Dr. Mohamed A. Ramady
Publication Date: 
Mon, 2007-12-17 03:00

There must have been those in the US administration that must have made a collective sigh of relief at the announcement of the GCC finance and monetary chiefs that, for the present, the GCC would continue to peg their currencies to the dollar. To many however, the decline of the dollar, a potent symbol of US global dominance and power for the past century, may have become irreversible.

The lack of confidence in the US greenback has become widespread that it is not only governments who are worried about this decline, but ordinary investors who are seeking refuge in alternative currencies. The statistics have been startling - the dollar is now at its lowest against the euro, the lowest against sterling since 1981, the Swiss franc since 1995, and, in the unkindest cut of all - the lowest against the Canadian dollar since 1950.

There are rumbling signs of discontent from countries with major dollar holdings such as China, with nearly $1300 billion of currency reserves. China has only to signal that its accumulation of the dollar will slow down to weaken the currency further. Stalwart US trading allies and those opposed to the US are having a rethink about the dollar, with South Korea’s central bank urging its shipbuilders to issue invoices in the Korean won. Several oil producers — Iran, Venezuela and Russia are demanding payments in euros.

Plagued by the fallout from the subprime loans, and credit crunch in the financial system, the US Federal Reserve has cut interest rates several times, which has made holding the dollar even less attractive to investors.

There are those that argue that the dollar’s decline is temporary, and that recovery will come around just like in previous cycles in the dollar’s fortunes. That may be the case, as much also depends on other countries, such as China, revaluing their under-priced currencies against the dollar. Recent history may seem to support those who are praying for a reverse in the dollar’s fortunes. Four years ago, the dollar rode high against the dollar, and many analysts were writing off the European currency. Both the sterling and the yen were also taking a battering against the dollar. What are the differences now and are those hopes misplaced?

There are several reasons why the dollar’s weakness is now more endemic and structural than before. Firstly, the relative size of the US economy has been shrinking, while the Asian economy — particularly those of China and India have been gaining ground. In 2008, China will pass Germany to become the world’s third largest economy after the US and Japan. On present growth patterns, China will pass Japan within a decade. And such, the US will find it does not dominate the world economy in a way it used to. The second reason is self-inflicted — a growing US currency account deficit which is now larger relative to its GDP than in any previous era of dollar weakness. A fall in the dollar’s value might make American products cheaper and ease on the current account deficit, but this stands at about 6 percent of the US GDP and is a significant factor.

Another reason is that, after a period of self-doubt as to whether rival currencies to the US currency existed, the euro is suddenly being talked up as a rival. The European Union economic zone is now comparable to the size of the US, and euro zone economic growth is picking up, with both Germany and France making headways after a period of sluggish growth. This new self-confident Europe makes it a magnet for investors and its currency rises.

History can still come on the side of the dollar, as currencies generally overshoot and their value declines as the other currencies’ supply dwindles, and their value goes up in turn. Some traders believe that the dollar is probably undervalued now and could make a rally, but the combination of the above long-term factors and erosion in confidence in the short term is chipping away at the dollar. The American currency could recover, but it will be in a world that is far different, so as to make its once undisputed hegemony a thing of the past.

Dr. Mohamed Ramady is visiting associate professor, finance and economics at King Fahd University of Petroleum and Minerals.

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