Since March, the dollar has been sliding precipitously against all major currencies. That’s because near-zero interest rates in America and the return of risk appetite has resulted in billions of dollars flowing into emerging economies and commodity markets. While a hopelessly lopsided trade balance and a mammoth budget deficit are making large Treasury holders grumble, the absence of alternatives means it can’t be a one-way street for the world’s dominant currency.The upshot: it’s time for the dollar to spring a surprise

This is not a good year for celebrated icons. In June, Michael Jackson, the King of Pop, died suddenly at 50, leaving legions of fans mourning in disbelief

Global investors don’t always tend to appreciate the politics that stand behind the dollar

. Now there’s talk that another American icon, the dollar, could be facing financial loss of face and eventual demise.

The dollar, the world’s most dominant currency, is going through one of its bleakest times, having hit a 15-month low on a trade-weighted basis recently. There are plenty of critics who think it’s time to start preparing the currency’s obituary. It’s going down, down, down, they say. Eventually, we’re all going to wake up one day and find the dollar dead, having overdosed on oversized borrowings from the rest of the world.

Come to think of it, MJ and the dollar share a lot in common. While they both still command phenomenal worldwide appeal, both have endured several trials and tribulations. Most of the time, both managed to emerge stronger and better than before.

Yet, the king of pop’s time ran out far sooner than anyone expected; is the king of currencies also in the throes of its final act? The US is facing its biggest financial crisis since the Great Depression of the 1930s

We’ve seen a dramatic swing between investor risk aversion and risk appetite

. Many fear that the way the government and regulatory authorities are going about tackling the crisis will eventually cause the economy to go broke and end the reign of the dollar as the world’s preferred currency.

Of course, the dollar’s fans will have none of it. “It’s the same old story again,” says Marc Chandler, global head of currency strategy at US partnership bank Brown Brothers Harriman (BBH) and author of the book Making Sense of the Dollar. “In the 1980s, everyone used to tell me that Russia would eat our (the US’s) lunch.Then it became Japan, after that it was Europe. Now it’s China. Global investors, while very strong on economics, don’t always tend to appreciate the politics that stand behind the dollar.” He’s betting that this time will be no different.

That’s a view shared by many currency trackers

There are a number of countries where the fiscal outlook will turn for the worse

. They say there’s a perfectly sensible explanation for the dollar’s sharp decline this year. Since late 2008, the US Federal Reserve has pumped billions of dollars into the financial system to prevent it from seizing up. Now there’s simply too much of the stuff. “We believe the current decline in the dollar is cyclical rather than structural,” says Vassili Serebriakov, vice president and currency strategist at Wells Fargo Bank in the US. “A massive injection of liquidity by global central banks, along with other economic stimulus measures by global governments, has played a large part in the dollar’s fall.”

In other words, a temporary loss of form for the still-reigning king of currencies

The dollar is anchored right now because no G3 country offers attractive returns and US inflation is low

. One which an increasing clutch of currency experts believe will reverse next year as some of that global liquidity is pulled back. Partly because the US economy – and the rest of the developed world – seem to have stopped freefalling. “This policy tightening is not necessarily designed to restrain growth or head off inflation, but rather to remove ‘emergency’ measures that are no longer appropriate as financial markets show some stabilisation, and as economies show a return to growth,” says Serebriakov. And when that happens, the dollar will “stabilise and then start recovering for a year or two,” he adds.

A few economists are even pencilling in an interest rate hike – about 25 basis points – in the US in the second half of next year, assuming economic growth happens according to plan. That could buoy the dollar as it would be a sign that the economy is healing. In the September-ending quarter, the US climbed out of recession with a 2.8 per cent expansion in economic activity.

The dollar’s decline this year began in March, just as a rally began in global equity and commodity markets

While the US has some serious financial challenges ahead of it, it also has the best chances of dealing with them successfully

. In a way, the greenback’s decline was expected: last year, at the height of the credit crisis, global investors dived into the safety of dollar assets (mainly US treasuries), abandoning all desire for risk. That led to the dollar rising to a near three-year high against a basket of six currencies. But with cheap money flooding the system and ridiculously low interest rates everywhere, investors were once again emboldened to leave the safe arms of US Treasuries and play with riskier assets. Much of the money is flooding Asia, where growth prospects seem brightest at the moment (See box: Leading the way).

