“The dollar is our currency, but your problem,” quipped US Secretary of the Treasury, John Connolly, to his European counterparts in 1971. Today, nearly 40 years later, his words couldn’t ring truer. While the value of the US dollar weakened relative to the world’s other major currencies for most of the George W. Bush presidency, the slide became ever more precipitous in the first half of 2008. This helped spur inflation across the Middle East — where the value of many countries’ currencies are pegged to the greenback — as imports priced in euros, yens and anything other than dollars quickly became more expensive.

For states in the Gulf Cooperation Council (GCC), the equation was even more costly as the dipping dollar eroded the value of their trillions in accumulated dollar holdings. New revenues from oil receipts are also priced in dollars, and so even as the dollar price per barrel of oil reached record highs through the first half of 2008, the value of each dollar earned from oil was declining.

What was pushing the dollar down? The factors are numerous, complex and interrelated, but part of the answer is that America has been living well beyond its means and is thereby exposed to significant liabilities. Total US government debt surpassed $10 trillion in September 2008, helped along by the trillion dollar tax cuts early in Bush’s presidency and the hundreds of billions absorbed by military adventures in Iraq and Afghanistan. More generally, however, the American economy simply consumes more than it produces and has been doing so for a long time — in 2008 this imbalance amounted to $677 billion. The US has run an annual balance of payments deficit on current accounts of approximately six percent of GDP for most of the last decade, implying that for every $100 worth of goods and services produced, America consumes $106 worth. Where does the other six dollars come from? In essence, America has been borrowing money from the rest of the world.

If the Americans could have continued forever printing more dollars to send out into the world in exchange for the tangible products the rest of the world makes, they might not have had a problem. However, as total American debt lurched ever higher through the 2000s, moneylenders everywhere began to question America’s ability to pay this money back. These creeping doubts meant that US debt — effectively the dollars sent abroad — became less attractive to hold onto, thus contributing to the dollars declining value.

US dollar against major world currencies

Monthly average values

Welcome to the financial crisis

The grinding slow-down in the US economy through 2008 led the US Federal Reserve Bank to continually lower interest rates to try and encourage growth, with the January 2008 rate of 4.25 percent falling to 0.25 percent — effectively zero — by year’s end. Yet as the global financial crisis began to cascade and investors’ August of angst morphed into September’s sheer panic, capitalists grabbed their money and ran to where they always run when Armageddon seems nigh, the pocket of their champion, Uncle Sam.

“Despite the next to nothing yield offered by dollar denominated investments, a flight to safety into US dollars and government bonds has kept the US dollar from collapsing,” wrote Kathy Lien, director of currency research at FX360.com, in a December 2008 report. “The concern for safety was so high that investors were willing to take negative yields just to park their money with the US government.”

Thus, since August 2008 the dollar’s dive has U-turned — albeit, far from smoothly — riding demand for dollar-shelter and appreciating nearly 20 percent against the euro between July 2008 and February 2009. How can this be happening when there are so many good reasons to sell the dollar? The non-partisan Committee for a Responsible Budget estimated that the different bailouts and stimulus packages the US government has announced will total $2.6 trillion in new spending; Morgan Stanley predicts the 2009 US deficit at $1.5 trillion, or some 10 percent of GDP. While some of this new spending will be paid for through new borrowing, the rest of the money will be created, in essence, out of thin air.

“The Federal Reserve is basically printing money and using that money to flood the market with liquidity, eroding the value of the US dollar in the process,” noted Lien. “The central bank will not be worried about a weaker currency and will in fact welcome one because they know that a weaker currency is like an interest rate cut in many ways because it helps to support and stimulate the economy.”

Foreign exchange traders are a cynical lot. More than one has noticed the long-term benefits to America in driving the dollar down. Effectively, it allows the US to renege on a portion of its foreign debt, as US debt is denominated in dollars. If, for example, an American borrowed $100 worth of euros and used them to purchase goods in July 2007, they would have been able to buy 73 euros worth of stuff. If they repaid the $100 a year later in July 2008, after the US dollar had declined in value, it would only have bought 64 euros worth of stuff, meaning whoever lent America that money is getting short changed.     

As well, American workers need jobs and American politicians lose theirs when unemployment remains high. A high value for the dollar means that foreign imports into the US are continually displacing American producers, while a low dollar produces a surge in exports and creates jobs for middle class Americans, thereby preserving political careers.

The Chinese checker

While many countries worry about dollar devaluation, few have more to lose than China, by far America’s largest lender with a staggering $1.95 trillion in its foreign exchange reserves. The US has been able to run such a large balance of trade deficit for so long in large part because China has, essentially, been recycling its trade surplus — which was $262 billion in 2008 — back into buying US treasury bonds, supporting the dollar’s value, keeping US interest rates low and lending America back the money to buy more Chinese goods. Daniel Sternoff, director of emerging markets and energy research at Medley Global Advisors (MGA), explains that China’s trade surplus will shrink if China’s exports fall as the world economy weakens, or if China’s own $580 billion economic stimulus package to bolster domestic demand successfully props up its economy, keeping imports “at a relatively decent level.” These possible scenarios make it uncertain whether China will continue to have sufficient trade surpluses in 2009 to recycle back into the US treasury market to prop up the dollar.

“And that’s just a question of what’s the overall supply of dollars they have to be purchasing more,” says Sternoff. “Whether they will begin to sell their reserves outright is more of a political question, and we have received some indications that they are going to be spending at least $300 billion of their foreign exchange reserves.” 

