This article was originally published in Asia Times Financial www.asiatimesfinancial.com.
The dollar has given many of us considerable headaches over the past few weeks. It has declined between 5-10% against other Western world 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 amid numerous economic luminaries to call for a crash of the dollar, some like reputed economist Stephen Roach even calling for 30%. 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 financial crisis, the sword of Damocles has undoubtedly been hanging over the globe’s dollar bloc. We had already 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 dollars.
In order to fight the health crisis, it has now been propelled to 7 trillion in the space of only 5 months. America’s national debt has commensurately risen to an incredible 26.5 trillion dollars. This will only be a snapshot on the rapid path to even loftier heights. Considering that June’s US federal budget deficit hit an absolute monthly record of 863 billion dollars, and in view of the Covid 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.
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 dollars, ie a debt-to-GDP ratio in the 150% area. Donald Trump will have handily beaten Barak Obama’s record of adding 9 trillion of debt across 2 terms in only 4 years. However, that is not to say that there is any improvement to be expected, whoever will be elected president in November.
Donald Trump would be likely to pursue his America First strategy, which of course remains a contradiction in terms as he claims for America to remain the sole global superpower and not disinclined to weaponise the dollar. Joe Biden, on the other hand, would have to perform the impossible split across the 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 to call 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 the crucial confidence in the US dollar, but no one should be surprised that chatter about a new Plaza Accord of sorts 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 in 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 as the world’s reserve currency. This argument in itself is 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 a total of 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 of the pundits out there.
I simply don’t know how people claim that the Renminbi 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 ever more escalating conflict between the countries.
The Japanese Yen does not qualify to become the leading reserve currency, full stop. 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, sort of. Well, Japan’s debt-to-GDP ratio is pushing 250%. And a deep government bond market is required. Also here, Japan can only offer little. Around half of all JGBs are BOJ-owned, and the market is not considered to be very liquid.
That leaves the Euro… Equally here, there are plenty of reasons to believe the currency 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 the 19 eurozone countries out of 27 European Union members and an unholy monetary experiment considering that those 19 nations are not being tied together by one fiscal policy. The constant battle for independence and fund transfers are a testament to it.
The thought of the Euro to be closest to a dollar challenger cannot that easily be disregarded, however. After all, the currency is embedded into 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. The 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 pandora’s box and we were at a watershed of European common debt to be issued, foreign central banks would be very inclined to accept such Euro-denominated paper as an increasing portion of their foreign reserves.
Central banks don’t seem interested in accumulating German Bunds at deeply negative yields. Equally, peripheral credit risk can only be digested in limited dosage. European exposure, however, in a joint and several format, 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.
