If you have been holding the US dollar in savings since 2002, you will find that you have now lost around 27 per cent or more of that wealth.
This has raised a stark question as to whether the US dollar can continue to become a standard of wealth. One US report has even gone so far as to suggest that the US is experiencing a breakdown of the dollar system, similar to the 1971 breakdown of the Bretton Woods system.
The US is now on the edge of a full-blown balance-of-payments crisis. Like Thailand during the pre-crisis of 1997, the US has been consuming beyond its means for several decades. This reflects in both the huge annual budget and trade deficits. At the same time, US consumers have been saddled with debt. Uncle Sam thought that it could bail itself out by printing the US dollar on even more debt. But the financial markets have their own rules.
A country may run a bad macro-economic policy for some time, but it can't continue to do it forever. A day of reckoning comes when the financial markets force the country to adjust the macro-economic conditions in a painful way.
Thailand faced that painful experience in 1997 when the financial markets forced it to abandon the currency peg, causing the baht to fall from Bt25-Bt26/dollar to Bt56/dollar between July 1997 and January 1998. With more than US$100 billion in foreign currency debt (Bt5 trillion), Thailand was declared bankrupt by the collapse of its currency. The US is about to face a similar crisis.
The US sub-prime mortgage crisis is a symptom of the US imbalances, which are the root of the crisis. Recent financial developments and extreme provisions of liquidity show that investors are now very bearish on the dollar. The US economy is led largely by domestic demand, driven by consumption. The Americans used to have easy credit. Now their access to credit has been shut down. As a result, US businesses are under financial strain. Dollar-denominated debt is trading at historically high spreads.
The US Federal Reserve has been providing unlimited liquidity to prevent the financial system from breaking down and to prevent the economy from sharp contraction. But unlimited liquidity does not address the underlying bad debt that has spread fast across the world's largest economy.
The US has been issuing Treasury bonds to finance its debt and to keep its financial system and economy afloat. So far there has not been a huge loss of appetite for US government bonds. But other countries, including Thailand, are shifting their reserve holdings into other assets such as the euro. With the contracting economy and the magnitude of the financial crisis, the US will find it even more difficult to attract foreign capital. If the situation is prolonged, it will face growing pressure on its balance of payments.
Sovereign funds from Singapore, China, and the Middle East snapped up US assets sold out at distressed value. Now a lot of people are saying that they got in too early, as the market is far from bottoming out.
The US balance of payments situation might lead to a sharp contraction of US consumption and also to a broader decline of the US dollar as US households find it difficult to get out of the debt cycle. The implication is that the income gap between US workers and those in emerging countries, now about 15 to 1, will have to narrow.
The US dollar decline will occur mostly against the emerging market currencies. So far, Asian countries, including Thailand, have been intervening in the foreign exchange market to curb the rise of their currencies. They all want to export goods because their domestic markets are too small to absorb their manufacturing activities.
Since 2002, the baht has appreciated by about 37.5 per cent against the dollar, compared with 35.6 per cent for the South Korea won, 33 per cent for the Singapore dollar, 31 per cent for the Japanese yen, 23.1 per cent for the Philippines peso, 19.5 per cent for the Malaysian ringgit, 18.2 per cent for the Chinese yuan and 10.3 per cent for the Indonesian rupiah.
This adjustment against the US dollar will continue and the pace is likely to accelerate. Singapore last Thursday announced a modest adjustment in the centre of its currency band. By doing so, it is telling the world that it is allowing its currency to adjust upward in a more orderly fashion. A UOB report on April 10 estimated that the Singapore dollar is likely to move up 2.50 per cent in the nominal effective exchange rate annually under the new currency arrangement.
The Thai authorities are also managing the baht under the nominal effective exchange rate framework, which has keep the currency relatively stable. The basket of currencies is believed to consist of 55 per cent dollar, 35 per cent euro and 10 Japanese yen.
Yet with China emerging as a regional anchor, any management of the baht will have to be in tandem with the yuan, which is also facing pressure of appreciation.
The world has not pondered deep enough what will happen to the dollar and the global financial system if the dollar loses its glamour amid the ongoing crisis. It could have far reaching implications.
Monday, April 21, 2008
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