Monday, January 23, 2006

US Dollar's On Prozac & Levitra

What does Bill Gates, George Soros and Warren Buffet have in common - all three predicted that the US dollar would correct in 2005, all betted against the dollar and lost.

If you follow an economics textbook, the US dollar would have, should have ... corrected by at least 30% by now to go anywhere close to solving their current account deficit. However, the US dollar looks likely to be thereabouts and thumb its nose at naysayers for the following reasons:

1) It is still the most popular reserve currency in the world. Go to any country for holidays and you cannot go wrong carrying US dollars. That reality is based on the convergence of some very important factors, and that perception will not go away overnight.

2) Somebody must be financing the deficit. Well, you now have the Middle East petrodollars being recycled to buy US Treasuries. China's emergence as an economic powerhouse have also recycled a lot of its savings into US assets.

The current account deficit is entirely sustainable and a natural consequence of globalization. In terms of fundamentals, there are no reasons why the dollar shouldn't be doing well. The dollar's 2005 bounce from three years of decline counters the traditional theory that an economy can't run a large current-account deficit for long. Harvard's Kenneth Rogoff, a former International Monetary Fund chief economist , said in a study last year that the dollar might need to fall 40 percent to keep luring the US$2.1 billion of foreign cash the U.S. needs every day to plug the gap, which last year reached a record 6.5 percent of gross domestic product.

3) Bank of China's strategy of delivering growth through exports is to keep buying U.S. government securities to keep the yuan undervalued. China's foreign-exchange reserves rose US$209 billion to a record US$818.9 billion last year, triple their level of 2002. China accounted for purchases of a net US$2.2 billion of U.S. Treasury securities in November 2005 alone, bringing its holdings to US$249.8 billion. Holding that much US Treasuries have the effect of holding down U.S. interest rates, stimulating consumer spending and the imports that widen the trade gap.

4) Naturally, what keeps Gates, Buffet and Soros in the bear camp is the prediction that the Chinese, Japanese and Arabs will not always continue to buy those Treasuries. Can you imagine if China or Japan decided to halve their holdings of US Treasuries in favour of the Euro - now that is what we call a correction, US interest rates will spike immediately to say 25%, while the dollar will drop 20%-30% in value overnight, after a while it will stabilise but interest rates will be hovering around the 10% level for a few years. That is just a scenario, a "what if" that is highly unlikely to happen because of this small thing called globalisation of trade. As trade is inter-connected and global, no one country can afford any of the top 5 trading nations to collapse as the domino effect will be severe and felt throughout the supply and demand chain. Nobody benefits with the US dollar collapsing. If it was, say 30 years ago, and trade wasn't so global, China could and probably would threaten to dump their holdings of US Treasuries just based on political scuffles too numerous to mention. The impact is very much localised, unlike now. No one can afford that domino effect, hence you have the big boys all making sure the sick patient don't die or slip into a coma, as the patient will come back to haunt them day and night, night and day!!!

5) Another premise for Gates, Buffet and Soros to boost their argument is that the deficit cannot keep rising forever indefinitely... Now its 3% of GDP, then 3.5%, next 4%, followed by 5%, will 6% be the critical figure, or is it 7% of GDP?? The US government cannot allow that because the other top trading nations will not allow that. Both sides have skeletons, both sides are pointing loaded guns at each others' temples. The only people who can stop the US government from running a deficit of 3% GDP or 4% GDP are the people responsible for the deficit in the first place - will China or Japan have the political will and economic leadership to do that? I'm afraid not bloody likely. In fact, I view the US lawmakers as jumping the gun by calling for China to devalue the yuan and asking for quotas and tarriffs - if the US lawmakers don't do that, China and Japan can turn around and take the initiative to ak for more debilitating measures to be undertaken by the US themselves to correct the problem. At least now, the amount of hoopla generated by the US spin doctors puts the ball in their opponents court and not theirs (but we know better which court the ball really is in).

6) I will start getting really bearish on US dollar when there is a viable alternative to holding US dollar. The Euro needs to grow up very quickly for that to happen. We need very deep Euro bond issues, and Euro countries need to expand their trading prowess into more countries. The EC will also need to take up economic leadership for the world, blah, blah.... probably not in another 5-10 years at least.

7) The other fallacy is that the deficit is so huge, its as if Americans do not have savings, and is mortgaging their assets. One big blip which is often not accounted for is the savings that is accumulated in their properties. Cut it anyway you like, many Americans have a lot of equity in their property besides their pension funds. A related fallacy is that USA will have to keep selling their companies to foreigners to sustain the trade imbalance. That again is not true, in fact US companies are sitting on the largest cash hoard ever, and just biding their time to reinvest or buy other investments to fund their future growth. As long as US leads in technology and business, it is very hard to undermine the value of the dollar.

In conclusion, yes the US dollar should be weaker this year, but it is not in for a major correction, maybe dropping 4%-5% in value. Soros and Buffet have been dollar bears for 3-5 years now - the thing about being bearish over the long, long, longer term is that you will be right eventually. But you will lose quite a bit of dough in between.

The US dollar is on Prozac because it puts up a happy face even when it is supposed to be depressed; obviously taking Levitra as the US dollar is showing nerves of steel when it should be flaccid.

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