By Benz Sudta
The dollar weakness in the long-run is undeniable fact given huge public debt and reserve asset reallocation. In daily life we see day-to-day report of dollar exchange rate against 2 major currencies: the euro and the yen.
Because of the Bretton Woods agreement, every countries had to maintain their exchange rate stability against world anchor currency of the gold exchange standard – the dollar. As a result, every currencies had to quote their own exchange rate against the dollar and their monetary policy since then has been linked to the dollar.
The dollar index emerged from the crisis in the 1970′s after the abandon of gold convertibility of the dollar. Investors fled the dollar and rush to the mark and yen as safe haven and expected the dollar falling against the two major currencies. The reason behind the fall against German mark and Japanese yen was that the US was running current account deficit against these two countries and their economies would be stronger.
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But today things have changed. We found that after the crisis in 1970′s the US came back while our 2 rising stars have fallen behind the US until this day. However, one fact still exists. The center of gravity is moving but not among the developed world as we understood the shift towards the east to Europe and Japan. The shift is moving further eastwards to developing countries led by China and the rest of developing world.
In the past decade, the developing world in Asia, Eastern Europe and Latin America had emerged from crisis and now enjoy high level of growth and unprecedented financial muscle even after financial crisis in 2007-2008. These countries rid the rise of China and the economic boom in the US after the global economy recovered from recession caused by tech stock bubble burst. The US unprecedented level of consumer spending caused the higher deficit in current and fiscal account as well as mounting debt. That situation prompted many people seeking new alternative reserve currencies to replace the dollar. The dollar weakness and volatility has caused too much risks to the global economy.
The euro, gold and other developed world hard currencies became the answers for avoiding dollar risk for developing economies who care their export sector. But we must not forget that the crisis is not absolutely over. We can see hidden risk in European economy from weakness in some Euro zone countries such as Spain, Greece as well as in Eastern Europe. High level of debt and sovereign default risk will stun the fundamental of Europe severely. Furthermore Europe must cope with its falling population problem in the near term. As a result, Europe will struggle to maintain rather than boost its economic size to keep living standard. The public debt burden and population decline are also the fundamental problem for Japan.
The collapse of Lehman Brothers does not reverse but accelerates the trend of economic power shift to the far east and the south. Many analysts have seen the euro and yen appreciation as mechanism of global rebalance. This reality is true as long as the developing world particularly Asia still relies on export as growth engine. However, the financial crisis has accerelated the trend of rebalance in developing world. The very strong economic fundamental and critical change in mode of growth will crush the artificial strength of European currencies and to the less extent for the yen. Some developed world can benefit from the rise of Asia and the rest of the developing world. Japan as well as Canada, Australia and New Zealand are the chief beneficiaries.
Record capital inflow to developing world led by so-called BRIC, the move of financial industry to Asia, the rise of new financial centers and Sovereign Wealth Funds are strongly supportive evidence of stronger currencies in developing world while European currencies especially euro and sterling will fall against the dollar and heavily against the major developing countries currencies. This is the new reality. The readjustment of global imbalance will have new source from surplus countries not from matured economies.
There is another important reality we must not forget. Until now we still see less open financial sector and high level of intervention and control in FX market. Such policies distort the reality in structure of global FX market too. According to BIS Triennial Survey of FX market in 2007, the total daily turnover has risen to $3.2 trillion in 2007 from $1.97 trillion in 2004 survey. This time we see the rally in the share of currencies from the developing world in global turnover. We can also see the rise of developing world in term of the source global FX transaction. This reflect the rise of new financial centers from this area too. However, the share of developing world currencies are still relatively low while the share in global trade, size of financial market and GDP are rising.
We can expect more relax in financial market and currency control in the future. The launch of stock index future of China signaled China’s willingness and ambition to promote the global status of Shanghai and RMB in the near future. Consider the 2007 share of all RMB transaction against all currencies was only $16 billion a day compare with $530 billion for the yen and $482 billion for the sterling. These reflect the major trend in the future: The change in structure of global money and FX market. We can expect the rise of share of currencies from the BRIC as well as from South Korea, Indonesia, Poland, South Africa and Mexico. Furthermore, we will see the rise in cross-currency transaction among old major currencies, among new major currencies and between new and old major currencies too.
But it is unfair when we watch the TV report such as Bloomberg about the latest value of dollar gauged by dollar index. The rise of dollar in term of 6 major currencies on average: euro, yen, sterling, Swiss franc, Swedish krona and Canadian dollar because of the risk from Greek fiscal health does not reflect the downtrend of the dollar. But this reiterates the new measure of dollar value under new environment. The new dollar index should dilute the weight of developed world currencies in calculation. Currently the formula is 57.6% for euro, 11.9% for sterling, 13.6% for yen, 3.6% for franc, 4.2% for Swedish krona and 9.2% for Canadian dollar (as of Jan 20, 2009). We should replace the western currencies with the most liquid currencies in developing world as well as gold to adjust the reality of dollar index.. This time we need is the gauge for broad value of dollar not the euro.
This is only first step to cope with future change. The new dollar index can help us assess the reality of the dollar more clearly. It can help central banks improve strategic reallocation of reserve asset in the long run. We can also have a guide to create new securities based on new basket for liquidity and risk management.
It’s easier to change the formula in computer software immediately than money flow in the computer screen.