Tuesday, 3 November 2009

The Future of the US Dollar

In this article, we talk to Marc Chandler, Global Head of Currency Strategy at Brown Brothers Harriman and discuss the future of the US Dollar, its role as a global reserve currency, its future, relationship to interest rates and inflation, and the state of the US economy.

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Vikas Shah, Thought Economics, November 2009

The foreign exchange market is the largest, and most liquid financial environment in the world, with governments, corporations, institutions, investors, central banks, and many other participants contributing to global turnover (as measured by the Bank for International Settlements) in excess of US$3.2 trillion per day. This daily turnover consists of around US$1 trillion in spot transactions, US$362bn in outright forwards, US$1.7 trillion in swaps, and the balance in other transactions.

In neo-classical economic theory, the concept of a 'perfect competition' was put forward to describe a market with infinite buyers and sellers, no barriers to entry or exit, costless transactions, participants maximising profits, perfect information and homogenous products. The foreign exchange market is the closest we have to an environment of 'perfect competition' where ample liquidity creates an environment of 'near infinite' buyers and sellers, combined with (in the main) extremely low transaction costs, few barriers to participation in the market, and highly homogenous products. The currency markets are, though, exposed to participants who may not all be trading with the same motive, some with the ability to manipulate prices (such as central banks), and a great deal of volatility from factors ranging from macro economics, to politics, social issues, and even meteorological conditions.

At the heart of this highly dispersed global market is US Dollar, a currency which (through the advent of capitalism, international trade and investment, globalisation, and US strength internationally in economics and military terms) has retained a ‘monopoly’ position as a reserve currency, and as the most widely adopted currency of international trade and capital flow (accounting, in 2007, for 86.3% of average daily market turnover).

Since the financial crisis of 2007-8, a great deal of discussion has occurred about the nature of US Dollar’s dominance in the market, and whether shifts in economic power could see it losing reserve status and relative monopoly.

In this exclusive interview, we speak to Marc Chandler, Global Head of Currency Strategy for Brown Brothers Harriman (the oldest and largest partnership bank in America, with over 4,000 employees worldwide). Marc is also Associate Professor of Global Affairs at NYU Stern, a prolific writer, speaker, and considered by many to be one of the world's leading experts on currency. Marc is also the author of the well-respected book Making Sense of the Dollar, Exposing Dangerous Myths About Trade and Foreign Exchange (Bloomberg Press, 2009). In this interview, we speak to Marc about the future of the US Dollar, its relationship to other currencies, valuation, reserve status, and the factors affecting its trade.

Q: What is your view on US Dollar's continued role as a reserve currency?

[Marc Chandler] I think that the dollar’s role as a reserve currency will continue. It has always been relatively stable, apart from some volatility at the time of the UMU and Maastricht treaty. In general, for the last two decades or so, dollar’s share of global reserves has remained around 65-66% with the Euro (and before that the basket of European currencies) making up around 25%. This figure [for Euro] has increased now to the extent that there has been a noticeable shift in reserve allocation, but in the main, reserves are shifting from Japanese yen to British pound.

I think part of the challenge is that there is no clear alternative. Before the Euro, for example, most pundits thought it [the Euro] would be the replacement. I have articles on my desk right now claiming “dollar abandoned” and others saying “oil to be denominated in other currencies”. These are not recent articles, but pieces from February 1995!

If you look at the history, in certain parts of the dollar cycle, particularly in the down part, investors exaggerate structural problems and minimise cyclical. I would suggest that most dollar problems are cyclical, and when the fed reserve raises interest rates, and the business cycle re-enters an upswing, there will be many reasons to buy dollar.


Q: What are your views on Dollar's valuation relative to other currencies?

[Marc Chandler] I think medium to long term, we are constructive on dollar. We see short-term downward risk stemming mainly from low US interest rates and liquidity.

The problem is people don’t agree on the future or the past. Many suspected that the dollar rally in 2008-2009 was due to it’s role as a ‘safe haven’; I don’t see it that way, and would suggest that one of the most successful Fed Reserve programmes was the currency swap lines, where they made available, around USD 580 billion to the rest of the world. This program has been wound back through lack of use to around USD 40 billion, and by the rest of the world, I mean EU banks, hedge funds, and investors from Mexico, Brazil and the like. Their borrowing of dollars to buy assets created a huge carry trade which financed the bubble. This resulted in a huge margin call as foreign investors scrambled to secure dollars, and this was at the moment when US bank balance sheets imploded. The major weight on dollar now comes from the fact that interest rates are low, and the system is awash with dollars.

It is interesting to note that several EU countries issue dollar denominated bonds. Imagine if the US issued a Japanese yen denominated bond. This would be considered a sign of weakness by the market, but when Italy and its counterparts issue dollar bonds, no comment is made. This shows, again, the role of ample dollar liquidity, and its role as a financing currency.

