The writing seems to be on the wall for the mighty greenback in 2007. The dollar is overvalued and has further to fall in the coming months, with major implications for many countries, not least the oil producers. It is not a coincidence that the US Treasury has just announced the reintroduction of the US silver dollar coin, phased out before the World War II, causing many cynics to wonder why the timing. But the silver dollar will not be the “magic silver bullet” to ease the looming pressure on the American currency. The forces that are driving the dollar down are now more transparent than ever on all fronts, and the good times of the US living on other nation’s surpluses, borrowing and patience is gradually being eroded.
The US balance of payments deficit is at a record 7 percent of a GDP of around $11,000 billion, and the era of the US lecturing other countries to take stringent measures to curb their wayward economic life is over. But there is a terrible dilemma — the United States is still the world’s strongest economy and the dollar is accepted the world over, GDP deficit or not — just ask countries caught up in conflict situations which currency they prefer. But for those countries lucky enough not to caught up in conflicts, and having some choice, the mood is turning sour and some are muttering, although very softly, that enough is enough.
Economists, as is their wont, are divided on how much further the dollar needs to weaken, before the economic imbalances are “put right”. Some say that a further 20 percent decline is necessary to correct an imbalance where the United States is currently importing 50 percent more than it exports. This is frightening some sections of the US, who fear an erosion of American manufacturing power, and has reinforced domestic protectionist pressures. This in turn is causing some nervousness from counties who have seen an export led boom to the US as their main engine of growth. A sharp fall in the value of the US dollar, and a resurgence of US exports, could paradoxically counter American protectionist pressures, but the issue is one of timing, and who feels most threatened now. A melting away of the dollar’s value is like global warming — a fall in the dollar cannot prove a trend like global warming, but, over time, the evidence is now building up.
For those countries that have amassed large dollar assets, or continue to peg their domestic currency against the dollar, the choices are indeed not pleasant. They cannot openly switch and diversify into other currencies, thus driving down the value of the dollar and further eroding their dollar assets. The issue is not an academic one — OPEC countries are estimated to have amassed around $400 billion in surpluses over the past year alone, twice the estimated Chinese trade balance of $150 billion, held mostly in dollars, despite some discreet Chinese diversification into other currencies.
Other countries have not been that discreet about their plans to switch away, at least part of their reserves and earnings, from the dollar to the euro and the British pound. Iran has openly stated that they will deal in the euro, Venezuela is diversifying, and Russia is already dealing in the euro for its major energy transactions.
There is debate in some of the GCC countries about the need for a modest diversification of their reserves and eventual GCC unified currency peg, but Oman’s decision not to join the unified GCC currency has put even this deliberation in doubt. Paradoxically, the above various country reactions could help the dollar gain in the long run, as fewer dollars will be available due to switching into other currencies. There will be pain for the euro though, or for whichever currency can take on the responsibility of the dollar. If such currencies appreciate in value, then this will in turn impair their exports or export led recovery for countries like Germany, as well as for the British, who are now finding out that a two dollar pound is not attractive to exports after all. A strong currency might seem like a virility symbol for nations. It was not too long ago, in 1985, that the pound was falling to one dollar levels when Prime Minister Thatcher called on the US to defend the UK’s currency, and implied virility symbol, at all cost.
However, the long fuse of the dollar’s decline in 2007 seems to have been lit, and the major question for the Chinese yuan, the euro, and even for the Thai baht is how to smoothly manage their currency appreciation against the dollar, without having economic growth and social upheavals. The Chinese are also nervous about possible turbulence in the Hong Kong markets, as the yuan moves quickly towards parity with the Hong Kong dollar due to speculation over the future of the Hong Kong dollar’s peg. The key will be how the US decides to move domestically in the face of its twin budget and trade deficits, as well as historically low US savings rate. Politics matters here, for the mighty greenback is also underpinned by the perception of the US military and political pre-eminence in the world. Once such a perception is shattered, or doubted, due to events such as Iraq, then the dollar’s fall will come about much quicker than desired, even from those that do not want it to fall without other currencies stepping up to replace it.
In the short run, the world is still unprepared to replace the dollar, and a joint dollar-euro system would need central bankers on both side of the Atlantic that can see eye to eye on monetary policy. An abrupt end to the dollar system would be chaotic, potentially inflationary and disruptive on world trade. Can it happen though? The answer is yes in the long term, and 2007 could see the beginning of a not so quiet shift away from the dollar, as the security and financial links that glue the dollar’s supremacy begins to unravel.
(Dr Mohamed A. Ramady is visiting associate professor, Department of Finance and Economics, at King Fahd University of Petroleum and Minerals, Dhahran, Saudi Arabia.)