“Between last year and this year, we’ve seen a dramatic swing between investor risk aversion and risk appetite,” says Daragh Maher, deputy head of global foreign exchange strategy at Calyon Bank in the UK. “This year, other considerations, besides risk, like relative growth rates of economies, interest rate differentials will come into play for investors.”

And relative growth rates between the US and the rest of the developed world could tilt in favour of the US. Stimulus measures in the Eurozone or the UK have not been as generous as they have been in the US, and that should keep the US in the lead on economic growth in the developed world, believe some experts. Make no mistake, recovery in the US is still highly fragile, but it’s a recovery nevertheless.

In fact, the current purging of excesses may also work towards making the economy -- corporate America in particular -- healthier than what it was in the past few years and trigger dollar gains in the short term. For instance, while the unemployment rate has climbed to an alarming 10 per cent, productivity has also soared, climbing an annual 9.5 per cent in the third quarter, the highest since 2003. While it’s a short-term phenomenon (businesses are slashing workers faster than output gains, and akin to inventory cycle gains), “the drop in unit labour costs coupled with the decline in the dollar may underscore the appeal of US companies for foreign investors,” says BBH’s Chandler. A view seconded by experts such as former Goldman Sachs strategist Abby Cohen who recently said that “if you’re a natural holder of the euro or pound sterling and you’re looking to buy something which is priced in dollars, it looks like you’re getting it at a discount.” She, like some other experts, forecasts a slew of mergers and acquisitions in coming months, boosting demand for the greenback.

Besides productivity gains, company profit margins will also be boosted by another reason – less cut-throat competition. In the past year, bankruptcy and the passing away of many small and big companies has cleared the field for the remaining ones to do business on far better terms. The most high-profile example is investment banking giant Goldman Sachs, which posted a $3 billion profit in the third quarter, a nearly 280 per cent leap from last year, on reduced competition and of course, roaring markets.

Indeed, even those not buying the economic recovery in the US theory (they think it’s just the morphine of easy liquidity talking) think the dollar could gain precisely because the economy might stumble going ahead. Another crisis, possibly triggered in the commercial real estate market or by credit card delinquencies, could unleash a fresh wave of money fleeing to safety just as it did during the height of the credit crisis last year.
In the futures markets, it seems that investors are already preparing for the greenback to make a thriller-style comeback. Don’t underestimate the ability of the dollar to spring a big surprise: the last rally took it from 1.60 against the euro in mid-2008 to 1.25 in early 2009. In fact, Wells Fargo advises “formulating hedging and investment strategies around a stronger dollar outlook for 2010”.

So there you have it: a short term bounce in the dollar in the first half of next year. Experts are still divided about whether it will be sharp or mild, but there’s growing consensus that the rally will take place.

Of course, this is not to deny that the dollar, like most real-life celebrities, has been waging a very public battle with some longstanding problems. In the long term, the actions of the dollar’s managers – the US government – and economic growth will determine if the American idol with worldwide recognition continues its rule or be forced to cede ground to young upstarts.

The problem is that the markets are mixing up the two -- short- and long-term influences – right now. “The markets tend to exaggerate structural difficulties and minimise cyclical events,” says BBH’s Chandler. 2010 may very well be about cyclical movements for the greenback. And if there’s one thing these cycles prove, it’s that the dollar isn’t going to slink away quietly into the night without a fight.

I’m bad

It’s not easy being a celebrity. For one thing, they’re rarely if ever paragons of perfection. Take MJ for instance. Despite raking in billions of dollars throughout his career, he was found to have racked up nearly $500 billion in debt when he died suddenly at 50. The musical genius had pursued an extravagant lifestyle, spending millions on toys and antiques and building a private amusement park called Neverland. Part of that was funded by loans which he had to reportedly refinance in 2006 to head off insolvency.

The dollar – whose strength or weakness is mostly a reflection of the state of the US economy – shares the same flaw (in economics, they’re called structural flaws). Its value in recent years has been held down in part by the excessive spending habits of American consumers. Until the credit crisis of 2008, US shoppers were snapping up everything from Korean televisions to Japanese cars and Middle East oil. Backed by cheap credit, rising home and stock values, Americans were spending wildly beyond their means.

