Vivek Kaul
Over the last few years a mini industry predicting the demise of the dollar has evolved. This writer has often been a part of it. But nothing of that sort has happened.
There are fundamental reasons that have led this writer and other writers to believe that dollar is likely to get into trouble sooner rather than later. The main reason is the rapid rate at which the Federal Reserve of United States has printed dollars over the last few years. This rapid money printing is expected to create high inflation sometime in the future.
But whenever markets have sensed any kind of trouble in the last few years money has rapidly moved into the dollar. In fact, even when the rating agency Standard & Poor’s downgraded America’s AAA status, money moved into the dollar. It couldn’t have been more ironical.
What is interesting nonetheless that the doubts on the continued existence of the dollar are getting graver by the day. Gillian Tett, the markets and finance commentator of The Financial Times has a very interesting example on this in her latest column Is Dollar As Good as Gold published on March 1, 2013.
As Tett writes “Should we all worry about the outlook for the mighty American dollar? That is a question that many economists and market traders have pondered as economic pressures have grown. But in recent weeks Virginia’s politicians have been discussing it with renewed zeal. Last month Bob Marshall, a local Republican, submitted a bill to the local assembly calling on the state to study whether it should create its own “metallic-based” currency.”
The reason for this as the bill pointed out was that “Unprecedented monetary policy actions taken by the Federal Reserve … have raised concern over the risk of dollar debasement.”
In fact Virginia is not the only state in the United States that has been talking about a currency backed by a precious metal(read gold). As Tett puts it “So guffaw at the Virginia bill if you like. And if you want an additional chuckle, you might also note that a dozen other state assemblies, in places such as North and South Carolina, have discussed similar ideas; indeed, Utah has a gold and silver depository which is trying to back debit cards with gold.”
The point is that the debate on the demise of the dollar if it continues to be printed at such a rapid rate, is now moving into the mainstream.
So what will be the fate of the US dollar? Will it continue to be at the heart of the global financial system? These are questions which are not easy to answer at all. There are too many interplaying factors involved.
While there are fundamental reasons behind the doubts people have over the future of the dollar. There are equally fundamental reasons behind why the dollar is likely to continue to survive. But one good place to start looking for a change is the composition of the total foreign exchange reserves held by countries all over the world. The International Monetary Fund puts out this data. The problem here is that a lot of countries declare only their total foreign exchange reserves without going into the composition of those reserves. Hence the fund divides the foreign exchange data into allocated reserves and total reserves. Allocated reserves are reserves for countries which give the composition of their foreign exchange reserves and tell us exactly the various currencies they hold as a part of their foreign exchange reserves.
Dollars formed 71% of the total allocable foreign exchange reserves in 1999, when the euro had just started functioning as a currency. Since then the proportion of foreign exchange reserves that countries hold in dollars has continued to fall. In fact in the third quarter of 2008 (around the time Lehman Brothers went bust) dollars formed around 64.5% of total allocable foreign exchange reserves. This kept falling and by the first quarter of 2010 it was at 61.8%. It has started rising since then and as per the last available data as of the third quarter of 2012, dollars as a proportion of total allocable foreign exchange reserves are at 62.1%. The fall of the dollar has all along been matched by the rise of the euro. But with Europe being in the doldrums lately it is unlikely that countries will increase their allocation to the euro in the days to come. Between first quarter of 2010 and the third quarter of 2012, the holdings of euro have fallen from 27.3% to 24.14%.
So the proportion of dollar in the total allocable foreign exchange reserves has fallen from 71% to 62.1% between 1999 and 2012. But then dollar as a percentage of total allocable foreign exchange reserves in 2012 was higher than it was in 1995, when the proportion was 59%.
So when it comes to international reserves, the American dollar still remains the currency of choice, despite the continued doubts raised about it. One reason for it is the fact that there has been no real alternative for the dollar. Euro was seen as an alternative but with large parts of Europe being in bigger trouble than America, that is no longer the case. Japan has been in a recession for more than two decades not making exactly yen the best currency to hold reserves in.
The British Pound has been in doldrums since the end of the Second World War. And the Chinese renminbi still remains a closed currency given that its value is not allowed to freely fluctuate against the dollar.
So that leaves really no alternative for countries to hold their reserves in other than the American dollar. But that is not just the only reason for countries to hold onto their reserves in dollars. The other major reason why countries cannot do away with the dollar given that a large proportion of international transactions still happen in dollar terms. And this includes oil.
The fact that oil is still bought and sold in American dollars is a major reason why American dollar remains where it is, despite all attempts being made by the American government and the Federal Reserve of United States, the American central bank, to destroy it. And for this the United States of America needs to be thankful to Franklin D Roosevelt, who was the President from 1933 till his death in 1945 (in those days an individual could be the President of United States for more than two terms).
At the end of the Second World War Roosevelt realised that a regular supply of oil was very important for the well being of America and the evolving American way of life. He travelled quietly to USS Quincy, a ship anchored in the Red Sea. Here he was met by King Ibn Sa’ud of Saudi Arabia, a country, which was by then home to the biggest oil reserves in the world.
The United States’ obsession with the automobile had led to a swift decline in domestic reserves, even though America was the biggest producer of oil in the world at that point of time. The country needed to secure another source of assured supply of oil. So in return for access to oil reserves of Saudi Arabia, King Ibn Sa’ud was promised full American military support to the ruling clan of Sa’ud..
Saudi Arabia over the years has emerged as the biggest producer of oil in the world. It also supposedly has the biggest oil reserves. It is also the biggest producer of oil within the Organisation of Petroleum Exporting Countries (OPEC), the oil cartel. Hence this has ensured that OPEC typically does what Saudi Arabia wants it to do. Within OPEC, Saudi Arabia has had the almost unquestioned support of what are known as the sheikhdom states of Bahrain, Kuwait, United Arab Emirates and Qatar.
In fact, in the late 1970s efforts were made by other OPEC countries, primarily Iran, to get OPEC to start pricing oil in a basket of currencies (which included the dollar) but that never happened as Saudi Arabia put its foot down on any such move. This led to oil being continued to be priced in dollars and was a major reason for the dollar continuing to be the major international reserve currency.
It is important to remember that the American security guarantee made by President Roosevelt after the Second World War was extended not to the people of Saudia Arabia nor to the government of Saudi Arabia but to the ruling clan of Al Sa’uds. Hence, it is in the interest of the Al Sa’ uds to ensure that oil is continued to be priced in American dollars.
And until oil is priced in dollars, any theory on the dollar being under threat will have to be taken with a pinch of salt because the world will need American dollars to buy oil. Also it is important to remember that financially America might be in a mess, but by and large it still remains the only superpower in the world. In 2010, the United States spent $698billion on defence. This was 43% of the global total.
So dollar in a way will continue to be as good as gold. Until it snaps.
The piece originally appeared on www.firstpost.com on March 5, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek and continues to actively bet against the dollar by buying gold through the mutual fund route)