Wednesday, 7 October 2009

The "demise of the Dollar" - what it's really about

I posted yesterday about this buzz doing the rounds. I didn't know at the time, but it was Chinese whispers (pun intended) started by Robert Fisk. Enough said.

But that doesn't mean that some of the facts reported could be correct and most probably are. Various oil exporting countries like Iran, Venezuela and developing economies such as Russia and China have almost certainly been thinking about the Dollar for some time. However, not for the reason and economic ramifications that the widespread reports all declare.

I dealt with the issue of the ramification of changing commodity pricing to a different numeraire. Here I will discuss what is the more likely reason behind the supposed deliberations about the role of the Dollar in international markets.

The background to this is exchange rate regimes. Every geographical region - not necessarily defined by sovereign national boundaries but usually so - has over time developed a currency to aid in the exchange of goods and services, the accounting of prices and values and as a way to store value. Those are the three primary function of money:
  • a unit of account
  • a medium of exchange
  • a store of value

These work fine within the regions in which they operate, but hit a road block when one currency region wants to exchange goods or services with another. Hence we need some exchange rate that will price one currency relative to another. This can be set by decree against some durable globally traded item (fixed to gold for example), or against the currency of another region or a basket of such currencies (fixed against the US Dollar for example), or left for the market to price it freely (a "floating" exchange rate). Note that there are all sorts of varieties of fixed rates with names likes "pegs", "crawling pegs", "currency boards" and others, but they are variations of a theme only.

Some floaters include the Australian Dollar, Sterling, Euro, the US Dollar. Some fixed rates include China, Iran, Venezuela, Russia, Saudi Arabia. Are you starting to see the pattern here? Well spotted. Those countries named as the ones colluding to bring the demise of the Dollar are those that fix their exchange rates to the Dollar. And this is what this story is really about.

This story is about the fact that these countries have tied their local currencies to the US Dollar, which means that they have effectively set the price of everything they produce (their income and output) to the price price of everything produced in the US, set in US Dollar prices. So if the US goes through an inflationary bubble and the price of things in US Dollars goes up, pressure will build in the country for prices to do the same thing, bringing in the first instance pressure on output (excess demand) and then inflation. That might seem confusing, but the simple point is that with a fixed exchange rate you will import inflation (or deflation) from the currency to which you are tied.

So it is with some of these countries. China in particular has been struggling with prices in Reminbi that have become out of kilter with the US. That means lots of demand for Chinese goods to be exported to the US. Current account surplus for China, deficit for the US. This brings pressure on Chinese productive potential, the economy is at full capacity and creates shortages and pressure for an increase in the price of these Chinese goods.

What is going on in the background is that this flow of demand for Chinese goods and services is creating a big demand for Chinese Reminbi in exchange for US Dollars at the fixed exchange rate. The Chinese government has agreed to give a fixed amount of Reminbi for each US Dollar and people are flocking to them in droves.

The Chinese authorities have two options.

  1. They keep selling the Reminbi to all comers at the fixed exchange rate. As they do this they accumulate more and more US Dollars, which they need to keep in the form of currency, deposits, bonds etc. This will mean there are more and more Remminbi out in the world looking for a home. That leads to Chinese prices rising - inflation. They try to sell some of the Reminbi for other currencies, but the Dollars are coming in thick and fast and it is a difficult task. Witness the recent Chinese spending spree around the world buying up all manner of foreign assets and interest. This is them trying to unload all these US Dollars. And more are coming in every day.
  2. The alternative is they "revalue" the exchange rate. Each Reminbi will now cost more Dollars in exchange. This chokes off the flow as it has increased the price of Chinese output relative to US output. It also relieves the Chinese economy of the inflationary pressures it was under. They might alternatively just let the currency float and allow the market to push the exchange rate where it will, most likely up in the first instance.

And this is what this story is all about. China in particular, but increasingly many oil producing nations since oil oil prices increased from the lows experienced over the entire 1990s, are following track #1. It is unsustainable as a policy, so they are being forced to consider #2. But there is a political problem with this. Having the exchange rate where it is, undervalued, is not healthy; the Chinese economy for instance is eroding under the inflationary pressures being put upon it the excessive growth that is occurring forcing much investment and expenditure that it might likely regret in years to come (the over-hyped expansion of a small number of urban areas for example). However, the Chinese government (and people to be honest) get a nationalistic pride out of a booming economy that is buying up foreign assets. That is not a criticism of the Chinese people, it is a common human trait. Anyone living in Ireland over the last 10 years will recognise instantly the swelling chests that come with an inflationary boom at home and the ability to stride foreign property markets like kings.

It is a familiar choice. Sensible economic policy, or populist sentiment and beliefs. The latter usually wins in the short term until the proverbial inevitably hits the fan. These countries have been dialling up the speed setting on their fans for a few years now and the projectiles are being stockpiled.

So Robert Fisk might have simply stumbled on the latest discussions about this problem, or this might be a straw in the wind indicating that the time of inevitable revaluation (or even currency float) for these countries is on the way.

That is a big story and an investment opportunity if you can find some cheap way to access it. Go long these mainly developing and OPEC currencies that are under pressure to revalue and short the US Dollar (the second part not necessary if you are US based already).

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