A nightmare scenario for the US and the global economy at large would be if China began dumping its US reserves. This would flood currency markets with dollars, causing their value to drop, in turn evaporating the value of US dollar savings held by countries, companies and people the world over and writing off the US as the globe’s largest export market. Beijing has “serious worries over the potential for much greater dollar weakness and the erosion of the value of their holdings,” and has been looking for ways to try and diversify its reserve holdings, Sternoff points out. Yet he adds that the Chinese also “have a very strong vested interest in the stability of the global financial system and in the stability of the US economy… They’re not about to start currency wars with the US by shooting themselves in the foot by selling their bond holdings.” A second nightmare scenario is that the vast overhang of dollars in portfolios around the world has grown to a magnitude that may be beyond the control of any single group of players — and that when everyone is worrying about currency depreciation, it may only take a small event to spark a stampede for the exits.

GCC’s dollar marriage

The fabric of Gulf economies has been intertwined with the dollar since the 1970s arrangement with the Organization of Petroleum Exporting Countries (OPEC) to have oil sales priced exclusively in dollars. With five out of the six GCC currencies currently pegged to the dollar, Kevin Muehring, a financial journalist specializing in macro economics and monetary policy, remarks that, “for better or for worse, the GCC states are locked into the dollar and the fate of the dollar is their fate as well.” The Gulf’s banking systems are structured around the dollar, the banks, the government and the private sector all hold huge proportions of their assets in dollars and, most importantly, “oil is priced in dollars and therefore most of their revenues, before they are converted into their domestic currencies through government spending, are in dollars,” says Muehring.

However, one need only look to Iran to see that a dollar divorce is, although long and unpleasant, possible. In 2003, the world’s fourth largest oil producer began large-scale movement of its foreign-held assets out of dollars and as American financial sanctions continued to press on the exposed parts of the Persian purse, Tehran announced in April 2008 that it was no longer taking dollars in exchange for its oil.

“We agreed with all the buyers of Iran’s crude to trade oil in currencies other than the dollar,” said Hojjatollah Ghanimifard, international affairs director of the National Iranian Oil Company, to the Fars News Agency. “In Europe, Iran’s crude is being sold in euro, in Asia in euro and yen.”

Kuwait also caused ripples through the Gulf when it became the first GCC country to break ranks and de-peg from the dollar in May 2007, instead locking its dinar into an exchange rate mechanism based on a ‘currency basket’, including the dollar, the euro, the pound and the yen.

“The massive decline in the dollar’s exchange rate against main currencies… has contributed to the increase in local inflation rates and this step is part of the central bank’s efforts to curb inflationary pressure,” said Sheikh Salem Abdul-Aziz al-Sabah at the time.

Inflation due to dollar devaluation had other GCC states openly speculating through the first half of 2008 that they might also de-peg their currencies, “but now, this discussion is not happening,” remarks Sven Behrendt, associate scholar at the Carnegie Middle East Center in Beirut. In recent years Gulf states have funnelled much of their surplus oil revenues into sovereign wealth funds (SWFs) to reinvest, with the Council on Foreign Relations estimating the Gulf SWFs’ 2007 external portfolio at $1.3 trillion. However, the global financial storm has pummeled Gulf SWF holdings, with the Abu Dhabi Investment Authority alone estimated to have lost some $140 billion through 2008.

“They shifted a lot into equity, and with that came a higher risk exposure to their portfolios,” says Behrendt. “Now they’ve burned — quite substantially — their fingers in some of their investments.”

Given the lack of transparency with which the SWFs operate, accurate fiscal assessments are difficult, but what is clear, says Behrendt, is that they have been burned with heavy losses and are now among those sheltering their bundles of cash in US treasury bonds, in turn helping to keep the dollar high.

Should a viable alternative to the dollar reveal itself to investors, support for the dollar will collapse

Forever a dollar world?

Everybody uses US dollars because everybody else accepts them, but this was not always the case. Historically, the pound was the world’s general medium of exchange and the invoice currency of much of international trade. In the 1960s, however, major weaknesses in Britain’s economy forced London to de-value the domestic currency and the sterling lost its international shine, making way for the assent of global dollar hegemony. Today, with the US economy plummeting and the greenback baring an ever-growing debt, is the dollar’s reign near its end?

Muehring, the financial journalist, acknowledges the dollar will experience massive downward pressure in 2009, but “the offsetting pressures will be the lack of currency alternatives as the underlying economies of both the euro and the yen are in worse shape than the US.”

This was highlighted last month when German Finance Minister Peer Steinbrueck stated that a number of the 16 euro zone countries were “getting into trouble” and may need help — read ‘financial bailout’ — from the euro’s two biggest economies, Germany and France. Bloomberg reported European countries have committed more than $1.5 trillion to “save their banking systems from collapse,” and a number of countries are now staggering under the debt-load. The cost of insuring the debt of Ireland, Greece and Spain against default is at an all-time high. As well, Austria’s exposure to banks in eastern Europe has Vienna pleading with the EU for help, as the country “is on the hook for so much money that essentially if they don’t get paid by eastern Europe they’ll go bust,” said Marc Faber, managing director of Marc Faber Ltd., to Bloomberg. 

And so as the global financial crisis pushes counties and economies to the cliff’s edge, investors continue to huddle under the dollar for lack of anywhere else to hide. But the foundations of the dollar’s dominance are cracking and should a viable alternative reveal itself to lure investors away, support for the dollar will collapse.