Will the deflating dollar take the wind out of markets?

The greenback is in danger of losing its pole position as the world's reserve currency. What does this mean for investors? And which other currency could possibly replace it? John Stepek investigates.

US Treasury Secretary Henry Hank' Paulson arrived in Africa this week for a meeting with the G20 group of nations. Treasury officials told Bloomberg about his goals for the trip.

In contrast to the usual perception of Africa as plagued by insurmountable problems, they said, "Secretary Paulson is going to try to shine a light on a place where sound governance, good economic management, implementation of fundamentally sound economic policy is having positive consequences".

Sadly for Mr Paulson, his peers at the meeting may have a great deal more to say about the soundness or otherwise of the US's economic policies, rather than Africa's.

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In recent months, the US has seen its housing slump maintain its steady progress towards a full-scale crash; heads have rolled at the country's biggest banks as they struggle to work out exactly how much money they've lost by lending carelessly during the good times; and a central bank eager to please Wall Street has slashed interest rates, despite growing evidence of rising inflationary pressures. This has triggered a slump in the already-fragile dollar since the first half-point rate cut in September, the dollar has fallen 4.6%.

Even the most egregiously incompetent African ruler might think twice before taking economic advice from the team running that particular economy. And the reality is that behind the scenes, Hank won't be getting much opportunity to talk about African success stories. Instead, just one topic will be uppermost in everyone's minds the weak dollar, and what should be done about it.

It's not hard to understand why the dollar is weak. If anything, it's harder to understand how it has managed to avoid a collapse for this long. As The Guardian puts it, the basic problem is that for a long time the US has been buying more goods and services than it has been selling. That's led to a large deficit with the rest of the world, and China in particular.

Up until recently, China has been willing to fund this effectively lending US consumers money that they then spend on goods imported from China. In doing so, China has built up vast foreign currency reserves $1.4trn or so in total. But increasingly China and other Asian and Middle Eastern countries are looking to diversify their currency reserves and earn a better return on their holdings by shifting out of dollars and into other currencies and asset classes.

The turmoil in the US economy has merely made this desire more urgent. Xu Jian, a vice-director at the People's Bank of China, helped initiate the most recent topple when he said that "the dollar is losing its status as a world currency". Meanwhile, Cheng Siwei, vice-chairman of China's National People's Congress, said "we will favour strong currencies over weaker ones, and will readjust accordingly".

The trouble is, when your currency is the most important one in the world, it's not just you that suffers when it takes a fall. In fact, when your currency is the most important one in the world, you are often the last to suffer. As John Connally, Treasury Secretary in the Nixon era, once told a group of visiting Europeans, the dollar "is our currency, but your problem".

Already Gulf nations are threatening to stop pegging their currencies to the dollar, amid surging inflation. Kuwait has abandoned its peg, while the United Arab Emirates has warned its link with the dollar has "reached a crossroads".

Meanwhile, the falling greenback is already playing havoc with global trade. As Ian Campbell reports on Breakingviews, "the tumbling dollar is making the US competitive but hitting growth elsewhere, especially in Europe." JP Morgan's October survey of purchasing managers, which provides an early indication of manufacturing and growth prospects, suggests that global manufacturing growth grew at its slowest pace since July 2003. While US exports picked up sharply, Germany, the world's biggest exporter, "suffered a huge five-point fall in its PMI in October".

Proponents of decoupling or the "happy handover" theory, as Ambrose Evans-Pritchards puts it in The Daily Telegraph like to think that the rest of the world will "pick up the growth baton as America slows". According to this view, "the US export boom is deemed proof of healthy rebalancing".

Unfortunately, this is looking more and more like a pipe dream. At the end of the day, no one wants their currency to be strong, particularly not against the dollar. Most of Asia is or is at least perceived to be extremely dependent on exports. You only have to witness the slide in Japan's Nikkei 225 every time the dollar falls against the yen to realise just how important exporters are to the country, while China's economy remains very much geared to providing the US population with cheap consumer goods.