That was clearly reflected in the US current account deficit (CAD). Since 1983, the current account, which primarily shows the balance of trade transactions between the US and other nations (along with some other transactions), has been persistently in deficit i.e., the US has been importing more than what it exports. In other words, the US owes other nations more than what these nations owe it. A widening current account deficit caused by freewheeling spending on credit can eventually stretch the goodwill of creditors to its limit.
If creditors decide they’ve had enough and demand payment, the dollar can fall into immediate trouble and possibly trigger a currency crisis. So far, that’s never happened because of the dollar’s status as the world’s dominant invoicing and reserve currency and the US economy’s pre-eminent position in world trade. Nevertheless, there is a price to pay for the spending binge – a weaker value for the dollar against other currencies.

It’s for the dollar’s own good really – in economic theory, a trade deficit can be cured by allowing a country’s currency to depreciate. A weaker dollar helps exports and curbs imports which become more expensive. Eventually, the currency regains strength as the trade gap narrows.

Current account deficits have been a big problem area for the US, reaching alarming proportions in 2006 when it hit 6 per cent of GDP (it has averaged 2.2 per cent until 2005). Blame that on sizzling oil prices, which soared past $100 a barrel during
2004-2008 (the US is the world’s largest consumer of oil). A Deutsche Bank (DB) report notes that between 2002 and mid-2008, America’s monthly oil trade balance soared to more than $40 billion a month from $10 billion. “By mid-2008, it was responsible for nearly two-thirds of the trade deficit, compared to its traditional share of a quarter,” the report says. “Consequently, it was the oil price collapse in Q42008 that caused the most dramatic improvement in the US trade balance.”

Dramatic indeed. Aided by lower oil prices, a visibly weakened dollar and subdued consumer spending (which brought down the non-oil trade deficit) the US current account deficit fell to $99 billion in the June ending quarter, the lowest since the fourth quarter of 2001. As a percentage of GDP, the trade gap is also down to a more acceptable 3.8 per cent.

Tempered oil prices and subdued consumer spending are likely to prevent America’s CAD from spiralling out of the comfort zone through 2010, according to experts. “Only outsized US growth relative to the rest of the world would lead to renewed concerns around the current account and hence the dollar, which is unlikely in 2010,” says the DB report.

The last time the CAD exhibited such good behaviour, it led to dollar gains, adds Serebriakov of Wells Fargo. A fact the DB report supports: “Episodes of past CAD reversals suggest that most currency weakness tends to occur in the run-up to the trough in the current account and the year or two after. Since the trough was in 2006, it suggests most of the necessary dollar weakness is behind us.”

The rediscovery of the old-world virtue of spending within your means among Americans, may help the dollar climb back into the good graces of its creditors, say experts. A weak dollar is currently working in favour of the US right now, by lowering the CAD, which is probably the key reason why despite voicing support for a “strong dollar”, monetary and government officials don’t seem to be too worried about the currency’s slide this year. At least on this front, the dollar can breathe a sigh of relief.

Don’t stop till you get enough

Of course, excessive spending isn’t the only flaw of the showman currency. There’s excessive borrowing too. Here too, there are parallels with Jackson’s lifestyle. The flamboyant entertainer, despite carting in record sales on most of his albums, still needed a $250-$350 million loan to fund his extravagant tastes.

It’s a similar story for the dollar. Of late, the US government has been borrowing like crazy, not just to pay up its trade obligations, but also to fill a mammoth hole in the federal budget. In the fiscal year ending last September, the government racked up a record federal budget deficit of $1.4 trillion, close to 9 per cent of GDP, primarily on account of its mega $787 billion fiscal stimulus package to prevent the economy from flat-lining in the aftermath of the financial crisis of 2008. To pay for the gap, the Treasury held an auction on average more than once a day to raise $7 trillion (gross issuances) in debt. The flood isn’t ending any time soon: net debt issuance will remain high in fiscal 2010 at $1.5-$2 trillion as the Treasury tackles cumulative deficits of $3.5 trillion over the next three fiscal years. “The level of government debt is a bigger worry for the dollar because it is a more long-term problem,” says Raj Gunaratna, London-based currency economist at IDEAglobal, an economic research organisation. “Given that the CAD is unlikely to expand much further, government debt takes centrestage.”

