Wednesday, November 24, 2004

The Death of the Dollar (Yankee that is!)


Mark Twain once wrote, after he had seen his name in the obituary column, .The rumors of my demise have been greatly exaggerated.. And maybe predicting the death of the Yankee sawbuck is a bit premature. But without a doubt, the US dollar is one sick puppy.

On Friday Mr. Sunshine, yes I mean Alan Greenspan, finally could take it no more. The sinking of the greenback has sickened even him. And so he abandoned his cryptic ways and spoke candidly about what continued weakness in the dollar could mean.

First some background. The US dollar has become the reserve currency for many countries, particularly in Asia. Their own currency is backed by reserves of US Treasury Bills. Japan has a lot of them and has periodically stepped in to buy more in an effort to prop up the dollar. Why? Because as the Yankee greenback falls, the yen appreciates, making Japan less competitive in the American market. And China has been accumulating US dollars because it has a huge trade surplus with the United States. More Chinese goods are heading to America than the other way around. To keep competitive, the Chinese government pegged the Chinese yuan to the American dollar, meaning that as the dollar moves, so does the yuan. Buck goes down, China stays competitive. The Americans have been railing against this policy to no avail.

But other currencies, including the Canadian dollar, have soared against the greenback. Why? Well, Canada has run seven consecutive fiscal surpluses. The United States has been running deficits, the latest one a $412 billion dollar deficit for the fiscal year ended September 30th. Canada also has a current account surplus, meaning that, like China, Canada exports more than it imports. The United States has a US$600 billion trade deficit meaning it has to borrow money from abroad to fund its imports. If individuals or corporations were as profligate as the United States government, the end result would eventually be bankruptcy.

Back to Greenspan. Friday he told the European Banking Congress in Frankfurt that given the size of the US trade deficit, .a diminished appetite for adding to dollar balances must occur at some point..

International investors, he added, will eventually adjust their accumulation of dollar assets or, alternatively, seek higher dollar returns to offset concentration risk, elevating the cost of financing the US current account deficit and rendering it increasingly less tenable..

In less elegant and perhaps more understandable English, the you-know-what is about to hit the fan! His remarks immediately sent the dollar down to a four year low against the yen and it also sank against the Euro, which is becoming increasingly attractive as an alternative reserve currency. And while the US stock markets blithely continue to rise, Mr. Greenspan warned Friday that at some point, foreigners might lose interest in US dollar denominated investments, something that would send stock markets into a tailspin and interest rates soaring.

This has, in fact, already started. A headline buried deep in Friday.s Financial Post blared Chinese dump US dollars.. The feature article told how individual Chinese are moving out of the dollar. One man who had set aside US$50,000 to educate his son in the United States told of his regrets he had not held the stronger Euro or Japanese yen. .The dollar doesn.t mean anything anymore,. said another person on line at the Bank of China waiting to unload her dollars. Some are converting US dollars into Chinese yuan despite the official peg. They don.t believe that parity can be maintained and that the yuan will inevitably rise against the greenback. .The renminbi (yuan) is the hard currency now,. shouted one man as he liquidated US$10,000 in US stocks and converted it into the Chinese currency.

It used to be that black markets in currency such as existed in the former Soviet Union sold US dollars at inflated prices to those wanting to bail out of a worthless ruble or other weak currency. Today the black market in Shanghai is selling yuan to those wanting to bail out of the dollar. This reversal of roles on the black market is possibly the most telling trouble sign of all.

In an unusually blunt statement, Mr. Greenspan noted that Rising interest rates have been advertised for so long and in so many places that anyone who has not appropriately hedged this position by now obviously is desirous of losing money..

Significantly, President Bush on Friday approved raising the US debt limit by US$800 billion to US$8.2 trillion. That is not small change!

It.s Baaacckkk!!!!

Compounding the woes of the US dollar is a dragon some thought the US government had soundly slain in the 80s. Inflation! Well, it.s baaaccckkk!!!!

Last Tuesday the Producer Price Index for October was released showing US wholesale prices up 1.7% for October. This was triple the expected 0.6% and the highest inflation jump in fifteen years. Some blame this on high oil prices and a trickle down effect on the economy, but even core inflation, which strips out volatile food and energy items, rose 0.3% in October, also three times expectations.

Wednesday the Consumer Price Index was released showing a 0.6% increase from September. The core rate was up 0.2%.

Some analysts averred that the stock market bubble of the late 90s was inflation driven, that even though traditional measures of inflation showed it to be in check, it was showing up in surging stock prices.

After the crash brought reality back to the stock market, a new bubble has formed. Real estate! Patti Croft, chief economist for Vancouver-based Phillips, Hager and North Investment Management, sounded the alarm after a recent PH&N study showed that there were clear signs of a continent wide bubble in the US housing market. A bubble, incidentally, not evident in the Canadian market. US housing prices are rising at a pace that .we just don.t think is sustainable,. said Croft. On top of that, US consumer debt is at record highs and many Americans have leveraged their homes to take advantage of low interest rates and high valuations. This has fuelled consumer spending in the States, helping fuel recovery. But as rates continue to rise, this bubble, like the stock market bubble, could collapse.

This would produce a double whammy effect . many debtors will face a cash flow crunch and will cut back on spending. This would create a downturn in the economy.

In fact, this has already happened in the UK and Australia where rapidly rising interest rates have cooled off house prices and in the Netherlands where a downturn in the housing sector has caused a .deep downturn. in the economy.

While the US stock market seems to have weathered the storm and is now on the rise again, the fiscal chickens are starting to come home to roost. How long this can continue until the crunch comes is anyone's guess. But investors should be cautious on the US market.


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