(ATF) The dollar has given many of us considerable headaches over the past few of weeks. It has declined by 5-10% against other Western majors, such as the Euro, the British Pound and the Japanese Yen. And the decline seems far from over.
As much as the market carnage amid the mother of unwinding trades in March had triggered a flight from every asset class including even gold into cash, ie US dollars, the tables have long turned against the greenback.
What’s worse is that the move has been happening as numerous economic luminaries call for a crash in the value of the dollar, some like reputed economist Stephen Roach have even been calling for a 30% drop. So, are we really at the end of a long road for the dollar as the major currency in the world? Or even the end of the dollar as the leading reserve currency?
To be fair, we have heard the Cassandras many times before, but with the disintegration of America’s finances, the rest of the world better be on the tips of their toes.
Let’s first look at why one should be worried. Ever since the Federal Reserve commenced with what one can only describe as monetary experimentation in the wake of the 2009 financial crisis, the sword of Damocles has undoubtedly been hanging over the globe’s dollar bloc. We had gasped for breath when the Fed balance sheet was employed to paper over the cracks of the credit meltdown 10 years ago and expanded to a then unthinkable size of over $4 trillion.
In order to fight the health crisis, that figure has now been propelled to $7 trillion in the space of only five months. America’s national debt has commensurately risen to an incredible $26.5 trillion. This will only be a snapshot on the rapid path to even loftier heights. Considering that the US federal budget deficit for June hit an absolute monthly record of $863 billion, and with the Covid-19 crisis nowhere near under control, the 2020 annual deficit will probably end up closer to $10 trillion as opposed to the $1 trillion expected earlier in the year.
New president will face a big debt-to-GDP ratio
In other words, before the incumbent or a new president gets inaugurated in January, we will most likely have arrived at a national debt level of in excess of $30 trillion, which is a debt-to-GDP ratio of about 150%. Donald Trump will have beaten Barack Obama’s record of adding $9 trillion of debt across two terms in just four years. But that is not to say any improvement can be expected whoever is elected president in November.
Donald Trump would likely pursue his America First strategy, which of course remains a contradiction in terms, as he aims for America to remain the sole global superpower and is not disinclined to weaponise the dollar. Joe Biden, on the other hand, would have to perform an impossible split across diverging factions of his party, who are demanding gazillions in government funding that could only be accommodated by applying more of the Modern Monetary Theory’s mechanism of new money creation.
Also, Trump hasn’t tired of calling every other country a currency manipulator while constantly triggering the perception that he would like to depreciate the dollar for reasons of trade competitiveness. Now, everyone can tell the White House that this would only have a temporary effect on the trade balance and very potentially a negative effect on confidence in the dollar, but no one should be surprised if chatter about a new Plaza Accord was to emerge early on in a Trump second term.
All this, however, does not mean that we are on the eve of a dollar crash and the demise of the financial system as we know it. We need to remember that, unlike 2009, this is a government-induced economic crisis due to the pandemic and not a conventional text-book recession. America has historically proven to be resilient and versatile. No one can tell how quickly the country will rebound and how much of a debt burden its economy is capable of carrying in the long run.
The dollar bulls keep pointing at the notion that there is no alternative to the dollar being the world’s reserve currency. This argument is in itself obviously weak, but it cannot be dismissed out of hand and has for the longest time lent support to the greenback. Much more credence is given by the fact that the dollar remains the currency most readily exchangeable into any other, and America continues to command the deepest and most liquid bond market on the globe, valued at around $40 trillion.
Others have developed a more daring view over time and particularly against the current deterioration of America’s finances. Well, while many currencies are simply too small to compete with the dollar to begin with, such as the British Pound, and others don’t qualify due to their emerging market nature, the Renminbi, the Yen and the Euro are being pointed to as potentials by some pundits.
RMB or Yen? No way
I simply don’t know how people can claim the Renminbi/Yuan could be taking the dollar’s crown, at least in the medium term. China’s currency isn’t freely convertible, and apart from a few central banks whose countries trade excessively with China, I cannot see incremental foreign demand. Besides, for the time being the PBoC seems to be preoccupied to almost peg the Renminbi to the dollar, for trade purposes and probably reasons of the escalating conflict between the countries.
The Japanese Yen also does not qualify to be the leading reserve currency. To aim for this status a currency area’s economic growth and demographics need to be on a healthy trajectory. The opposite is the case for Japan. The country’s financial system needs to be sound. But Japan’s debt-to-GDP ratio is pushing 250%. And a deep government bond market is required. Japan can only offer a little. Around half of all Japanese Government Bonds are owned by the Bank of Japan, and the market is not considered to be very liquid.
That only leaves the Euro. and equally, there are plenty of reasons to believe it will not be a threat to the dollar’s predominance. For one, the Euro was only created 20 years ago and is by all measures a young and little tested construct. It is the currency of 19 eurozone countries out of 27 European Union members and an unholy monetary experiment considering that those 19 nations are not tied together by one fiscal policy. The constant battle for independence and fund transfers are testament to that.
Euro the closest challenger?
However, the thought of the Euro being the closest to a dollar challenger cannot be easily disregarded. After all, the currency is embedded in an economic area commanding 750 million people and is its major instrument of exchange. The Euro’s M2 money supply of around 13 trillion Euros compares with Japan’s dollar equivalent of 13 trillion and is closest to the dollar’s $18 trillion. To be fair, though, the size of the eurozone government bond market of not even 4 trillion Euros cannot yet compare to America’s.
But what we witnessed at the EU summit two weeks ago could well be the catalyst for the Euro’s ascent. EU members officially agreed to shoulder joint and several liabilities for the first time in history in order to bail out the periphery. If this was an opening of a Pandora’s box and we were at a watershed of European common debt being issued, foreign central banks would be very inclined to accept Euro-denominated paper as an increasing portion of their foreign reserves.
But central banks don’t seem interested in accumulating German Bunds at deeply negative yields. Equally, peripheral credit risk can only be digested in limited doses. European exposure, however, in joint and several formats, would be an entirely different ballgame and could catapult the asset class, as well as the associated currency into a new sphere, potentially rivalling the dollar at one point down the road.
Roland Hinterkoerner is a former banker and founder of www.expertise-asia.com