But Canada and Europe are currently the most concerned about the dollar's slump. With China's currency trading in a tightly controlled range, and Japanese interest rates at negligible levels, they are being forced to bear the brunt of the plunge. The dollar has fallen by around 17% against the loonie since the start of the year, and by 11% on the euro, falling as low as a record $1.47. French president Nicolas Sarkozy has already warned Congress that "the yuan is already a problem for everyone. The dollar should not remain simply a problem for others. If we are not careful, monetary disarray could morph into economic war. We could all be victims".

But it's hard to see any reason why the dollar's lot will improve any time soon. The outlook for the US isn't getting any brighter. As Wolfgang Munchau puts it in the FT, "it is time to admit that the US economy is headed for a serious economic downturn." Former Economist editor Bill Emmott recently put the chances of a recession at 60%.

With the housing market set to get much worse before it gets any better and plenty of unexploded ordinance still waiting to be uncovered in the banking sectors' balance sheets, even that sounds optimistic to us. And even as the economy slips into recession, the weak dollar will fuel inflationary pressures.

In fact, research group Capital Economics reckons that "the massive surge in crude oil prices to close to $100 a barrel means that CPI inflation will probably jump to almost 5% by December. There is also now a good chance that GDP will contract over the final three months of the year as higher energy prices squeeze real incomes". The situation "is now bad enough to justify the stagflation label".

Ben Bernanke has tried to ease these concerns by claiming that "we're going to make sure the inflationary impact that may come from the weakening dollar is not passed into broader prices". But as Brady Willett says on FinancialSense.com, "beyond keeping the inflation statistics rigged, how exactly can Bernanke accomplish such a feat?" He could raise interest rates but that would mean accepting that a recession is a worthwhile price to pay to protect the dollar, something that would be politically unpopular and entirely out of keeping with recent central banking track records.


Mr Paulson (left) remains a staunch defender of the US. It may be in trouble now, but "looking out over any reasonable period of time, you're going to see our strong economic fundamentals shine through". But will they? Edward Hadas on Breakingviews isn't so sure. In fact, Hadas believes this latest bout of dollar weakness heralds "a new era the post-US period". "US global dominance is finally coming to an end years of trade deficits and underinvestment in infrastructure have lessened its economic might," while the war in Iraq has hurt its "military and political authority."

That's a pretty strong statement. After all, many of us have never known a time when the dollar was not the world's dominant currency that makes it particularly hard to imagine a world without it in pole position.

But then, until a couple of months ago, it was hard to imagine that we'd ever again see queues lining up outside a stricken British bank. And as Hadas points out, a loss of faith in the dollar could have very similar consequences to the recent loss of faith in the financial system caused by US subprime mortgages only much worse. "The biggest long-term risk from a fast-falling dollar is financial, not industrial," he argues. "Foreigners are owed a net $8trn by US debtors, the cumulative effect of decades of trade deficits." Even with the trade deficit slipping back recently, "foreigners have to be willing to add almost $700bn a year to their dollar portfolios" to keep the currency from falling. "That's a big bet on an economy with falling interest rates and signs of sharply slowing growth."

Hadas notes that "if traders come to doubt the value, in foreign currency terms, of their dollar assets, many cross-border financial markets could freeze up. Think of the troubles that have followed doubts on mortgage-backed securities and multiply by eight."

Even if the transition from the dollar standard isn't this traumatic, Hadas isn't the only one who suspects the dollar's days are numbered. Merrill Lynch last month released a note using the decline of the gold standard as a template for how the shift from dollar dominance could take place. "Following the demise of the gold standard, central banks only slowly moved to reduce the share of gold in their reserves."

There are three stages to the process, says Merrill. Denial is when central banks refuse to accept diversification is necessary this stage is now over. "Now there are many central banks discussing the possibility of diversification and their desire to do so." Step two, "don't sell, don't buy", is when central banks stop buying as many dollars, but don't sell existing stocks. "Given US financing needs, even this sort of passive diversification will put downward pressure on the US dollar."

Finally, at stage three, central banks decide to sell dollars and this is where it can get messy. Merrill says that something like the Washington Gold Agreement established to "provide a structure to central bank gold sales" could be the best bet to prevent a messy rush for the exits and a dollar collapse. The bank reckons the whole process could take five to ten years to pan out. "It takes time to accommodate global agreements and co-ordination and then physically diversify the massive level of existing stocks."

