Thursday, October 9, 2008

Will the US dollar collapse?


As we mentioned in The ABCs of hedging, the first step in hedging our investments is to subject our portfolio to ‘war-games,’ where we work out how it may perform under various economic what-if scenarios and come up with strategies to counter the unfavourable outcomes.

Today, we look at one possible scenario—the decline (or collapse) of the US dollar.

Lately, we are again hearing that central bankers are murmuring about diversifying their foreign reserves away from the US dollar. Does it mean that there is an imminent liquidation of their US dollar reserves? Well, this is not the first time they murmured about it and it is definitely not in their (including the Federal Reserve’s) interest to see a collapse of the US dollar. The Chinese, with their US$1 trillion of reserves, would not want to see their stockpile of US dollars to lose significant value. The same goes for the Japanese and the oil-rich Middle-Eastern nations. The US too, would not want to see their dollar collapse as that would result in soaring inflation in their homeland. Therefore, we do not expect mass selling of US currency reserves by central bankers in the near term.

On the other hand, it is open knowledge that the status quo is unsustainable. This morning, we heard that Alan Greenspan (the former US head of Federal Reserve) warned investors in a business conference in Tel Aviv to expect a few years of dollar weakness. He further said that is imprudent to hold everything in one currency. This prompted a further slide of the US dollar against the Euro. The US has the dubious honour of having the world’s greatest trade deficit. If not for the fact that the US dollar is (maybe ‘was’ is the more appropriate word) the world’s reserve currency, the US would be consigned a banana republic long ago. The world cannot lend to the US indefinitely. Sooner or later, they will demand a pay back. The moment they decide that the US will not and is unable to repay its debt, what will happen to the US dollar? What will happen to the global financial system when that happens?

Thus, this situation is akin to an individual owning the bank money. If he owes the bank a million dollars, he is in trouble. But if he owes the bank a billion dollars, the bank is in trouble—if he goes bankrupt, a large portion of bank’s loan portfolio will be wiped out, rendering the bank insolvent. The US owes the rest of the world so much money that they cannot afford to let the US go ‘bankrupt.’ But the rest of the world knows that sooner or later, the US will go ‘bankrupt.’ (Of course, a country cannot be bankrupt in the same way as individuals do because there is always the option to print money to remain solvent. But the end result will be just as horrible—hyperinflation.) What can be done?

We are all living in a precarious situation. We shudder to think of the day when a black swan event happens. On that day, whoever owns gold will have a lot of friends.
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