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The dollar is close to finding a floor after falling for nearly six years. We expect the greenback to ease a bit further lower over the coming months as concerns about the state of the U.S. economy take a toll. But other factors point to a more-stable U.S. currency on the near horizon.
The shrinking U.S. trade gap is another feather in the dollar's cap. The trade gap is contracting both in absolute terms and as a percentage of gross domestic product. It is on track toward $520 billion and 3.8% of GDP in 2008, down substantially from $685 billion and 5.1% of GDP in 2007 and $758.5 billion and 5.7% of GDP in 2006. Widespread fears about the U.S.' ability to sustain ever-increasing trade deficits was a major factor in the dollar's decline over the course of the decade. A shrinking deficit will now have an opposite, supportive effect.
Some countries are talking about taking their currencies off their pegs to the dollar. Bus this isn't a danger sign for the buck. For the most part, East Asian and Persian Gulf economies will remain very cautious about slipping their links to the dollar. Ultimately, the other economies with currencies linked to the U.S. dollar or limited to narrow trading bands against it will move toward basket trading and even free floats. But such moves are more likely to come about as part of moves to limit inflation, rather than as a response to the dollar's own weakness. And as the other countries' currencies appreciate, so will their ability to purchase U.S. goods and services.
The same goes for talk about China, Saudi Arabia and other holders of large dollar reserves wanting to diversify their huge foreign exchange reserves into other currencies. "There is a limit to the size of the [currency] market and just how much you can adjust [reserves] at any moment in time," says Adolfo Laurenti, senior economist with Mesirow Financial. He adds that countries wanting to diversify away from greenbacks in their reserves also face something of a catch-22: "The moment they started to [sell off dollars], they would sustain a huge capital loss in the dollars they have remaining in their portfolios." Thus, holders of these reserves have little incentive to simply dump the buck.
Currently, roughly 65% of all publicly-declared foreign exchange reserves in the world are held in dollars -- down from 70% in 2000 but about the same level as in the early 1990s. Note that the figures exclude reserve holdings of both China and the Persian Gulf states, which do not openly declare the composition of their reserves. So, the actual percentage accounted for by dollars is probably much greater.
In fact, far from losing faith in the greenback, Beijing and the Gulf monarchies have recently made some large, high-profile direct investments in the U.S. financial sector. For example, CITIC Securities, a unit of one of China's largest government-owned multinational firms, has formed a strategic alliance with Bear Stearns, one of the U.S. investment banks hit hardest by the subprime mortgage crisis. The alliance will involve cross investments of about $1 billion by each firm in the other.
Also, the two richest governments of the United Arab Emirates have expressed similar faith in the U.S. economy and hence the dollar. Abu Dhabi Investment Authority, the sovereign wealth fund of the Government of Abu Dhabi, reached an agreement with Citigroup to purchase a 4.9% stake in Citi for $7.5 billion. And Dubai International Capital LLC -- a unit of Dubai Holdings, the Government of Dubai's investment company -- has reached an agreement to purchase a 9.9% equity stake in Och-Ziff Capital Management Group LLC.
The dollar's global dominance will erode, but the process is going to take decades. Indeed, the dollar's position as a force to be reckoned with is likely to last well after China eclipses the U.S. as the world's largest economy, which is expected around 2040. The British can attest to this. Though the U.S. economy displaced the United Kingdom at the top of the global economic heap at the start of the twentieth century, the pound sterling remained a major global reserve currency into the 1950s. It's also worth remembering that the last two times talk of the greenback's demise was so widespread were 1978 and 1995 -- right before the dollar began lengthy rebounds. So don't buy into the gloom and doom.
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POSTED BY: patrickjspring (December 12, 2007 07:06 AM)
You don't have to buy into the doom and gloom until you're living in it. It seems to me we are heading in the direction of a one world currency to solve the world wide economic problems we face
POSTED BY: JOE H ONICK (December 13, 2007 01:12 AM)
You like so many others have completely overlooked the virtual impoverishment of tens of thousands of American expats and military in Europe who have had their incomes flushed by nearly 42% due to the dollar dive. No matter how much the drop may have helped some exports, it has screwed a lot of American citizens abroad, despite certain commissary privileges and cost of living help. Why do you not deal with this subject? Why do you not pose the question to the long list of those who want to be president?
POSTED BY: Andrew C. Schneider (December 14, 2007 12:51 PM)
Andrew Schneider of Kiplinger here. Mr. Honick does raise a fair point, one which he and others asked about at the time of our last web story on the dollar. In response to this, we began conducting research on how the dollar's decline was affecting American expats. What we learned in the course of this was that, while US expats living in Europe and Canada have definitely been hurt by the decline of the dollar, the overwhelming majority of US expats live in regions relatively unaffected by the dollar's fall--primarily Mexico and Central America.
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