What’s driving DOWN The DOLLAR?

In May, the Kuwaiti government abandoned the dollar peg to curb soaring inflation triggered by the high cost of imports from Europe and the Far East. This came on the heels of similar decisions by Russia, China and Malaysia. The Kuwaiti Dinar is now linked to a basket of currencies and is set to increase in value by 0.35 per cent by the end of the year. It might have been more but Kuwait decreased interest rates in order to deter speculators. Other GCC countries, including the UAE, are reluctant to follow suit. Sultan bin Nasser Al Suweidi, Governor of the UAE’s Central Bank has described his country’s dollar peg as a stable anchor for the economy. Until comparatively recently, few could argue with that statement. But how stable is the dollar now?

July 3 was a black day for the dollar which traded one cent short of a record low against the euro at $1.3611 and experienced a 26-year low against the British pound at $2.0197. Britain was recovering from thwarted terrorist attacks, which made the pound’s strength against the dollar that much more remarkable.

This dollar weakness was particularly bad news for Gulf expatriates who are paid in dollars or dollar-linked currencies and who have monthly financial commitments overseas such as home mortgages or families to support.

People who receive their pensions in dollars are also affected. A friend who spent his life working with UNESCO complained that 25 per cent has been lobbed off the value of his pension.

Most hope that the dollar’s fragility is merely a temporarily blip and are prepared to ride the storm. But a growing number of financial experts are warning there is worse to come with a few bearers of doom and gloom saying the greenback may never recover.

Let’s look at the factors driving the dollar down.

- Interest rates have recently played a role in the dollar’s descent. The Bank of England has increased the base rate to 5.75 per cent partly in an effort to slow down the over heated British housing market. And it’s anticipated that the EU, which has held rates steady at 4 per cent, will raise them later in the year to reflect strong growth.

On the other hand the US is constrained because its housing bubble has burst with a bang, which means if the Federal Reserve increases interest rates property sales could stagnate further. This would, in turn, have a knock-on effect on consumer spending and possibly trigger a recession.

Moreover, as the IMF warned earlier this year, the dollar value needs to decline to reduce US debt and narrow the $765 billion trade deficit. This, in effect, means that due to the devalued dollar the US gets a discount on its imports, which is not good news for exporters.

Naturally, more and more currency speculators, investors and savers are lured by the higher interest rates on Sterling and the Euro, which have proved to be more stable than the dollar.

- Phenomenal growth throughout the euro zone has made Eurobonds more attractive to investors than dollar-denominated bonds. Indeed, Eurobonds have greatly outpaced their dollar rivals.

- Central banks have begun to diversify their foreign reserves. In March, China’s Central bank announced that China does not intend to accumulate any more foreign reserves, while Syria and Iran have eliminated the dollar completely.

- Countries in the Middle East and the Gulf are diversifying their investments overseas and investing money that would have once been held as foreign reserves to fuel their own economies. This is particularly true in the case of Saudi Arabia, Bahrain and the UAE.

- There is the worry that oil exporting countries will begin trading in Euros or other currencies as Iraq did before it was invaded and Iran, Libya and Venezuela threaten to do.
This would translate to oil importing countries - currently forced to hold large reserves of petrodollars – being free to dump dollars in favour of other currencies. Currently 66 per cent of central bank reserves worldwide are held in dollars.

If that were to happen the dollar would lose its coveted position as the global reserve currency when the US would find its grip on world economies greatly loosened. There could conceivably be a domino effect that would lead to a giant sell-off and a massive decrease in value.

Furthermore, if the dollar were to lose its importance relative to oil its real worth would come under increased scrutiny in relation to the US economy, trade deficit and fiscal debt.

Americans have generally been living above their means for many years. Their consumption is high and so is their borrowing. Incredibly, in mid-2007, their National Debt was $8.8 trillion or $28,000 per capita of the population.

At the same time the US government is in the red as much as $9 billion or seven per cent of GDP.

GDP is due to rise only 2.1 per cent this year – down from 3.3 in 2006.

Plus, a decrease in manufacturing, investment and increased job outsourcing are damaging America’s ability to compete in the global marketplace.

This depressing data means that although the dollar has fallen to historic lows, its real value based on economic factors could be a lot less.

There is a likelihood that there are fewer dollars circulating throughout the world than their used to be as the Federal Reserve is no longer willing to publish its figures.

This unwillingness to be transparent does not inspire investor confidence and elicits such questions as ‘what are they hiding?’ Are they concerned that if the flight from the dollar becomes public knowledge, the trickle will turn into a flood?

Addison Wiggin, the editorial director and publisher of the Daily Reckoning and the co-author of “Financial Reckoning Day: Surviving the soft depression of the 21st century” asks “Does this mean the age of America is ending?” answering his own question with “No. It simply means that economic muscle will be flexed by someone else in the future”.

Countries tipped to fill the gap and keep the global economy afloat are Japan, China and India together with the Euro Zone.

However, there is another point of view reflected by Anatole Kaletsky column titled “Demise of the dollar is greatly exaggerated” published in The Times last December.

Kaletsky admits that “newspaper headlines are screaming that the dollar is becoming worthless, while market leaders, central bankers and politicians seem to be in unanimous agreement that there is only one way for the US economy and currency to move from now on and that is down”.

“Rarely in living memory has an important currency, or any financial asset, been as friendless as the dollar is today,” he says.

But despite the signs, Kaletsky is optimistic. He believes the American economy will reaccelerate later this year, while those of the Euro Zone and Britain “are likely to suffer a severe slowdown if the euro and the pound remain at anywhere near present levels against the dollar and the Asian currencies”. And, thus, he predicts “a big change of direction in the currency markets is probable”.

Billionaire businessman and philanthropist Warren Buffet disagrees. He has advised investors to “build an ark” to protect themselves against the descending dollar. Former head of the Federal Reserve Board Paul Volcker has predicted at 75 per cent chance of an economic crisis within two years, while a former researcher at the IMF Kenneth Rogoff warns the dollar could ultimately drop 40 per cent off its value.

If and when GCC states finally get around to adopting a common currency in 2010 when a common market is due to be formed, it will be interesting to see whether the single Gulf currency will be linked to the dollar. The joint decision will, no doubt depend on the dollar’s status at that time and whether member states can agree on whether to peg or not to peg. Much will also depend on whether the GCC wants to set interest rates in keeping with their growing economies rather than having to adhere to US interest rates, currently devised for a slowing economy.

There was talk of setting up a common currency earlier but the Kuwaiti decision has put a spoke in the wheel. The Deputy Governor of the Saudi Central Bank Mohammed Al-Jasser described the proposed monetary union as having become “more difficult” due to Kuwait’s switch while Mr. Al-Suwaidi says he doesn’t know what prompted Kuwait “to deviate” from the consensus of its fellow GCC members.

Three years is a long time in terms of currency fluctuations and trends. Global economies and currencies will have ebbed and flowed. There will be a new team in the White House with new policies and strategies. The GCC would do well to adopt a wait and see approach.

Some experts say there is a political component to the dollar’s weakness. In that case, a new US administration might be able to mend fences and build bridges with countries now contributing to the dollar’s downward spiral. On the other hand, there may be new wars; unpredictable wars being waged, which could elevate oil prices and heap further pressure on the dollar.

While they wait, some cautious investors are turning to gold along with traditional safe haven currencies. The euro and the pound are also big winners…but for how long?

Will the dollar ever reign supreme again or will its global monopoly become a mere footnote in history? If anyone could answer that they would not only be clairvoyant but super rich. Sadly, I’m neither.

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