Dollar's wild fluctuations point to an uncertain future

The US dollar was trading as high as 1.6 against the euro over the summer, fell to a 2008 low of 1.25 in November then yo-yoed back to 1.45 earlier this month, only to begin another descent over the past few days.

The fall season's run-up of the dollar was due largely to a flight-to-safety by worried investors seeking a safe haven for their capital. The financial crisis has made investors, many of whom have experienced huge portfolio losses, cherish preservation of capital over returns. And US Treasury bills have generally been regarded as being as close to a risk-free investment as possible.

But now bets are mounting against the dollar. Reuters reports that the dollar has lost 6 per cent so far this month against a basket of international currencies and may see the largest drop since 1985. This may be the future, because the US dollar is increasingly being subjected to almost relentless downward pressure.

Most significantly, the United States has been forced to "radical" fiscal measures to bolster its sagging economy. The primary mechanism is to increase money supply which explains why the interest rate has recently been cut to almost zero.

But this also means that US Treasuries - which are the main lever for controlling money supply - will be less attractive to investors. While some might cling to these investments as a refuge during the immediate period of financial uncertainty, a migration away from the dollar into other currencies will begin as the world economy stabilises.

Recovery

As investors recover their courage, they begin snapping-up bargain-priced assets throughout the world. Many of those are in developing countries including Asia where countries like China are still experiencing positive economic growth. Recovery will begin during the second half of 2009, many observers believe, though investors are likely to begin liquidating their dollar positions and embark on their shopping sprees well before then.

Inflation poses an even greater threat. Since the high-inflation 1970s, US Federal Reserve Bank policies have generally been inflation-adverse. A major reason is that Americans now have far more debt so that an economic downturn creates significantly greater potential for financial default. But the Federal Reserve has run through many of its options for boosting the sagging US economy other than to increase the supply of dollars.

Moreover, the huge US government debt has been made more precarious by expenditures for the Iraq war as well as massive bail-outs - all piled onto existing obligations accumulated from years of deficit spending. The result is a lethal combination - a mountain of debt plus a stumbling economy. Other dark clouds on the horizon include the clamour for US medical reform and the mushrooming burden of retiring baby boomers.

Politically, the pressure is intense and will get stronger for further devaluations to cut financial obligations - including those to American citizens - down to manageable size. A cheaper dollar would also make lower cost American goods and services overseas more competitive.

But the result is likely to be 'from the frying pan into the fire' meaning the liquidity crunch of 2008 may turn into markets awash in liquidity in 2009 and beyond. This scenario, Wim Boonstra, chief economist with New Zealand's Rabobank, describes as "very dangerous territory."

Stability

Two major factors about the future of the dollar are unknown. The first is what President-Elect Barack Obama will do when he takes office on January 20. What is unknown is not whether he will make wise decisions to restore the US economy and the dollar but whether they will make much difference. In other words, what options does the United States realistically have with respect to stabilising the dollar?

The second factor is how the world regards the dollar. In the past, the dollar has been the de facto currency standard especially after the abandonment of the gold standard. Nations, including the UAE, have made significant sacrifices by tying their own currencies to the dollar. China has done so as well, though this was a conscious strategy to promote domestic economic growth.

But those days are over. One outcome of the financial crisis will be major changes to the global monetary system. In that sense, the recent Bretton Woods II meeting was more important than is generally believed.

A cornerstone of Bretton Woods II must be movement away from the dollar as the basis for the world's currency system. What replaces it is still unknown but the likelihood is that will be exchange rates based on baskets of currencies rather than a single currency.

Dr Rod Monger writes on economic, business and political issues.