So the dollar's relegation from the position of world reserve currency won't happen overnight, but it's by no means an impossible or unlikely event. We take a look at how the world's other currencies measure up below, and at the one investment that should benefit, regardless of how the dollar's decline plays out.

Which currency could replace the dollar?

The dollar is becoming less popular. The share of global currency reserves allocated to dollars fell to 64.8% in the second quarter, from 66.1% the year before, says the International Monetary Fund. The euro's share hit an all-time high of 25.6% from 24.8%, while the pound accounts for just 4.7% and the yen, 2.8%.

Clearly, when a currency still accounts for nearly two-thirds of global reserves, it will take a long time to change the balance, but the financial turmoil certainly makes a transition seem more likely. The question is: which currency could take its place?

The euro

Having been derided in its early days, the euro has rapidly gained mainstream respectability and is seen by many as the most obvious candidate for new world reserve currency. "The euro has earned what it has got," said Stephen Jen of Morgan Stanley recently of the currency's strength. "It is not simply rallying by default." And as Edward Hadas says on Breakingviews, "the euro represents a larger economic zone than the dollar, with the added advantage of a trade surplus."

But the euro hasn't been around for long and it has some serious potential structural problems. The likes of Spain and Ireland are heading for housing-market crashes, while interest rates are set at levels more suited to the eurozone's dominant economies, such as Germany, which could lead to disputes between members or even to some countries attempting to leave the euro. The single currency has yet to be tested in a major economic crisis, although it may not be long before the opportunity arises.

The pound

The weak dollar is bad news for sterling investors. A recent study from Morgan Stanley suggests that, due to the number of companies reporting in dollars, for every 10% fall in the dollar, 2.6% is wiped off dividends paid on the FTSE 350. So it could be a good thing that sterling's strength isn't likely to continue for much longer. The pound has risen 9% against the dollar this year, but has actually fallen 5.5% against the euro.

The trouble is that the UK suffers from many of the same problems as the US. We have a significant current-account deficit, while our housing market is also in danger of suffering a US-style fall. Consultancy group Capital Economics expects the pound to fall back to $1.95 by the end of 2008.

The yuan

Commodities guru Jim Rogers says he is in the process of moving all of his money out of dollar assets and into yuan (and the carry trade currencies see below). "The yuan has to triple, it has to quadruple," he says. The Chinese currency is currently tied to within a very tight range of the dollar, but Rogers believes it will be allowed to float freely by 2010, if not before, because while the weak yuan props up exports, it is starting to cause serious inflationary problems.

However, China's dependence on the US consumer buying its cheap goods would be sorely tested if the yuan were to strengthen significantly. And if investors are concerned about the eurozone, then how much more proof will they need that China's growth is sustainable without a major economic crisis? No wonder Stephen Roach of Morgan Stanley is sceptical. "There's no way the yuan can even approach the dollar's status as the world currency."

The yen

The yen is probably the most interesting currency at the moment. Held back for years by low interest rates and central bank intervention it seems an unlikely candidate for reserve currency. But investors shouldn't dismiss it. It is likely to be one of the main beneficiaries of turmoil in the financial markets because it is the main carry trade currency along with the Swiss franc.

As fearful traders bail out of risky positions fuelled by cheap loans in yen, the currency will rise. The move has already started since July, the yen has risen from around 124 to the dollar to around 110 now.

For those who want to play the yen directly, spreadbetting is probably the easiest way to do so, but you must be very careful see How to make big profits from small stakes for more on how to spreadbet currencies. A safer option is to buy Japanese assets, which will appreciate in sterling terms as the yen rises.


Right up until 1971, gold played a role in underwriting the financial system. As fears grow over the reliability of paper money, the yellow metal's role as a store of wealth is once again making it increasingly attractive to investors.

The odds of a gold-backed currency re-emerging still seem very slim. But with central banks and individuals uncertain about which paper currency will end up being the most dominant a situation that could go on for years they will be increasingly drawn to the one asset that holds its value regardless of what paper money does.

There are many ways to buy into gold, but British investors may be interested in a sterling-denominated Exchange Traded Fund from ETF Securities. Launched last month, the fund ETFS Physical Gold (PHGP) tracks the gold price in sterling and can be put into an Isa.

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.