Economically, I believe that most of the bad news is now known. Last year there was, in fact, a shortage of dollars. Many thought there was a surplus, but there was really a shortage, and the Fed Reserve flooded the market.

I can illustrate the current situation in the form of a story. Two boys were being chased by a Tiger. One boy stops to put on running shoes, and the other boy says, “What are you doing?” The first boy responds, “I don’t have to outrun the Tiger, I just have to outrun you”.

When you look at many of the financial centres such as The City of London, Wall St, and their counterparts, they think of things in Economic terms. There is, however, a reason why the likes of Alfred Smith, and Karl Marx studied politics and not economics. The role of the dollar rests on many other things, not just economics. Look at thins like human capital, for example. Many say the US has stopped inventing, but in 2008 there was one company which applied for more patents than all the others put together, this company was IBM. Seventeen of the top twenty universities in the world are in the USA, one third of all students who leave their countries to study in another come to the USA. There are only a handful of countries who spend relatively more on R&D than the USA, and these include Norway (telecommunications based) and Japan. The GDP in USA is around USD 45,000 per capita, some have higher GDP’s but almost all have a smaller population than the greater NY area. When you look at all the factors including military power, transparency, innovation, and so forth, you can see that even with the problems we have, the institutional capacity, culture and these factors suggest to me that we are very capable.

Anther interesting point on this is fertility rate which, in the US, is above 2.1 (versus around 1.6 for most of Europe and Japan). By the end of 2010, for example, Japan will have 5 million less workers, and this complicates their problems.

I try to look at the political economy, the role of the dollar based on economic AND non-economic variables. Abraham Maslow (a famous psychologist) once commented, “if all you have is a hammer, everything is a nail”. Investors currently have a hammer, and that hammer is economics.

Q: What is the role of deficits in Dollar's valuation? And what other key indicators (economically) carry the greatest influence?

[Marc Chandler] There are many people who believe that our [US] current account deficit is a major driver and a major imbalance for dollar. I, however, think there is a fetish about balances. If we agree, for example, that a key macro-economic variable is fertility, or population rates, how can you have a balanced economy when some are producing rates of 2.1(USA), and some like Japan, around 1.6 and falling. On the eve of the First World War, the absolute value of deficits in major countries was almost twice today, and capital flows are now far greater.

A lot of the problems stem also from measuring using nineteenth century models. Almost half the US trade deficit can, for example, be accounted for by movements within the same company. If General Motors, for example, export parts between state X and Detroit, this is counted in the trade deficit. In a survey of current business released by the BEA, it puts forward that if they have an alternative ‘ownership’ based framework for measurement, this will reduce the trade deficit figure by over 30%.

You also have to look at how US countries service foreign demand. For countries like Germany, this is done using pure exports (which, in the case of Germany, accounts for around 40% of GDP). In the US, we export over 1 Trillion dollars a year, but the real way we service foreign market is by building and selling locally. These affiliates of multinationals will sell more than 4 Trillion dollars of goods and services this year. This phenomenon complicates trade a lot, by finding the role of inter-firm trade and production. If we sell a good in the USA, sell widgets to China, or make and sell a good in China, is that not tantamount to the same thing? It turns out that for every ipod sold by Apple, it makes the US trade deficit go up by USD 150. Is the US poorer because the world loves ipods? No, we accrue the high-value elements like intellectual property, profit, and so forth, and outsource the lower-value parts of the chain.

I can find you may times where the deficit has widened, and dollar strengthened, and vice versa, this is not a reliable means of forecasting currency.

For Japan, pre-crisis into 2007, it was amongst the weakest of currencies in terms of the trade weighted average. Look also at the Swiss Franc, they have a major surplus and are now intervening in the foreign exchange markets. There are a lot of factors influencing values.

When most people focus on trade, they miss a significant development, namely the huge and immense mobility of capital. The daily turnover of the foreign exchange market is around USD 3.2 Trillion, meaning that in a few weeks of trade, enough capital is circulated to pay for all of global trade in a year. Capital is the driver, NOT trade.

Q: What are your views on inflation and interest rates for the USA?

[Marc Chandler] In the near term, in 2009 and for most of 2010, inflation is not a major problem. That said, the key is not inflation. To use an analogy, when you squeeze toothpaste out of a tube, it’s quite hard to get it back in. By the same token, by the time you see inflation, it’s too late. The key is inflation expectations.

The first rate hike may come in August 2010, which will follow from around 3% growth over the next few quarters led by inventory, government and residential spending. These factors, including consumption, lift economies, and after a few quarters of growth, the fed will raise interest rates, maybe by 0.25%. Interest rates will, though, have to be raised for a while for monetary policy to become tight again. Right now, rate setting is akin to the moment when titanic hit an ice-berg. In ten months, the ship will be further away in safety, and they can adjust rates slightly, but I suspect they will still be low.

