The value of the dollar is heading down the drain, but is anyone paying attention? Quite perplexing is the rumor that is swirling on the Street that the U.S. government is intentionally allowing the currency to depreciate. Rumor mills are churning out stories about how the U.S. Federal Reserve and the Treasury Department are working together to implement a slow devaluation of the dollar rather than allowing a collapse. The predicament comes as a turn of events for the currency, whose reign was once termed as "dollar hegemony" in economic parlance. The bearish sentiment on the greenback is perceptible from a recent International Monetary Market report that showed that the total value of short positions on the dollar has gone up to $30.73 billion in the week ended October 30th from $27.16 billion in the previous week. The recent down leg of the dollar is due to concerns over the credit crisis impacting the banks and markets. The dollar index, which tracks the U.S. dollar against the currencies of 6 major trading partners, has been on an extended downtrend since 2002 and is currently trading near an all time low of 75.40. Wachovia Securities expects the downward trend in the value of the dollar that has been place for nearly six years to continue, as the recent dislocation in credit markets has significantly reduced the new issuance of structured fixed income product market, giving foreign investors fewer U.S. securities to purchase. Additionally, the interest rate environment in the U.S. and the rest of the world is supportive of a secular dollar decline. The U.S. central bank is on an easing spree, while most other global central banks have been either holding rates steady or showing an inclination
towards tightening. Despite sporadic corrections, the dollar may be heading lower until the end of next year, when domestic economic growth in the U.S. is expected to pick up. The Canadian dollar reached parity against the dollar in late September, marking the first time it has occurred in nearly three decades. Against the euro, the dollar has been moving to fresh record lows day after day. On Friday, the dollar dropped to a new record low of $1.4754 against the 13-nation currency before recovering some ground. The euro has a different tale to tell. From humble beginnings when it was launched in 1999, the euro faltered to a low of $0.82 in October 2000, but since then it has been in high gear. Against the U.K.'s pound, the greenback is near a 26-year low. Recently, Credit Suisse lowered its forecast for dollar, and said it expects the dollar to fall to $1.51 a euro and 111 yen in three months compared to its earlier estimate of $1.45 per euro and 121 yen. Since its peak in 2002, the U.S. dollar has depreciated against most majors. The devaluation of the dollar was considered to be inevitable by many analysts, and the anticipated development could engender a global economic crisis, given the buck's status as a reserve currency. However, White House officials are tight-lipped about the dollar's weakness. U.S. officials continue to reiterate that a strong dollar is in the best interest of their nation. While speaking to Chinese and U.S. business leaders in New York yesterday, Henry Paulson, the U.S. Treasury Secretary, reiterated his commitment to a strong dollar. Paulson also said the value of the currency should be determined competitively based on economic fundamentals. Meanwhile, the others nations who are feeling the pinch of a weaker dollar have been voicing concern. French President Nicolas Sarkozy is among the few who are very vocal in their call for steps to arrest the slide in the value of the dollar. In his recent visit to the U.S., Sarkozy cautioned that the Bush administration has to do something about the dollar or risk an economic war. China has been issuing threats that it will liquidate about $1.43 trillion of its forex reserves if the U.S. contemplates a move to impose trade sanctions against the communist country in a bid to force a yuan revaluation. A significant portion of China's forex reserves is invested in U.S. treasury bonds. There has been evidence of a shift of reserves away from dollar. Most recently, the Vice Chairman of the Chinese National People's Congress said the nation is contemplating shifting its foreign exchange reserves away from dollar into some better performing currencies. The sentiment was echoed by the Vice Director of the People's Bank of China, who said the dollar is losing its status as the world currency. Euro-a Credible Alternative? A reserve currency is one that is widely held by governments and institutions as part of their forex reserves. According to estimates, about 65.7% of foreign exchange reserves were held in dollars in 2006, with the euro taking the second spot, accounting for 25.2% of the reserves. The main factors that determine the choice of a reserve currency is the liquidity conditions in the asset markets, the prevalence of an active short-term money market, low inflation, large economy and confidence in the value of the currency. The European Monetary Union has actively lobbied for reserve building in the euro by creating the second largest government securities market in the world, and the euro area economy is almost as much as the size of the U.S. economy, all solid reasons for the euro's ascension to the top spot. Notwithstanding the threat of reserve diversification, analysts believe that the global central banks are unlikely to radically change their reserve portfolios, given the negative impact of an accelerated dollar decline. If the dollar coinage of the U.S. The value of the dollar was then set at $20.67 per ounce. Subsequently, in 1944, the dollar was revalued following the adoption of the Bretton Wood Systems in response to the Great Depression. The system called for each country to tie world currencies to the U.S. dollar, which in turn was to be convertible into gold at $35 per ounce. The Wall Street crash of October 24, 1929 triggered the Great Depression, with the ill effects spreading from the U.S. to most other nations. The Depression lasted till the late 1930s. After the adoption of the Bretton Wood Systems, foreign central banks maintained fixed exchange rates between their currencies and the dollar by intervening in the markets. It was through the Bretton Woods Conference that the institutions of the World Bank, the GATT and IMF were set up. The Bretton Wood Systems was abandoned in 1971, when the U.S. dollar was taken off the gold standard and began to be weighed down by mounting trade deficits and flaring inflationary pressures. The dollar was allowed to freely float against other currencies. After stray attempts at steadying the dollar, the nations finally settled for a managed float system, whereby most currencies were allowed to float, but central banks still intervened to prevent violent fluctuations. Dollar-Outlook Thus far, the dollar's plunge has not significantly impacted pricing pressures or inflation expectations, which is a very welcome development. The weak dollar along with strong global growth has pushed up exports, which has helped to unwind external imbalances to some extent. The trade deficit has been shrinking in recent months, and America's current account surplus narrowed to 5.5% of GDP in the second quarter from its peak of 7% at the end of 2005. However, there have been calls to strengthen the currency through interventions. Just as how former Treasury Secretary Robert Rubin and former Federal Reserve Chairman Alan Greenspan came to the rescue of the dollar through interventions and maintaining firm control over the creation of new dollars in the past, the time may now be ripe for an official intervention. Nonetheless, any intervention may not have a long lasting impact. As long as the U.S. piles up trade and current account deficits, the U.S. dollar is expected to remain weak. Most currency analysts foresee a gradual decline, interspersed by min-rallies. Nevertheless, the dollar may find support from action of the other nations. The Chinese government has been buying up dollars, with the less than altruistic intention of keeping down the value of its own currency.
November 11, 2007 1:06 AM
