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Who Cares About the Dollar?

Who cares about the dollar? It turns out quite a few do, except for those who could put it on a course to long-term recovery. First of all, you should care, as the purchasing power of your dollar savings is at risk when the dollar plunges versus other currencies. Let's examine a couple of groups, what they have at stake and how influential they may be.

Those Who Care

Savers. That may well be you and me. Though we hear praise about the "recovery" in the equity markets, the dollar index is down more over the past year than the Dow Jones is up. That's not a recovery, that's an illusion. Oil is trading at around $80 a barrel - that's not a reflection of economic strength, it's a reflection of dollar weakness - and we have to pay for it, at the pump.

India. Why India? Because actions speak louder than words. While numerous governments have discussed diversifying out of the dollar, India has put its money where its mouth is - buying gold, the ultimate hard currency. India's finance minister exchanged US$6.7 billion with 200 tons of gold (a lot! - about 8% of global gold production) because, in the finance minister's words, "Europe collapsed and North America collapsed." You can't get much clearer than that. The gold India bought came from the International Monetary Fund (IMF) which recently authorized the sale of 400 tons. China had been rumored to be the likely buyer, but wanted to absorb the gold at a discount. The fact that India stepped up to the plate and swooped up half the amount within just a few weeks at market rates shows the very real interest some central banks have in diversifying out of the U.S. dollar.

China. While China has not (yet) purchased IMF gold, China has been increasing its gold reserves, while deploying more of its newly acquired reserves in euro and yen. China is very sensitive to not rocking the markets; as a result, China has increased its gold reserves mostly by buying up domestic production as large-scale open market purchases may cause gold prices to spike. However, because the gold market is much smaller than the currency market, China's gold reserves as a percentage of total reserves has actually been going down. China continues to be a contender for the remaining gold the IMF considers selling.

The reason China is concerned about the U.S. dollar is simple: in their own assessment, they may hold too much of the greenback. Why? Because China has on the one hand tried to keep a quasi-currency peg versus the U.S. dollar: when China exports goods, they receive dollars; to keep their own currency from rising, they keep the dollars rather than sell them to buy Chinese yuan. And, on the other hand, China has been hamstrung by the lack of liquidity, not just in the gold market, but also in the money markets outside of the U.S. dollar. While the currency market is the most liquid in the world (more liquid than the equity or bond markets), the U.S. continues to be the place of choice to deploy large amounts of cash. The eurozone's liquidity is a distant second; and indeed, the eurozone is a primary beneficiary of China's diversification strategy into a basket of currencies. The Chinese, too, have moved from talk to action; aside from the euro, the Japanese yen has been another beneficiary of China's managed basket approach to its reserves.

Soon, China may no longer be able to prop up the dollar; it's not so much that its massive reserves are beyond the point most would have dreamed possible, but their domestic money supply has been going through the roof as a result of a successful domestic stimulus package and the implicit stimulus created by subsidizing exports through a weak currency; the resulting inflationary pressures may be best tamed by allowing the yuan to float higher.

Europeans. Europeans care about the strong dollar. While European firms have extensive experience with volatile exchange rates and have learned to hedge their currency exposure, the strong euro is hindering a recovery - especially in Germany, an economy heavily dependent on exports. However, Europeans remember hyperinflation and stoically resist the temptations U.S. policy makers have fallen victim to. The European Central Bank (ECB) is foremost critical of exchange rate volatility while giving thinly veiled criticisms of U.S. policies, urging the U.S. to - and that is our interpretation - return to a path of sound monetary policy. While the ECB would not outright criticize U.S. policies, the ECB openly talks about how its support programs are inherently more flexible; the ECB also urges the U.S. to pursue a strong dollar policy.

In the U.S., the federal government can launch a trillion dollar stimulus package; similarly, the Treasury can inject hundreds of billions into ailing banks. Not so in Europe: fiscal stimuli have to come from regional governments; the same with bank bailouts: the money comes from regional pockets. As a result, the Eurozone cannot ramp up spending as quickly as the U.S. Similarly, in our assessment, the ECB's support programs to the markets carry fewer inflationary risks than those of the Fed; the ECB programs keep banks alive (by providing liquidity on an unlimited basis), although they are slower to recapitalize. As a result, we may see lackluster growth, if any, in Europe, but it may well be with the backdrop of a much stronger currency. It's a fallacy to assume that one always needs economic growth to support a strong currency (see our analysis of the yen) - that's only the case when financing from abroad is required to support a current account deficit.

Corporate America. We are told a weak dollar is good for exports and, thus, corporate America favors a weaker dollar. Not exactly. No country has ever depreciated itself into prosperity and corporate America is well aware of that: it is highly unlikely that the U.S. will thrive exporting sneakers to Vietnam. A weaker dollar may indeed help out corporate America for the next quarter's earnings in making foreign income look more attractive. However, with a weaker currency, corporations lack an important incentive to invest in quality. The Europeans have long learned that they cannot compete on price, but must produce value added products such as luxury cars or complex machinery; incidentally, producers and service providers at the higher end of the value chain have more pricing power. China's industry has also recognized this, allowing its low-end industries (e.g. toy industry) to fail and move to lower cost countries.

Corporations that have their share prices valued in a strong currency may go on an acquisition spree; those that are based in countries with weak currencies get acquired (e.g. Cadbury, the British chocolate maker, is under siege because the British Pound is even weaker than the U.S. dollar). But possibly most telling is the sad fact that an increasing number of U.S. corporations are looking for ways to hedge their domestic currency risk. That's something traditionally reserved for corporations in developing countries.

Those Who Seem Not To Care

Your elected official. A weak dollar is really in no one's interest. The reason why the U.S. dollar has gained reserve currency status is because the U.S., over many decades, has pursued reasonably sound policies. But such privilege must not be taken for granted; at some point, policy makers may be getting more than they are bargaining for; at that point, it may be very costly to try to stem a disorderly decline of the dollar.

Policy makers in the U.S. only peripherally care about the dollar: up-and-down moves in the dollar are a side effect of their policy agendas. For many policy makers, that may simply be a reflection of their lack of understanding of basic economic principles. But for others, such Federal Re

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Posted in Monetary Commentary, Guest Commentary, Axel Merk

2007154
 
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