Q: To what extent is the dollar valuation politicised?

[Marc Chandler] For me, this is the key to the ‘strong dollar policy’ which Trichet keeps mentioning at the European Central Bank. Previous to the ‘strong dollar is in US interests’ speech, and before 1995, the US had several treasury secretaries who used dollar as a weapon against countries like Germany and Japan. A ‘strong dollar policy’ means the US is foreswearing against this kind of activity, and we will not purposely seek dollar devaluations to achieve policy objectives, but if the dollar falls because of monetary policy? So be it.

I think in some ways, the US has tried to depoliticise the dollar. The political economy is important, though, and the competition between nations is like playing chess on many levels. I can’t separate politics from economics, as this would be doing both disciplines a disservice.

Dollar has also taken on symbolic value, representing “Anglo-America” and capitalism, and this symbology also gives it value and imparts more than just ‘means of transaction’.

An example of the politics of dollar can be seen where recently China proposed its feelings that there should be an alternative international monetary regime. This was purely a political move as it would be impractical, any time soon, to do this. What they did was play a classic sports strategy where, “the best defence is to go on offence”. After many years of haranguing by the US to revalue their currency, they went on the offensive. This strategy worked in their favour as pundits picked up this proposal and ran with it, and the US has backed away from China-bashing, instead letting other forms like the IMF take charge.

Q: What are your views on commodities being non-dollar denominated?

[Marc Chandler] I don’t think this will happen for a long time, certainly not in my lifetime. Ronald McKinnon (Stanford) and many others have argued there is a natural monopoly for dollar. Imagine you are OPEC and you are looking at many different countries to sell oil. Having a single currency, rather than bringing instability, brings economies of scale and efficiency.

These changes do not, though, happen by agreement. Take, for example, the language of ‘Esperanto’. This was a made-up language, with no country, which intellectuals said the whole world should adopt. It is not an alternative to English, but English has become a language of speaking for the world. It is the same principle. There is inertia, but a lack of alternatives.

Even if you priced oil, for example, in Euros, SDR’s or even a basket which includes Gold. OPEC would still accumulate surpluses, as would China. This is not a pricing problem, it is about principles such as savings, investment, and consumption.

Another good example is the QWERTY keyboard. To replace this, you have to bring out something which is more a little better. Whatever replaces the dollar has to be a whole lot better which is currently beyond our imaginations.

Q: With emerging markets playing an increasingly important role, do you think there are any currencies traders should watch more carefully, and why?

[Marc Chandler] With the advent of Euro, we lost many currencies and currently the GCC are even talking about adopting a common currency. BRIC is a great marketing term, but for me, it lacks substance. China and India are at odds on many things, for example. What we find is that China is in the early stage of becoming the centre of the emerging markets, buying commodities, investing cash, and so forth. This seems like a new form of imperialism, akin to what the British and the French did historically.

In some African states, for example, they have Gold and Zinc, on the way, we will build a road, or deepen a port, but the aim is to buy the resources and leave. In many ways we will see China competing with emerging markets, rather than existing with them, due in part to a cheap currency pegged to the dollar. The Economist says, for example, that by the end of 2010, there will be over one million Chinese farmers in Africa. If the US takes a project, they may bring US citizens over for management roles, but China has a lot of unemployment problems, so they bring the workers too. What’s been happening is that the market thinks that emerging economies are dead, but some funds I speak to think that Poland and Brazil are safer than US treasuries!.

We have had a love affair and have mistaken cyclical and liquidity factors for nirvana. Some countries have made progress, like Brazil, but it could be that BRIC should be renamed CRIB as most, leaving aside China, are small and in the early stages of development.

Looking at other countries, though, markets like Indonesia are very interesting, and I think the gulf is too. It is a cycle; as currencies become more traded, spreads narrow and eventually investors feel safe to pile in. We look at frontier economies such as Vietnam, Kenya and even some of the Baltics (if they survive) in this way. Just as interesting are the currencies which may not exist in ten years such as those in Eastern and Central Europe.

There are also moves to create a single unified currency in Latin America and East Asia.

