x Abu Dhabi, UAESaturday 29 July 2017

Sinking dollar bound to resurface again

Fears about a long-term decline in the role and value of the greenback are valid, but speculation of the currency's ultimate demise is greatly exaggerated.

Greenback, buck, monopoly money, moolah: whatever you call the US dollar, it seems to be sinking in value.
Greenback, buck, monopoly money, moolah: whatever you call the US dollar, it seems to be sinking in value.

Fears about a long-term decline in the role and value of the greenback are valid, but speculation of the currency's ultimate demise is greatly exaggerated. Greenback, buck, monopoly money, moolah: whatever you call the US dollar, it seems to be sinking in value. As we approach 2010, what will be the fate of the world's largest global currency? The dollar is important because it underpins more than 60 per cent of global foreign exchange reserves. Pervasive pessimism this year forced it down to about US$1.50 against the euro and a surprising decade low of about 88 versus the yen, substantially reversing the safe haven dollar rally of last year.

While the dollar may remain weak in coming months, we think it is oversold and expect the euro-dollar exchange rate to strengthen from mid to late next year to about $1.35. This assumes that related macro predictions of a moderating global recovery and investor risk aversion materialise. While the pervasive fears about a long-term decline in the role and value of the US dollar are valid, the pessimism is overdone. At current levels of about $1.50 versus the euro, the dollar has already priced in many, but not all, of the prevalent fears about the debt-ridden US economy and the eventual likelihood of high inflation. Based on purchasing power parity "fair value" models, the dollar is worth between $1.15 and $1.20 versus the euro. This means it is already 20 per cent or more undervalued.

Since inflation plays a large role in determining currency value, additional substantial downside to the dollar is likely only if we see inflationary signals in the US. This is unlikely until its moribund economy achieves significantly higher capacity utilisation levels. Yet, in the near term, if emerging economies continue to post better than expected growth, we will continue to see the recent speculative trend play out a bit longer, which is shorting dollars to invest in riskier markets overseas.

This could create moderate levels of additional downside for the dollar, but such damage will not be lasting. If emerging markets, especially China, throw off any negative surprises on economic data, which could be the case next year given escalating expectations, investors will recede from risk and rally back to the safety of the dollar. Regardless of what near-term trading range the dollar settles into, two things have become clear in the past year.

First, the dominant status it has enjoyed as a global reserve currency in the past half century is increasingly resented, especially by China, and is likely to gradually give way to a multi-polar currency reserve system. Second, there is no single good choice to replace the dollar as a global reserve, and there are precious few good choices to lead a new currency order. Given these twin realities, the most likely outcome is a multi-polar currency world with the dollar still dominant, but less so, and the euro gaining share in international settlements.

The wild card of course is the undervalued yuan, which China has thoughtfully allowed to appreciate about 17 per cent in the past four years. This managed rise of more than 4 per cent a year is likely to continue and strikes a delicate balance between China's largest consumer, the US, which argues for a stronger yuan, and its myriad exporters who moan about its relative strength to rivals such as India.

Since China clearly has the strongest economy exiting the credit crisis, the currency is set to play a much larger role as its global GDP share rapidly increases. However, as long as the currency remains pegged to the dollar and currency convertibility is lacking, it cannot play a leadership role in the currency reserve system. Yet the stunning large dollar reserves it continues to accumulate will steadily increase its voting power in deciding the future of the currency reserve system.

In the wildest of scenarios, could China force a return to the Bretton Woods era of fixed exchange rates a decade hence? While unlikely and undesirable, it cannot be ruled out; even if its foreign exchange reserves and treasury holdings compound at a rate much lower than that of the past decade, its monetary muscle will substantially increase. Whether China will accept a floating currency depends substantially on how much it reduces its substantial dependence on an export-led growth model by fostering greater internal consumption.

If the Chinese consumer's appetite fades over the next decade, as its demographics deteriorate, the export engine will need to continue to drive critical job creation, which means the authorities cannot allow the currency to float up to its significantly higher fair value. While a return to a Bretton Woods-type fixed rate system goes against the grain of globalisation, the current situation where one half of the world has floating rates while the other half is pegged is unsustainable because the non-pegged nations disproportionately absorb the pain of global trade imbalances. The media has clearly slammed the dollar as the inevitable loser in the years ahead, propelled by sensationalist comments from political figures playing to local audiences and rightly disregarding the US cant of a strong dollar.

While the dollar's market share will clearly give way to the aforementioned alternatives, a disorderly collapse in its value is unlikely because the US is a net importer and all the major exporter nations, especially China and Japan, prefer a strong dollar. This mode of competitive devaluation, when reconciled against the dollar already trading well below its purchasing power parity value, will help it achieve a soft landing. Also, since these exporter nations are substantial creditors they are saddled with several trillion worth of dollar-denominated assets, another self-preserving motivation to engineer an orderly transition in the decades ahead.

Is gold a good currency? While it is often touted as a dollar alternative, and inverse correlation between the two validates the premise in the short term, it is a poor currency choice for the long term. I expect the big structural break of 1971, when the US severed the strong peg between currency and gold, will not reverse course barring any cataclysmic geopolitical scenario. The future economy will be more globalised or "flat" than that of the past. Hence, the flow of goods, services and capital across borders will be aided by a more flexible currency regime, which corrects the extraordinary trade imbalances that have built up in the past decade due to the tension between the mostly fixed and floating currencies.

Gold, famously described eons ago as a "barbarous relic" by the masterful John Maynard Keynes, detracts from the desired enhancements in currency flexibility. You should own some gold but for the right reasons: it is highly responsive to inflationary signals, but not a probable future currency anchor. Finally, close to home in the Middle East, we are likely to see the pegged foreign exchange regimes continue for the foreseeable future. Even the brave are likely to conduct only timid experiments in flexible currencies, as in the case of Kuwait, where the currency has traded in a narrow range since its flotation.

The slow progress toward a GCC common currency and the abstention of Oman and the UAE are unlikely to change quickly. The GCC central banks have been slowly and quietly diversifying their once dollar-centric foreign exchange reserves towards a trade-weighted currency basket and will sensibly continue to do so, but as long as their primary energy-centric revenue stream is priced predominantly in dollars, they are motivated to maintain a strong peg.

Rehan Syed is the head of portfolio management at the ABN AMRO private bank in Dubai.