Carlo's Think Pieces

Reflections of a Filipino in the Netherlands

Posts Tagged ‘balance of trade’

$1.45: 1 Euro by the end of 2011

Posted by butalidnl on 31 December 2010

The year 2011 will be marked by a very significant deterioration in the dollar exchange rate. I think that the exchange rate by this time next year will indeed be $1.45: 1 . Why do I think so?

Well, the most obvious reason is that the US is printing too much money, accumulating too high budget and trade deficits, and borrowing too much. The US Fed is stimulating the US economy as if it was the only economy in the world. They don’t see the international effects of US economic policies. Well, I think that 2011 will show that there is a limit to the amount of US dollars the world can take. At a certain point, people from other countries will have to be convinced by high interest rates to invest in US treasuries. And this would mean a devaluation of the dollar.

Even without “Quantitative Easing 2” and the extension of the Bush tax breaks, I think the US dollar will be in trouble anyway. At the beginning of the year, Central Bankers (Central Bankers are very “neat” in that they make policies that start at the beginning of the year, or half year, or quarter) will most likely set their policy regarding the amount of US dollars they will keep in reserve for the coming year. And I think that they will set the target percentage for dollars at either the same or at a lower level than that for 2010.  The dollar is a declining component in world trade, and it is also expected to devalue, so prudent Central Bankers will aim to have a lower percentage of dollars in their reserves. This, together with the rise in the amount of dollars that go around the world’s financial system, would mean that there will be a growing amount of dollars that are dumped by all these Central Banks. All these extra dollars means that the US dollar will devalue.

What about the Euro and its crisis? Well, to make the long story short: the Euro crisis is over. 2011 will be the time of the dollar crisis; and as a result, the problems of the Euro will be overlooked or actually get solved. Investors are sure to notice that the US economy is heavily indebted, and that the dollar is devaluating; so, they will think twice before buying US treasuries. After all, the US economy is worse off that either the Portuguese or Spanish economies. People will see that, and will eventually have to act accordingly.
This will bring about a domino effect: lower demand for treasuries; speculators betting (through Credit Default Swaps e.g.)that the interest on treasuries will rise; interest on treasuries actually rising as a result, etc. If speculators get the idea of dumping their other US dollar denominated assets, then devaluation will surely result.

The US can still stop this trend of a devaluating dollar. However, I think it won’t, and for the simple reason that they want the dollar to devalue. US economists seem to think that this is a good idea – that devaluation will stimulate exports and lessen imports. So, the Fed will not do anything to defend the dollar; and thus the dollar will devalue in 2011.

Is Devaluation a Good Idea?
For a small economy, it indeed could be a good idea to devalue its currency in order to restore its balance of trade. Devaluation will make that country’s exports cheaper and make imports more expensive, forcing the market to restore the trade balance after a while.

For the US dollar, however, it will be a bad thing if it devaluates. And this is because it is the world’s main reserve currency. Devaluation will not only lower the price of the US’ exports, it will also lower the value of reserves other countries have built up. For many countries, holding US dollars becomes a game of chicken: they would keep it as long as possible, but dump it before everybody else does. But when the Central Banks start dumping dollars, there will be no stopping the trend.

So, devaluation will not only affect the trade balance. It will affect how other countries view the dollar. And this means that if they sense a trend of devaluation, they will  dump their dollars in the hope of preserving the value of their reserves.

Devaluation will also be bad for the US itself. When the dollar loses value, the amount of imports will take 6 months or longer before it starts going down. This means that oil and other commodities will sap the US trade balance for some time before going down.  And it will take some time before exports get a boost. There is a lag time before companies are able to increase production accordingly.  And there is China: if present trends continue, China’s yuan will maintain its value rate relative to the dollar. This means that imports from China will not be affected, and exports to China will also not increase.

Devaluation will mean that people will pay a higher price for oil. I would estimate it to reach $4/gallon in 2011, at least. Other commodities will also rise in price: from iron ore to rubber, copper, aluminum. And this will cause the price of goods produced in the US to rise accordingly.
Devaluation means that consumer prices in the US will rise. It may not rise by the same percentage as the devaluation, due to importers absorbing part of the loses, but it will surely rise.

Devaluation of the US dollar, if it goes beyond a point, would mean that other countries would consider dropping the dollar as the currency used to price certain commodities. Take for instance oil – it is still denominated in dollars. But if the dollar devalues too much, OPEC may just decide to drop the dollar/barrel measurement, and revert to perhaps a Euro to metric ton pricing.

It could be worse
That the dollar will devaluate, is practically a given. But a depreciation of 10% is not the worst possible case. It could indeed be worse. Here are some things that could make the scenario even worse for the dollar.

Germany Agrees to ECB Issuing Euro Bonds. So far, the Germans are holding back on this, for the reason that it pays much lower interest rates with the present system of each country issuing its own bonds. However, if for whatever reason, the Germans (and other “Northern” countries, e.g. the Netherlands) agree to let the ECB issue common bonds for the whole of the Euro zone – which would then have an “average” interest rate; then it will forever get rid of any reason for a Euro crisis. And this would mean that international investors will more enthusiastically tear down the price of US treasuries.

China Shifts Its Peg to a “Basket of Currencies”. If China lets go of its dollar peg, it will not be good for the US. It’s funny – the US has been insisting for years that the Chinese should revalue its currency. But if China does so, even if only a little, it will mean a lot of trouble for the dollar. Changing the peg for the yuan will mean almost certainly that China will stop buying US treasuries. This means that the price of treasuries will drop, and effective interest rates on them will rise.  And China’s dumping of US treasuries will be sure to trigger similar actions by other countries.

Big Disruption in the Supply of Oil. The price of oil is now at about $90/barrel.  It will slowly rise to about $100/barrel by the end of the year, given present supplies.  If there were to be a major disruption in the supply of oil – perhaps a total stop of Nigerian or Venezuelan exports – the price will rise to even $150/barrel.  While the world has seen these price before, it is now less able to cope with it. So, a big rise in the price of oil will be greeted by a return to recession for the US, and a big drop in the value of the dollar.  The dollar will lose more than 10% of its value, as a result of this.

I don’t think that these “worse case” scenarios will happen in 2011 (well, 2012 is another story altogether). So, this means that the US dollar will devalue by “just” 10%.

Unfortunately, I think that this trend is inevitable. The dollar will devalue by about 10% in 2011. It may devalue by the same amount in 2012. And if this continues, the dollar will cease to be the main reserve currency soon after. Only the Fed can stop this. But it won’t. It is not politically expedient for the Fed to do so.


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