

    Apart from the simple economic reality that there is not enough surplus money in the world to continue supporting US debt, there are two other emerging reasons, which contradict these assumptions:

    1. Crisis of Credibility & Legitimacy

    US, admittedly, has been a debt-based economy since long. During last couple of decades, the deficit had kept on accumulating, but the US economy has continued to grow.

    So what has changed now, that the rest of the world not continue to provide debt to US?

    One simple reason why this may not happen, is because globally, US has been losing its credibility as a moderate, peace-loving nation - not only in the Muslim world[5], but even among its traditional European allies[6].

    One reason for this loss of US legitimacy and moral supremacy has been its unilateral dismissal of multilateral mechanisms and treaties (see the list)[7]

    In their recent article in Foreign Affairs (Nov/Dec, 2004), The Sources of American Legitimacy[8], Robert W. Tucker (Professor Emeritus of American Foreign Policy, Johns Hopkins University) & David C. Hendrickson (Robert J. Fox Distinguished Service Professor at Colorado College) observed:

    "The 18 months since the launching of the second Iraq war have brought home, even to its advocates, that the United States has a serious legitimacy problem. The pattern of the first Iraq war, in which an overwhelming victory set aside the reservations of most skeptics, has failed to emerge in the aftermath of the second. If anything, skepticism has deepened. The United States' approval ratings have plunged, especially in Europe-the cooperation of which Washington needs for a broad array of purposes-and in the Muslim world, where the United States must win over "hearts and minds" if it is to lessen the appeal of terrorism. In both areas, confidence in the propriety and purposes of U.S. power has dropped precipitously and shows little sign of recovery.... Legitimacy arises from the conviction that state action proceeds within the ambit of law, in two senses: first, that action issues from rightful authority, that is, from the political institution authorized to take it; and second, that it does not violate a legal or moral norm."

    The fallout of losing moral legitimacy on economic was summed up by the economist James Galbraith a couple of days back (, Dec 6, 2004):[9]

    "For decades, the Western World tolerated the "exorbitant privilege" of a dollar-reserve economy because the United States was the indispensable power, providing reliable security against communism and insurrection without intolerable violence or oppression, thus conditions under which many countries on this side of the Iron Curtain grew and prospered. Those rationales evaporated 15 years ago, and the "Global War on Terror" is not a persuasive replacement. Thus, what was once a grudging bargain with the world's stabilizing hegemon country is now widely seen as a lingering subsidy for a predator state."

    Similarly, another article by Joseph Quinlan (Chief Market Strategist at Banc of America), Behind the Sinking Dollar: America’s Image as a "Rogue Nation? (The Globalist, Dec 7, 2004)[10] notes:

    "...the dollar’s decline mirrors America’s plunging approval rating with the rest of the world. Concerns over the U.S.-led war in Iraq, the Kyoto agreement, the U.S. relationships with international institutions and its allies, U.S. visa restrictions and burdensome custom procedures all could have converged to taint America’s global image."

    And one lends money only if one trusts the person's intentions, integrity and repaying capacity.

    2. The Rise of an Alternative Currency - Euro!!!

    Some of the reasons why, inspite of its "weak fundamentals", US$ has remained a global currency-of-choice, are/were:

  • About 80% foreign exchange transactions are conducted in US$.
  • Approximately half the world exports are done using US$.
  • To conduct international trade, countries and banks keep US$ in their reserves.
  • Currently, US$ accounts for 68% of all global exchange reserves.
  • All IMF loans are given in US$, and the debt servicing can be done only in US$ (which incidentally is not surprising, since US Treasury holds 51% stakes in IMF)

  • But perhaps the most importnt reason for the strength of US$ was the petro-dollar. By agreement with OPEC, all global oil trade has been done in US$. Since oil is needed by all economies, the necessity of buying US$ remained intact.

    However, since 1999, Euro has emerged as a strong contender for this spot. Starting weak at $0.85, over the last 4-5 years, it has been gaining strength over US$ to the current exchange rate of $1.33... And even though a strong Euro would hurt the European exports, and the European central banks would try to correct the situation), the global trade is gradually - and often imperceptibly - shifting to Euro. Consider, for instance:

  • In January, 2002, China announced its intention to diversify its portfolio of reserve currencies to increase the proportion of Euros in the kitty. This was a significant development, since China is not only one of the largest single market and exporter, but also holds $208bn - the second largest after Japan - in forex reserves in US$. While the forex currency portfoilio is a state secret in China, according to BNP Paribas, the Central Bank for Euro, this could have led to the share of US$ in China's forex portfolio from around 80% in 1998 to less than 50%.
  • Between, 2001 and 2003, Canada increased the Euro proportion in its forex reserves from 23% to 42%, while reducing the US$ from 75% to 55%.
  • In August 2002, Iran converted more than half of its forex reserves from US$ to Euro. Switching to oil payment in Euro would be just the next step. With 12,000 million tonnes of oil reserves, Iran has the 5th largest oil reserves in the world.
  • In January, 2003, Russian Central Bank announced that it had increased its Euro holdings in forex from 5% to 10%, while reducing the dollar's share from 90% to 75%. It made sense also, since 42% of Russia's imports come from Europe.
  • by mid-2002, many central banks in Taiwan, HongKong, and East European countries, had also started increasing their Euro holdings, while going slow on buying US$. Following the trend, in March 2003, Bank Indonesia was also considering shifting its forex from US$ to Euro.
  • The other country in the "Axis of Evil" - North Korea - also stopped dealing in US$ from December, 2002

    And Most importantly, during the last three years, OPEC is also shifting to Euro. According to a report by Bank of International Settlement, "At the end of June 2004, OPEC members' Euro denominated deposits reached 44 billion Euro nearly doubled compared to 23.5 billion Euro held in the third quarter of 2001... By comparison, OPEC dollar denominated deposits stood at $132.1 billion, down from $145.3 billion in the third quarter of 2001."[11]

    So do all these trends portend the end of global dollar economy?



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