Renegades!

The US Dollar: Currency Revolution

Sounding the alarm over the decrease in value over the US dollar has become de rigeur in many publications, including the Economist, which may still install a red alarm for its articles on the currency's deficiencies. But what is at the roots of this sensationalist bell ringing? But are the opportunities and threats to Canada, and other countries?

The first problem that has caught unprepared exporters off-guard has been the rapid decrease in the USD (US Dollar) value. If exporters had not been hedging their sales to the US, they would find that the sale they made last year while the Canadian dollar was in the 70 cent range has lost significant value. Without hedging, many exporters would be exposed to extreme currency risk. While this probably did not affect larger, sophisticated operations, many smaller operators were probably blindsided by the currency shift. In the long term, however, even large exporters will have to face up to the fact that Canadian goods are proportionately more expensive, and will probably only increase in value relative to the USD. According to the 'Big Mac' index, the CDN Dollar is still undervalued, and has room to run.

This means that in the near term, as Canadian exporters and manufacturers attempt to improve their products or productivity to offset the currency gains, the trade balance with the US will probably approach parity. Currently, there is still a monthly trade gap of $9 B. in Canada's favour.

It is not all bad news for Canadians of course. Previously, goods across the border that were too expensive, are now becoming more affordable. Canadians will have greater choice and a more competitive consumer market for their dollars, and that can only mean greater relative wealth for the consumer as they immediately get more bang for their buck. Apart from the obvious benefits for consumers, manufacturers, particularly those interested in the Canadian domestic market, will reap a whirlwind of opportunity as improved buying power means that they can finally buy high tech machinery from the US that can improve their own productivity on the cheap. While our trade surplus with the US may decrease somewhat, the Canadian productivity should go up, leading to higher relative wages for workers.

For the larger world, there is a bigger game going on with a very intersting dynamic between trading blocs. Obviously, Canada is the largest trading partner with the US, but other markets are emerging and are about to surpass Canada's top spot. The EU for instance, a massive economic bloc on its own, has had its own currency skyrocket in comparison to the USD. At 1.30, the EU is at a serious competitive disadvantage, and may see a flood of manufacturing jobs for export products be curtailed. With the current situation of massive unemployment in certain areas and demographics, the integrity of the EU itself is threatened as some members (ie: Ireland) see the central bank and Brussels as becoming an albatross around the neck of their economy. The EU may be forced to lower interest rates, and in turn add more pressure to a global housing bubble.

Britain also faces relative pressure to keep Sterling competitive,and will keep its rates low. For Britain, the country is between a rock and a hard place. London faces one of the worst housing bubbles on earth, as even London's suburb ghettos like Brixton and Sutton face prices in the stratosphere. If the interest rates stay low to keep competitive with the USD, the bubble will continue to expand and will become unstable and possibly dangerous. The policy choice between popping the bubble and destroying the competitiveness of the sterling is stark, and Blair cannot afford to walk a tightrope forever, as the longer the situation continues, the worse the fallout will become afterwards.

China for its part, is playing up its status as the world's workshop, as manufacturing jobs from the US float across the pacific and into the provinces of the mainland Chinese. With China's currency, the yuan, pegged to the USD, the US cannot improve its massive tade deficit with the emerging economy. Worse, as China buys up consumer goods and consumer product manufacturers stationed in the US (ie: IBM's PC division), the Chinese will be able to move more and more of the manufacturing off the continent. As the US attempts to keep the USD low against the EU to protect manufacturing jobs, the same jobs are being slipped out the backdoor to China. Ultimately, this is a zero sum game for the US: they cannot win against a competitor who keeps them at bay with a straight arm known as the 'pegged currency'.

This stiatuion is not necessarily going to stay the same forever. China's own currency is coming under ferocious pressure to either be revalued, or have its own interest rates increased to decrease the inflationary pressure against the pegged currency. Recently, China upped its own interest rates, and has continued to buy up USD to relieve pressure against the yuan. This phenomenon of an Asian country buying up USD to relieve pressure on their own currency is nothing new, and is widespread.

