As Laurent Guerby excerpts in a recent interchange here on ET:
The US dollar bill's standing as the world's favourite form of cash is being usurped by the five-year-old euro.
The value of euro notes in circulation is this month likely to exceed the value of circulating dollar notes, according to calculations by the Financial Times. Converted at Wednesday's exchange rates, the euro took the lead in October.
The figures highlight the remarkable growth in euro notes since their launch on January 1 2002, three years after the start of Europe's monetary union, which in January welcomes its 13th member - Slovenia, the former Yugoslav republic...
By the end of October the $759bn-worth of US dollar notes in circulation was only a fraction ahead of the value of euro notes, converted at exchange rates at that time.
But since October the euro has risen strongly against the dollar and this month the value of euro notes has risen to more than €610bn, or in excess of $800bn at the latest exchange rates. That level is unlikely to have been beaten by the greenback.
Setting aside questions about what exactly US all of this really means, there is indeed quite a bit of angst in the financial press, as well as among us common plebes, about the value of the dollar. Some see in a weak dollar opportunity: exports become more competitive when cheaper on world markets, which is good, at least theoretically, for manufacturing jobs. Others worry about the inflationary pressure devaluation necessarily ratchets up. Still others point out that a falling dollar solves little: exports may grow somewhat, but the US simply doesn't make enough stuff other countries want to buy, causing continuing trade deficits financed by, increasingly exclusively, foreign central banks. Sure the dollar is falling, they say, yet the trade deficit with the Euro zone has continued to grow, as affluent America's taste for high-end goods and main-street American's continuing need for European-manufactured goods, financed by foreign capital inflows, outpaced the export growth. Now imagine what would happen if the dollar began to fall against more currencies than the Euro...
And this angst is creeping into more places than the shadier parts of the on-line financial press that Ron Paul tends to inhabit. Even the solidly respectable neo-liberals at the Economist get into the act, opining on US calls, via its Treasury Secretary (Minister of Finance) Henry Paulson , for the PRC to allow its currency to strengthen:
Even if the Chinese central bank does, as some expect, let the yuan strengthen more than previously anticipated, this will not be the panacea that many hope for. As Tyler Cowen, an economics professor at George Mason University, points out, China imports many of the components it assembles into finished products; a strengthening yuan will make these components cheaper, eroding some of the effect on export prices. Nor is China's competitive advantage limited to a cheap currency. And although China is one of the big funders of America's current-account deficit, it is certainly not alone. Unless Americans curb their appetite for imports bought with borrowed money--and start making more things other countries want to buy--the deficit will continue to be a problem. This is roughly what the Chinese government has been saying.
A rising yuan will have some negative effects on the West, not limited to a shortage of cheap electronics. Cheap Chinese imports have kept a lid on inflation in many countries, letting central banks keep interest rates low without worrying about their economies overheating. As Mervyn King, the governor of the Bank of England, has warned, once the yuan begins to strengthen, central banks will face higher inflationary pressures. With oil prices already pushing inflation to worrying levels, Mr Paulson may not be as eager as he seems for a rising yuan.
Why Current Accounts Matter
People, serious or otherwise, are vaguely aware of the US' huge trade imbalances with most of the rest of the world. It's trade deficit is chronic, currently representing roughly 6% of GDP, which is extremely high, historically, for a developed country and, needless to say, unsustainable in the long run. Adding in the money foreign nationals working in the US send back home, the country's Current Account deficit is quickly approaching 7% and beyond, also unsustainable. But this is not of much concern to Joe Sixpack, as it hasn't started hurting him yet; the deficit, similar to taking on more household debt, hasn't crimped his style yet - the banks are still giving him credit. And so in similar fashion the US Current Accounts deficits is funded by capital inflows from abroad.
And, if the US Treasury Department's Foreign Inflows report is any gauge, those inflows are increasingly dominated by central banks. You can see this by seeing how much of the inflows are "private" versus how much are "official". The official flows are coming from the PRC, Japan, Korea, and Saudi Arabia, in part to manage their exchange rates viz the dollar to facilitate exports to the US, in part to manage the value of the USD-denominated assets they already hold in reserve. (In the former case, you see the banker offering credit to America's consuming middle-class, while in the latter, you see the banker offering more credit so that the consumer can more easily pay for the former.) On the other hand, private flows normally represent actual investment in productive US assets, and thereby indicate a more broad sentiment of confidence both in the dollar as a source of value stability, and in dollar-denominated assets as a source of future economic value.
