The value of U.S. Dollar
One of the most powerful and potentially profitable investment implications likely to result from emerging economies reaching critical mass is the future value of the U.S. dollar, which has been the undisputed global reserve currency since the end of WWII. Many thoughtful and influential market participants expect the U.S. dollar to continue to play that role, if for no other reason that there are no viable alternatives. They will likely point to the euro (€) as suffering from a lack of political union among member states and the significant financial crises among peripheral countries. The British pound, notwithstanding the fact that it was the global reserve currency for most of the 18th and 19th centuries, is not a realistic contender given the small size of the U.K. economy. Nor is the yen, with the diminishing economic status of Japan, following two decades of economic stagnation.
Notably absent from the list of alternatives above are the currencies of the BRIC countries. Why? Because none of these currencies are freely convertible. Each of these countries has some system of capital controls that significantly limit foreign exchange transactions. Governments use capital controls to keep control of their currencies by not allowing currency to leave the country freely and by requiring foreign entities to exchange only with the central bank or its agents. On the trading floors of the large international banks you can trade U.S. dollars, Japanese yen, euros, British pounds, Mexican pesos and Polish zlotys and dozens of other currencies for delivery into your bank account, but if you want to buy or sell Chinese renminbi, Brazilian real, Indian rupees or Russian rubles you can only do so in the “offshore” derivative market, where buyers and sellers pair up with no physical currency changing hand, and all gains or losses are settled in a different agreed currency.
So while it is true that no emerging currencies have yet reached critical mass as a viable replacement, there are many reasons to expect a secular decline in the value of the U.S. dollar.
Emerging countries hold the lion’s share of international reserves, mainly in the form of U.S. dollars and to a lesser extent euros. They appear to be increasingly concerned that the weakening U.S. economy and banking system, the increase in money supply and other factors may reduce the value of the dollar over time. Notably, they have been voicing concerns in international forums like recent G8 meetings, and they have taken some (perhaps small) steps to reduce dependency on the U.S. dollar.
Capital must flow somewhere, and recent data suggest that the patterns of the previous decades, when capital flowed out of emerging countries and back into core countries has to some degree reversed. Clearly the U.S. dollar benefitted from a strong flight to quality bid during the global banking crisis. However, recently we have witnessed a reversal of those flows, arguably at least in part due to concerns that the massive amounts of U.S. dollar liquidity produced in response to the crisis.
And while we have not yet reached the point where a new global reserve currency will arise, we are clearly seeing a loss of status for the U.S. dollar as a store of value even in the absence of a single viable alternative. In combination with other factors, that likely means a continuing devaluing of the U.S. dollars versus other currencies, especially the EM currencies.
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