This brings us to the dynamic between Asia and the US: The trading relationship that has ultimately supported the US' bad habits. During the Asian crisis in 1997-8, the USD was the only currency worth obtaining. Countries began getting rid of their own currencies to buy up USD to maintain their worth. This death spiral of currencies spread across Indonesia and most of Asia, causing havoc with their economies.

These countries made it policy to continue the purchase of massive amounts of USD after the crisis to ensure they had a safeguard in case of a currency meltdown. In the case of Japan and China, these countries used the USD as a safeguard to ensure pressure on their domestic currencies would be decreased. The idea behind the purchase of USD, is that that the US' credibility and the strength of the dollar would keep the relative value of the US currency would remain high. This faith in the USD now means that for every business day, the US requires 2.6 B in USD be bought to keep the US government solvent. For the time being, there is still a market for the US debt, meaning that the US can keep its up high spending without having to account for its higher risk with higher interest rates.

The result has been a disaster for American fiscal conservatives. The government is able to spend vast sums of money well beyond its means on the premise that 'deficits don't matter', while the currency markets still temporarily back up this delusion by continuing to buy the USD. As terrible consequence of this unfortunate problem, the American consumer is afforded lower interest rates which they use to buy foreign goods at Walmart (a huge importer of foreign goods) exasperating the trade deficit problem, but also ramping up the enourmous consumer debt of the nation as well.

The problem for the US government, currently flying high on hubris and intellectual arrogance, is that this situation is not static. There might be short term inertia towards changing the world's standard currency, but in the long term the situation is intensely dynamic. Just as gold, the pound, the dinar, and other currencies owned the world's respect for a time, their time came came and passed. And just as these currencies encountered a perfect storm of problems that heralded the end of their monetary supremecy, the USD may well be entering its own hurricane of challenges.

One of the key challenges will be the emergence of China. By itself, China's ascendence onto the world's stage does not mean the end of the USD, but some of the factors that are accompanying its rise will certainly be detrimental. For instance, the EU has decided to drop much of its arms embargo against China, heralding a new era of trade between the two trading behemoths. China's increased trade with the EU will mean that the EU's relative importance will rise, and China's choice of holding 400 B in USD will change. Even now, China is increasing its holdings of the Euro. As an investment, the Euro is smarter, as its value is only increasing relative to the USD. If trade with the US is a priority, holding Euros until the date of payment will result in huge exchange gains if current trends continue.

There are also a multitude of coming problems that could end the reign of the USD in a hearbeat. A military showdown in the Pacific over North Korea or Taiwan could precipitate a flood of USD on to the market as investors instantly find the Euro more safe as the US trade with the Pac Rim would drop immediately. China could attack simply by dropping its reserves immediately into the lap of the US government and run. Since 9/11, the USD has appeared more and more vulnerable to speculation and one more attack might mean a run on the bank by foreign investors.

Or the end could come by attrition, as the US government simply decides in ignorance that the deficits (which will continue until at least 2009) will simply become a fact of life. As Republicans have consolidated their hold on the Senate, House and Executive office, the chances of spending bills being vetoed becomes relatively less and less. The interest rates will have to increase eventually, and the markets will simply start dumping the currency, slowly and surely.

The fallout for the American consumer and government will be horrendous. As interest rates permanently rise, the borrowing costs will rise exponentially meaning that the US will have to spend more money for their risky prospects, and meaning more money will be spent on financial institutions rather than on the purchase of goods that might increase productivity, decrease costs or save labour expenses. As much as any economic downturn, the rise of the interest rates coupled with hardcore inflationary pressures on the dollar as they flood the markets might mean a return to the seventies style staglation.

There is a very real possibility that the US government's policies will bring some dark days economically.

posted by Shamrocks! @ 4:38 PM