In ordinary times, holding a dollar asset or dollars, was never a problem for investors or nations. With no real risk of default, dollar assets like US Treasuries (short- and long-term) are, even today, considered the safest asset in the world. When the credit crisis erupted last year, investors pulled out of riskier assets from around the world to dive into US Treasuries, never mind the fact that the crisis originated in the American banking system. Even when Treasury yields turned negative (investors were getting back lower than the principal) at the height of the crisis, the queue of investors didn’t stop.

Until recently, lending to the US government came easy for global lenders, backed by the belief that the economy’s strength and the privileged status of the dollar made them worth the credit. Every sort of financial institution from commercial banks, both in the US and overseas, foreign central banks, private investment firms to pension funds, mutual funds and insurance companies, was eager to hold US Treasuries. Ironically, the biggest buyers of US Treasuries today are China and Japan — the two nations against which the US runs the biggest trade deficits. That’s akin to your creditor also being your lender. There’s self-interest involved here: export-dependent China pegs its currency to the US to encourage exports. The dollars it receives for its goods and services are invested back in US securities rather than converted into local currency because that would only drive up demand – and value – of the local unit and the Chinese do not want that. It’s a strategy pursued by most Asian nations, which depend mainly on export-led growth to the US. In essence, foreigners are picking up the tab for America’s overspending. For all these years, it seemed like a solution everyone could live with. Not anymore.

The US government’s record debt levels are alarming investors. China, for instance, owns close to $800 billion of these securities, has voiced concern about the dollar’s decline; of late, those purchases seemed to have slowed down, but they are continuing (See table: Grumpy but still game). Overall Treasury purchases by foreigners, however, don’t show any visible signs of slowing down, now totalling about a whopping $3.5 trillion (See chart: In demand).

Dangerous

But there’s little doubt that the gargantuan government borrowings are affecting the dollar’s top-dog image. Already, that ‘I am invincible’ aura has been decisively pierced by the pounding the economy took in the 2008 crisis. The borrowing binge isn’t helping either. In the dollar’s defence, the kind of heavy-duty borrowing being indulged in by the US government is pretty much in line with what other governments around the world are doing. So the greenback can legitimately use the oft-used celebrity line of defence: “Everyone’s doing it. Why single me out?”

Many currency trackers agree. “The US fiscal outlook is expected to deteriorate,” says Paul Mackel, London-based senior currency strategist at HSBC. “That said, there are a number of countries where the fiscal outlook will turn for the worse. With exchange rates being a relative concept, it is hard to punish the dollar alone for poor fiscal discipline if it will deteriorate in the UK, Eurozone, Japan, etc.” Public-sector debt is currently close to 60 per cent of GDP in the US, not that different than in the UK (59 per cent), the eurozone (estimated at 84 per cent in 2010) and Japan (100 per cent).

Still, the fact remains that all this debt has to be serviced at some time. It would not have mattered had the economy been expected to put in a chart-busting performance. But that’s very unlikely. In such an environment, as the government borrows more and more, the fear among some economists is that it will ‘crowd out’ the private sector, which will have lesser funds for its needs. Interest rates then need to rise as the private and public sector compete for funds. At the moment, there’s no problem — credit growth remains moribund, down 5 per cent from October 2008 levels. But with economic growth still feeble, the big question is how will all those billion-dollar government IOUs be repaid?
When faith in the government’s ability to repay those debts evaporates, the dollar’s VIP status in the currency world will come apart. Some experts also cite the possibility of exploding inflation as a concern – what if the US Federal Reserve is unable to suck out all the billions of dollars it has flushed into the system, in time before it cascades into hyperinflation? Even as demand in the US (and many other economies) seems to be driven purely by fiscal incentives, rising asset prices are threatening to cause a worldwide bubble. Normal demand needs to come back eventually because debt-burdened governments can’t keep pumping money and offering tax breaks for their economies forever. Will that happen? Some people like BBH’s Chandler think so.

