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November 5th, 2009
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 Reserve (Fed) Chairman Bernanke, it's more than that. Having worked to prevent a financial meltdown, Bernanke wants to jump-start the economy. He has testified in Congress that during the Great Depression, moving away from the gold standard was the way to do it: you "allow the price level to rise." In our assessment, the dollar is a means, not an end for Bernanke. That's little consolation for savers whose purchasing power may be destroyed in the process. Think about it this way: when someone takes away half of your purchasing power, you have a greater incentive to work - top line economic growth may go up. Bernanke's policies are squarely designed at pushing home prices higher, which may be an effective way to bail out those who are 'underwater' in their mortgages. To achieve this goal, low interest rates are being touted; but the way low interest rates are achieve, through the purchases of mortgage backed securities (MBS) and government bonds, these securities are now intentionally overpriced. As a result, rational investors - both domestic and foreign - may be looking overseas for securities with a less manipulated risk/return profile. A weaker dollar may also prove inflationary as the cost of imports may rise. Bernanke seems not to be concerned as he has stated that, historically, a weaker dollar has not necessarily been inflationary. Here, we strongly disagree: in the spring of 2008, import prices soared as Asian producers could no longer absorb the higher cost of doing business with the U.S. - it wasn't simply the high price of oil, but global inflationary pressures that could no longer be contained; the credit bust "saved" the world at the time from what may have been inflationary nightmare. And guess what: Asian exporters had pricing power and were able to raise prices.
Inflation, of course, may also drive up home prices; although it is difficult to direct where inflation may show its ugly head. Many policy makers believe we cannot have inflation when there is no wage pressure. But that's wrong: think of a room with 10 people, 8 poor and 2 rich; the 2 rich people can drive up prices even if the other 8 cannot afford the item. The wealth gap in the U.S. has been widening - in our assessment as a result of too loose a monetary policy allowing those who understand credit to move ahead whereas many more fall through the cracks; look at Latin America - the type of society our policies drives us towards - to see that inflation is possible even when a great part of the population earns low wages.
But it's not just Fed officials that have a "neglect" of the dollar. When Congress spends too much money, it's a negative for the dollar - again, the focus may not be the dollar, but it's the valve of excessive policies. Or think of entitlement programs: in the absence of reform, an erosion in purchasing power (through a weaker dollar and inflation - especially inflation that is not fully reflected in government inflation statistics) appears to be the politically most convenient solution to nominally deliver on promises, even though in real terms, less is delivered.
Worst for the dollar may be when trade disputes flare up. One great feature of the U.S. economy is that it is flexible. Over the years, the economy has shifted towards one that is focused on trade. When protectionist sentiment flares up, those who have learned to adjust are the ones who get punished the most. That's part of the reason why the dollar tends to take a nosedive when politicians heat up their rhetoric on trade issues.
What To Do?
The world is what it is. There are different ways to address what we believe may be a continued threat to the dollar.
Warren Buffett. As one of the more famous dollar bears, Warren Buffett, has in the past exclusively bet against the dollar; more recently, he has emphasized that he would not bet against America. That may well be, but his Berkshire Hathaway is selling dollars to engage in his largest purchase yet: Buffett believes an additional $26 billion investment in railroads is preferable to holding U.S. dollar cash.
New Zealand. New Zealand's finance minister is reasonably relaxed about the strength of the New Zealand Dollar, colloquially called the kiwi. His reasoning why the kiwi is so strong? "One of the reasons that we are high against the U.K. and the U.S. is because frankly they are in a bit of a mess." Of the major economies, New Zealand had the most laisser-faire approach to the credit crisis, allowing market forces to play out. As a currency with a high current account deficit, the kiwi plunged during the credit crisis, but has since been a leader in the recovery. While New Zealand is not happy about its strong currency (it makes agricultural exports less competitive), it realizes that the currency is an important valve and that excess regulation may cause more harm than good.
Australia. Similarly, Australia has decided it cannot wait for the rest of the world to get its act together. Australia has raised rates twice in a few weeks. The U.S. continues monetary easing through purchases of MBS, while Australia is well on the way of tightening. Australia does what's right for its economy; and sure enough, while the Australian dollar is strong, it cannot be the driver of its monetary policies.
Canada. Canada would be well advised to take a lesson from Australia. Canada benefits from the global reflationary efforts as its economy benefits from the rise in commodity prices; but Canada's economy is also highly dependent on exports to the U.S. As a result, the Bank of Canada has refrained from tightening because it is afraid a stronger loonie, as the Canadian currency is colloquially called, would stifle economic growth. Switzerland has fallen into a similar predicament, even actively intervening to keep its currency from appreciating versus the euro. Both of these countries are in a better position than Vietnam which is exclusively dependent on exporting by focusing on price; Vietnam was in the news just again for engaging in policies that may lead to competitive devaluation. Both Canada and Switzerland are no Vietnman, and as a result, their citizens deserve better than a pursuit of policies that put them at risk of being placed into the same camp. We are exaggerating here, but do so to make a point: Switzerland and Canada ought to pursue sound monetary policy and must not be tempted to make their policies dependent on the U.S. In the eurozone, in contrast, the ECB has long been independent and decided it cannot join the potentially inflationary path the U.S. is pursuing; if U.S. policies cause a global inflationary outbreak, the eurozone may not be immune, but, structurally, the eurozone should then be in a much stronger position to adapt. That's because European consumers have long stopped spending and are far less interest rate sensitive compared to their U.S. counterparts; as a result, a tightening to tame inflation would have less negative implications on the European economy.
Investors. Investors are caught in the middle of these forces and can either lament or choose to take action. There is a bright side to the fact that some don't care about the dollar: it may provide for profit opportunities - or shall we say, ways to potentially mitigate the negative effects of the neglect. Aside from U.S. policy makers, the dollar is also "neglected" by direct participants in these markets: tourists, corporate hedging departments as well as governments on occasion engage in the currency markets not for the primary purpose of seeking a profit. As a result, there may be inefficiencies in the currency markets that do not exist in other fields.
By no means would we want to encourage investors to become arbitrage players engaging in the types of leveraged bets hedge funds engage in to take advantage of perceived inefficiencies. But we do believe that it makes sense to ponder the macro forces of supply and demand and consider putting one's money where one's mouth is. Central banks are diversifying into baskets of currencies; we have been promoting that very strategy for years. Ultimately, a managed basket for a country allows them to pursue a management of their reserves fine-tuned to national interests. While some may dream of a return to the gold standard, the trend over the past 100 years has been moving in the opposite direction, albeit with an increasing gold element in recent years for some countries. We don't think there will be a world currency sponsored by the IMF - such a concept looks good on the drawing board, but national interests differ too widely. And there is no need as governments can manage their baskets of currencies. Similarly, investors can manage their investments according to what is most suitable for them, and they may want to consider whether a basket of currencies is part of that.
ABOUT THE AUTHOR
Disclaimer: The opinions expressed above are not intended to be taken as investment advice. It is to be taken as opinion only and I encourage you to complete your own due diligence when making an investment decision.
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