Either way, without those inflows, the value of US dollar-denominated assets starts a toilet-like spiral not unlike that which one observes while taking ones morning constitutional. And the shift towards more "official" inflows indicates that the robustness of those inflows is in doubt, while the indication that even some central banks are moving away from USD (South Korea did this last year, Iran and, to some extent, Venezuela recently) puts those inflows in doubt, period. And so, the hand-wringing about whither the dollar continues apace.
As noted above, none of this concerns Joe Six-pack in any but the most vague way, if but for no other rightful reason than he can still get his Molson Canadian for $13.99US a two-four, the Chinese-made underwear he buys at Walmart still costs $0.89US a pair, and the US-made Cheetohs he favors have even gotten a little cheaper. Why? Because the People's Bank of China is loaning him the money to buy those skivvies, while fortunately, Molson has bought an American brewer, complete with US-based production facilities, making for itself a natural hedge which allows it to sell decent quality beer to Americans for the same price as five years ago, despite the acute appreciate of the Canadian dollar over that time frame. Similarly, Joseph Snifter-drinker also can afford to be insouciant about the state of affairs, for the simple reason that the People's Bank of China is, indirectly, financing his consumption of French champagne, German cars and his wives' Italian handbags, too. Thankfully, there is a banker on hand for consumption-directed lending.
And none of this concerns the mainstream finance world overmuch, though the situation is certainly taken seriously, as the Economist cite above attests. And the reason for this is a little different, having more to do with the banker who lends to keep the creditor afloat so as to better pay for prior loans. Which is the deconstructed meaning of statements like "Saudi Arabia will never sell off USD because it has so many that when it starts doing this, it devalues its own reserves far to onerously to be considered" or " It doesn't all collapse with a bang because that's in no one's interest."
The fact of the matter is that it probably doesn't, ie the USD, while clearly headed downward as long as its Current Accounts is still a mess, will not crash. But if a tipping point accidentally gets hit, it's another matter entirely. These tipping points can happen any number of ways. Geopolitical risk weighs heavily on such things. Imagine, for instance, a major row over Taiwan, leading to open conflict between the US and the PRC. Or civil unrest, certainly not out of the question, due to an economic slow-down, again in the PRC. Or what might happen if the House of Saud fell. Or what might happen to South Koreas reserve in the event of resumed conflict with the north or, alternately, abrupt re-unification. Well you get the picture. All of these events could cause major turbulence for the US dollar and, by extension, its economy (via inflationary pressure).
The Argentine Connection
But you don't even need to resort to disaster planning scenarios to talk about tipping points. And Argentina in the 1990's can tell us a thing or two about tipping points in a more or less stable geopolitical environment.
Back then, everyone knew Argentina's position in the '90's was unsustainable. Damn near every issue of the Economist talked about it. Mendoza state was printing money (essentially issuing debt) to pay its public service workers. The country ran twin deficits, just like America, public and trade. The public deficits were in the 2% of GDP range, less than America of course, but then, the Argentine peso is hardly a reserve currency anymore, so there was no effective zero-interest financing available to it either. And the trade deficit was, like America's, pretty structural as well, for the most part in the 3-5% of gdp range throughout the 90's, again roughly half that run in America. And masked, like America, by offsetting capital inflows.
And, just like America, the federal public deficit seen at first glance masked even deeper structural flaws - its states were also running up debt, as is the case in the US (witness California's recent bonding in order pay essentially operating expenses which, being denominated in USD, were backed by the US Central Bank, not terribly dissimilar to the situation of Mendoza state issuing its own currency).