Q: Currencies are often used by ‘black box’ traders (e.g. quant funds), and by those developing trading models using technical analysis. How effective do you think statistical modelling is of currency movements? And do you think the number of market participants using quantitative trading systems influences prices? (eg. Everyone trades at same points, large volumes, etc)

[Marc Chandler] It has certainly been an interesting development to see the increased accessibility to the foreign exchange market. It does, though, raise a general question in the back of our minds about how markets work. In practice, many see it as a bunch of profit making people who work to create a clearing price, but that’s not how it works in practice. Think of a list of players including corporations, unit trusts (mutual funds), central banks and the like. These major players do not see currencies as an asset class, but as a risk that needs to be managed. Many equity funds do not hedge currency risk, they see it only as a transaction vehicle and central banks do not have any profit motive. Only some participants in the market are true profit seekers. These include inter-bank dealers, proprietary desks, and hedge funds. Some people say it is a zero-sum market, but in practice its more complicated as some participants look to lock in certainty and reduce risk, and some are there to make profit. I think black-box high frequency traders and other technical traders are a factor in the market, but they may not differentiate from other speculators. The real battle in the market is between the profit seekers, and the not-profit-seekers.


On the Wider Economy

Q: What do you think the true picture is of the state of the US and Global Economy? And what are the key factors you think will influence our ‘post crisis’ economy?

[Marc Chandler] Imagine a person who got hit by a car, who was wrapped up in a full body cast. Slowly they are coming off, but the patient is still bruised, there’s a lot of pain, but as more time transpires following the accident, the patient get stronger.

What worries me is that while policy makers were (necessarily) quick to respond, many key market participants have not sufficiently changed their behaviours. We, as major industrialised nations, have survived this crisis, but I am not sure whether, for example, Germany would be prepared to give up on its “40% exports” strategy (a behaviour). The US household net-worth fell by 14 Trillion dollars, it has recovered 2 trillion dollars and Q2/09 and a further again in Q3, but with rising unemployment there is still a lot of stress.

Many people in the US and Western Europe have cited that our children may have lower living standards as a result of this crisis. My view is that it many not be as bad. Instead of retiring at 60, we now work till 65, and our children may work till 70. In the US, we have a car for every licensed driver. Is this really necessary? If my son doesn’t have a car, but uses shared vehicles like “zipcar” is this really a change in living standards? We, in the US, go through 150 gallons of water a day per person. The WHO says you need less than 20, so if my son has to buy appliances that are water saving, is the standard of living less? But the net effect is that he is consuming less automobiles and water.

People talk of an age of austerity, but in the USA and in other countries, we look at the fact that people are not starving but the opposite. Maybe it’s my own milieu from being in New York, but I see the fact that people are not embracing progress and change, they see old is good and new is bad. Over time, people have to embrace progress, and not see it as a threat. Progress may be daunting, with job losses, and loss of standing, but we have to help each other through it. It is only through progress that we will overcome these problems.


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We can see, therefore, that the foreign exchange market is a more dynamic and complex system than many realise.

It may be useful for us to understand the market, more in terms of game theory, than in terms of any single discipline such as economics, mathematics, philosophy, sociology or otherwise. If we consider the global market as our game ‘theatre’, we can see a range of actors (including central banks, investors, institutions and corporations). Each actor has a different motive (profit seeking, stabilisation, risk management, transaction) and each may have different characteristics and behaviours. By looking at the market in this way, we can see the interplay of disciplines to help us understand the true dynamic, as each actor can be influenced by issues ranging from politics (for example, government policies), psychology (for example, flights to safety, market sentiment), economics (for example, macro data) and more. This kind of model not only provides a more realistic picture of the market, but helps understand the nuances and complexities which result in its behaviour and volatility, something which a ‘single discipline’ view could never provide.

This actor and theatre based model is becoming increasingly common in science, particularly biology, where similar models are used to more accurately simulate (for example) cells, viruses, and body systems.

For US Dollar, we can see that every economic crisis we have faced, historically, has created pressure on its status in the market. Marc explains, though, that the monopoly has not only created efficiencies in the market, but is borne of a deeper sentiment towards dollar as a symbolic currency representing capitalism and its many tenets. US economic and military strength, as well as its international reach will certainly help US Dollar maintain this commanding position in the future, as many international bodies (such as governments and corporations) are tied into the currency due to volume of reserves held. For many countries (such as Zimbabwe) for example, the US Dollar has been part of the mechanism which is delivering economic stability, and aiding them in entering an environment of global participation.

We must, though, always remain aware of the capability for the world to generate high-impact, hard-to-predict, and rare events beyond the realm of normal expectations (as characterised by Nassim Nicholas Taleb in his book, Black Swan). Many functions of life which held monopolies were, eventually, displaced by innovations which made the function considerably easier or better. In context, look at the impact of email on ‘the letter’ or the impact of mobile telephony on ‘fixed line’.

In the currency markets, there is nothing to say that within our lifetimes, there could be an innovation which displaces the US Dollar as a dominant force, but it would be impossible, until we see it, to understand the shape or nature of this innovation and until then, we must understand and appreciate, that the complexity and interdependence of global trade and financial environments means that the US Dollar will retain a necessary and efficient monopolistic status in the market.

As Barry Eichengreen once said, “More than Coca-Cola, the dollar is surely the United States' signature export.”

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