LONDON (ResourceInvestor.com) -- The U.S. dollar closed 2005 having gained ground on other major currencies more or less throughout the year, in defiance of fundamentals that should form a millstone around its neck.
The primary bear point for the dollar is the fact that the imports of the U.S. economy continue to significantly outweigh its exports in terms of aggregate value; the balance of trade deficit. The balance of trade is usually the most significant determinant of a free floating currency's level of parity with other currencies, which generally speaking should adjust to foster something approximating to longer term equilibrium.
Yet, the U.S. trade deficit persists, and the dollar holds a higher valuation than should be the case on the basis of the U.S. economy's trading position. There is of course an explanation for this; a conglomerate of factors not directly related to the U.S. balance of trade is currently supporting the dollar, leaving the currency's longer term position unresolved.
As your correspondent has previously expounded at some length, this monumental discrepancy in the global economic system is probably the main factor that has been propelling the price of gold upwards, by virtue of the metal's widely perceived status as a safe haven when the values of other asset classes, including major currencies and in particular the dollar, are uncertain.
The dollar has played the role of the world's main reserve currency since shortly after the Second World War, but can no longer be considered eminently suitable for this role due to its obvious overvaluation from a longer term perspective. The precarious position of the dollar puts the valuation of mineral commodities other than gold in jeopardy, as a shock to general U.S. demand brought on by the decline of the dollar and its consequent impact on the international purchasing power of U.S. economic agents could potentially induce a temporary global economic downturn, which could depress the prices of such commodities for its duration.
In fact, it is the fear of this downturn that is impelling the dollar's two major sources of support: the central banks of East Asia, namely those of China, South Korea and Japan and the Federal Reserve Bank of the U.S. Both have an interest in delaying and ameliorating the impact of the eventual downward settlement of the dollar's parity, in order to safeguard the interests of their respective economies.
The East Asian central banks are all acutely aware of the significant role played in their economies by exports to the U.S., plus to the rest of the Anglosphere and to continental Europe, the economies of both of which groups could be damaged by a downturn in the economy of the U.S.
Therefore, the East Asian central banks are supporting the valuation of the dollar by pouring much of the accumulated proceeds of their economies' trade surpluses into the purchase of U.S. treasuries, not out of enthusiasm for U.S. government debt, but in the knowledge that these purchases shore up the value of the dollar by creating a demand for the currency on the open market.
This shoring up protects U.S. economic agents from the reduction in their global purchasing power that is inextricably accompanied by any decline in the parity of the dollar, and as a result helps maintain their demand for the exports of the East Asian economies.
The Fed's recent policy of rate tightening, though ostensibly motivated by a zeal to combat inflation, may also be motivated by a desire to maintain the value of the dollar, or at least ease its downward adjustment. This task can be seen as currently central to the Fed's broader mission of encouraging economic growth and stability in the US economy.
A secondary factor supporting the dollar is the flow of funds from Petrostates, largely those in the Middle East, into U.S. assets. Much of this flow is channeled through London, partly to take advantage of the financial expertise of the City and partly to conceal the origins of the flow.
It is unclear whether the direction of Middle Eastern oil revenues into U.S. assets is being motivated by the simple desire for profit, given the comparative absence of attractive investment opportunities in the Middle East itself, or by an impulse similar, though not totally analogous, to that of the East Asian central banks; to maintain U.S., East Asian and European demand for Middle Eastern oil and perpetuate the windfall currently being enjoyed by the region as global demand for oil grows and revenues accrue to the Middle East out of all proportion to the region's otherwise almost nonexistent economic output.
It is however somewhat questionable whether the governments of the Middle East would be likely to formulate such a sophisticated policy as to deliberately engineer support for the dollar, meaning that the seeking of profit may be the main motive behind flows of Middle Eastern funds to the U.S. In any case, with regard to the dollar, the activities of the East Asian central banks and of the Fed are clearly and intrinsically of greater importance than the flow of Middle Eastern oil revenues, although the latter is still worth noting.
Masking the issue of the dollar's overvaluation is the misconception that the real issue is an undervaluation of the Chinese yuan. Although the yuan may be undervalued to a degree, this is almost certainly less significant than the overvaluation of the dollar. It is instructive to remember that the U.S. does not only run a trade deficit with China but with the world as a whole, trade with China accounting for only part of this. Furthermore, some appreciation of the yuan has already been allowed by the Chinese authorities, with no noticeable effect on the U.S. balance of trade.
For a long time, the dollar has enjoyed a valuation premium as the U.S. was perceived as the world's leader economy, the roots of which situation date back more than half a century to the ravages of World War II, which the U.S. was alone among the natural first rank economies in escaping.
But now that the status of leader economy is no longer deemed to be merited, the dollar is due a decline. Although this has already begun to occur, in spite of the mild resurgence that has characterized 2005, the factors here adumbrated that are supporting the dollar at its current level can be seen as indicating strongly that in all likelihood, there is more depreciation to come.
Assuming that this is the case, two pertinent questions arise: when will this further depreciation occur, and how economically benign will the process of adjustment be? The best scenario would be for the Federal Reserve and the East Asian central banks, whether by cooperating or simply through their independent targeting of the same objective, to manage the dollar's decline in a manner that minimizes or eliminates the potentially consequent damage to the global economy. Hopefully, this will be the scenario that prevails, for the alternatives may not be pleasant.