A fervent believer in the dollar’s ability to recover after every punch, Chandler insists that while the US has some serious financial challenges ahead of it, “it also has the best chances of dealing with them successfully”. For now, the markets seem to be buying that idea: at the end of October, yield on treasury securities averaged 3.36 per cent, down from 4 per cent a year ago, according to the Treasury. Even the benchmark 10-year US Treasury bond yielded 3.35 per cent; in comparison, the German 10-year bond (considered the gold standard among European bonds) yielded 3.25 per cent. “For all our fiscal excesses, we’re being charged 10-15 basis points higher,” adds Chandler.

Invincible?

Yet there’s no denying that the US fiscal challenges are making a lot of investors jittery. But that doesn’t make the dollar a one-way bet – yet. Admittedly, heavy debt may blight the dollar’s long-term prospects, but ditching the dollar now is nearly impossible. “The weakness of the dollar will make holders of dollars more and more uncomfortable,” says Barry Eichengreen, economics professor at the University of California, Berkeley. “But there is little that they can do about it given the alternatives are not that attractive.”
Criticism of the dollar’s role as the world’s main reserve currency has grown in the wake of the financial crisis, but so far, there are no signs of a sharp collapse of confidence in the currency. True, there have been attempts by nations to diversify away from the greenback, but experts say these are likely to affect the dollar’s standing “at the margins”. Iran, for instance, denominates the price of the oil it sells to the outside world in euros. China, the biggest holder of US Treasuries, has started encouraging the use of its own currency in intra-Asian trade. India’s purchase of 200 tonnes of gold from the IMF for $6.7 billion is believed to have been financed by selling some US Treasuries.

There are market reports (denied by the parties involved) that major oil-producing nations are also looking at pricing their output against a basket of currencies rather than the dollar. And a recent IMF update suggested that 63 per cent of the increase in global central bank forex holdings went into euros in the June-ending quarter. But don’t panic. “This could be a function of euro strength or the actual accumulation of euros above and beyond the dollar in this period,” says HSBC’s Mackel.

Nevertheless, experts warn that it’s not a wise idea for the US to test the goodwill of investors too much. “If the US were to bungle its economic policy terribly and allow its fiscal condition to remain out of balance indefinitely, then the likelihood of there being a tipping point when everybody might break away from the dollar to other alternatives becomes more likely,” says Eichengreen.

Easier said than done, given that there aren’t that many currencies that can immediately replace the dollar. The euro by far is the most talked about currency in this context, but it suffers from one big problem — the lack of a deep and unified market for government bonds, the way US Treasuries do. There is no single unified market for investing in euro assets — German euro bonds are separate from French euro bonds which are distinct from Spanish euro bonds. More importantly, all these bonds have different credit ratings. The euro might seem like the closest replacement to the dollar, but it’s not quite there yet.
The Chinese yuan? Forget it. “The renminbi is not a serious contender to begin with,” says Richard Portes, economics professor at the London Business School and president of the Centre for Economic Policy Research. “It simply does not have a financial sector big enough to support the renminbi as a global reserve currency. It also has capital controls which the government shows no sign of wanting to lift as of now.” The Japanese yen and Swiss franc aren’t considered real contenders either. It all goes to prove that the dollar, despite its flaws, will remain a one-of-a-kind currency in the reserve currency stakes for 10-20 years. “While we expect some dollar weakness in the long term, we don’t see some seismic shift in the way the dollar is viewed,” says Jyoti Narasimhan, research director for India - country intelligence group at IHS Global Insight, a US economic forecasting firm.

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This is it

In the short term, the dollar’s attempt at making a successful comeback will depend a lot on how the US Federal Reserve tightens liquidity. “The dollar is anchored right now because no G3 country (US/eurozone/Japan) offers attractive returns and US inflation is low,” says Steven Englander, chief US currency strategist for Barclays Capital. “If confidence were lost in the inflation anchor, or if fiscal policy became unsustainable, or if a trade war broke out, there could be a precipitous dollar shock.”

That’s why the dollar rally is highly likely to be short-lived. The US economy is bedevilled with some serious problems, and only if regulatory authorities fully convince investors that the solution it’s offering isn’t going to set off a new chain reaction of more problems, will the dollar once again regain the long-term loyalty of its audience.

Time for the dollar to step out of Neverland to prove it still has what it takes to stay at the top.