Wednesday, 7 October 2009

Diversifying away from US dollar dependency - no more hurry up and wait

The report yesterday in the UK's Independent newspaper by Robert Fisk triggered several slightly bizarre reactions which ranged from brandishing the respected reporter as a conspiracy nut to dismissing the allegations as not very useful since Mr. Fisk is not by training an economist. (Actually I would have thought that was to his credit).

What was questionable about the Independent article was the emphasis that was placed on the notion that pricing oil in another currency than US dollars was really the thin end of the wedge which will lead to a phasing out of the greenback's role as the global reserve currency.

The problem with that part of the story is that it was not news, and nor does the pricing of oil really address the core issue which is the appetite that foreigners will have for dollar denominated securities, and in particular US Treasuries. I have expressed views on the unsettling implications of relying solely on the US dollar as the global reserve currency several times before including here, in this article , and also here.

As is often the case the Daily Telegraph's Ambrose Evans Pritchard has a good piece on the issue.

Beijing does not need to raise money abroad since it has $2 trillion (£1.26 trillion) in reserves. The sole purpose is to prepare the way for the emergence of the yuan as a full-fledged global currency.

"It's the tolling of the bell," said Michael Power from Investec Asset Management. "We are only beginning to grasp the enormity and historical significance of what has happened."

It is this shift in China and other parts of rising Asia and Latin America that threatens dollar domination, not the pricing of oil contracts. The markets were rattled yesterday by reports – since denied – that China, France, Japan, Russia, and Gulf states were plotting to replace the Greenback as the currency for commodity sales, but it makes little difference whether crude is sold in dollars, euros, or Venetian Ducats.

What matters is where OPEC oil producers and rising export powers choose to invest their surpluses. If they cease to rotate this wealth into US Treasuries, mortgage bonds, and other US assets, the dollar must weaken over time.

"Everybody in the world is massively overweight the US dollar," said David Bloom, currency chief at HSBC. "As they invest a little here and little there in other currencies, or gold, it slowly erodes the dollar. It is like sterling after World War One. Everybody can see it's happening."

What I find most unsettling about the way in which many pundits continue to dismiss the de facto decline in confidence in the US dollar is the the highly complacent notion that policy making with respect to the state of the US public finances is fundamentally a domestic, Washington based, matter. Until the global financial system has moved further along the path of diversifying itself away from dependence on a single reserve currency, the trillions of dollar which are piling up on the public balance sheet in the US are not issues which can be decided upon by interest groups, politicians and a central bank in Washington acting only with regard to their domestic agenda.

A crisis in confidence in US government securities, brought on by the ongoing attrition in the dollar as a store of value, would lead to an avalanche of liquidations which would completely overshadow the near meltdown of last October.
In the dire circumstance where there is a serious questioning as to whether to continue to prop up an asset class which has passed its "sell-by" date, cleverly chosen phrases from Messrs Bernanke and Obama about further guarantees, underwritten by US taxpayers, would be unlikely to restore calm and appease anxious foreign sellers of US securities.

The time to move forward on further reserve currency diversification is sooner rather than later and the gold market is now sending that message loudly and clearly.

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