Such imbalances are accidents waiting to happen, and like the situation in the US, there were many, in particular American and Spanish banks, who had an interest in making sure that when the accident came to pass, it happened in an orderly fashion in a manner which protected their assets, all the while reserving for losses on those assets. Accordingly, Banco Santander and Banco Bilbao Vizcaya both foresaw the risk (that is what risk managers do) and, when the boom finally fell, when the Argentine Peso lost 40% of its value overnight, exposing the banks collectively to approximately EUR 1.5 billion in losses in nominal terms, their reserves were sufficiently large as to not even warrant an analyst downgrade. Such was not, of course, the case for a large segment of the Argentine population, and when they started going hungry, they began to riot, bringing down the government.
America is no Argentina. For one thing, its economy is far bigger and, well at least historically, is far more diversified. For another, America has a lot of interest-free creditors, the inherent advantage of the faith and credit of a government whose central bank issues the world's premier reserve currency.
But while it's probably likely that America's economic standing will observe a long, gradual, secular decline, and its currency will continue to weaking equally gradually, I don't think we can completely discount an Argentina-like collapse, if but to a less extreme extent, either.
The reason for this is two-fold. First, US twin deficits are not only unsustainable, they are, in nominal terms, roughly double those in Argentina.
Second, we take as a given that lenders to America will continue to throw good money after bad in order to maintain the value of their existing USD-denominated holding and, importantly, be able to continue to export to the US consumer markets. But this is not a given. Other growing markets exist for those products; the pipeline increasingly is becoming diversified for exporters like Japan (which shifts to the high-end PRC market, among other places), the PRC (Russia, the EU, NDCs in East Asia, India) and elsewhere. And it is a truism that creditors tend to keep lending in an effort to keep their existing investments intact; current analysis of the situtation largely ignores the concept of sunk costs, whereby there is indeed a point where throwing good money after bad becomes a losing proposition. Which is why good creditors reserve for losses, and increase those reserves when the losses become more likely. And, once they've achieved adequate coverage, there's no reason to be quite so diligent about how the accident comes to pass. If the accident has already been priced into ones expectations, it has already taken place, after all. And so, the IMF saw fit to pull the plug on Buenos Aires, and Argentina saw a helluva financial crisis.
When I was a kid, the franc was worth 25 cents US. Right now, its worth more like 20 cents, triangulating via the Euro. I can see it going easily to 25 cents or more. Other Western Europeans can probably come up with similar statistics. But this is largely irrelevant in and of itself to America's economic prospects; we are simply a contributing factor to the mosaic which is a mess waiting to unravel.
The real pain hits when the same things happen with the renminbi and the yen. And then what? The US produces less and less stuff, so it's not like it can export itself out of this. Again, like Argentina, when the boom falls, it will be painful to average citizens. And I think we all remember what happened in Argentina. Of course, the good news is that only after such a crisis and misery befalling Argentina's middle class was real reform possible, and poverty rates are falling, economic growth robust, and the neo-liberal orthodoxy has been chucked away like the cheap, ill-fitting suit it always was.
In any event, one thing is clear. The US dollar has nowhere to go but down. It's simply a matter of time. It's impossible to predict, as with any forecast of bubbles bursting, to predict day that Americans, middle-class on up, be forced to live within their means, but the the day will come - that much is easy to predict. Unpredictable is what follows, both in terms of global economic impact, and internal political impact in the US.
When the boom falls on the US dollar (and in truth, its not a matter of if, it's a matter of when, and how), it is likely that the currency will inexorably forfeit its role as premier reserve currency. It may happen as it did to Sterling - over a long period of time. Or it may, somewhat less probably, happen via a shock or two.
Will the Euro take its place? In my opinion, probably not. Rather, what will begin to emerge will be more multilaterally-managed reserves, much like the modern multinational corporation manages currency risk. This involves baskets of currencies on reserve, in direct proportion to the currency inflows and outflows forecasted in the future with ones major trading partner. And, given that the EU is the leading trader in the world, the Euro will be a major reserve currency. But so will Chinese yuan, Japanese yen, a less-weighted US dollar, and perhaps Indian rupees as well. The Euro may get a favorable bias in your typical central banker's allocation model, much like Swiss francs get today, on the basis of its historically tight monetary policy (and whether this is a good thing or not is a topic for a different discussion). But given the increasingly multilateral nature of trade, it is likely that the days of massively preferential terms of reserve for one currency or the other are going to be over, probably sooner than later.