The impending end of $ as we know it

BANGALORE: Does life move in circles or do we? I ran into her in a coffee shop in Bangalore yesterday.

“What are you doing here?” I asked.

“Waiting for you,” she said with a mischievous smile.

“The last time we met, you said the US dollar might be the next big bubble waiting to burst. Why did you say that?” she asked as I started sipping my coffee.

“I said that because that’s the way I see it. In order to get out of the current financial crisis, the US government is literally printing dollars. And this I feel will lead to the US dollar getting into big trouble in the days to come.”

“As simple as that, is it?” she asked.

“Let me give you an example of a Japanese investor who invested in a 30-year US Treasury Bond in 1985. Treasury Bonds are essentially long-term debt securities issued by the government to raise money to make up for the difference between what it earns and what it has to spend. At that point of time, one US dollar was worth 250 Japanese Yen. Today, one US dollar is worth 92 Yen. So the Japanese investor has lost nearly 64% of the principal he had invested.”

“Now, how did you arrive at the 64% figure?”

“Simple. Let us say a Japanese investor wanted to invest $1 in 1985. He would have needed 250 Yen back then to buy $1. Now if he wants to convert that $1 back to Japanese Yen, he would get only 91 Yen. That means a loss of 159 Yen (250 Yen - 91 Yen). This when expressed in percentage terms is 64% (159 Yen as a percentage of 250 Yen). The logical takeaway here is that when the currency of the country whose financial securities you have invested in depreciates in value against your currency, as the US dollar has against the Japanese Yen, you lose money.”

“Hmmm, interesting. But what are you trying to suggest?”

“When does a currency depreciate or lose value against other currencies?” I asked.

“That I guess happens when people do not want to hold investments in that currency anymore and sell that currency to convert into some other currency. Since the supply of that currency increases, its value falls against other currencies.”

“Are you telling me that in the days to come people won’t want to hold investments in the US dollar? That they would want to get out of the US dollar and that would mean they wouldn’t want to invest in financial securities issued by the US government either?”

“Yes on all the counts,” I said.

“But that does not seem to be the situation right now. The US dollar has appreciated against most currencies except the Japanese Yen and this clearly means that more and more people are buying the dollar to invest in US government financial securities. How do you explain that contradiction?”

“Well. In the recent past, most of the bigger investors have pulled money out of various markets across the world, converted that money into the US dollar and used that money to buy securities issued by the US government. Right now, there is great demand for securities issued by the US government. And that to a large extent explains why the returns on US government securities have reached an all-time low. The return on three month US Treasury Securities currently is at around 0.02%. The return on one-year security is around 0.61%. This is surprising in light of the fact that the US government debt currently stands at $10.6 trillion, the highest it has ever been. At the same time, the government is borrowing big time. Lately, it has also been printing dollars to carry out the various rescue measures for the financial system. Given all this, it is surprising that the return demanded on the financial securities issued by the US government hasn’t been going up.”

“So why is the return being demanded not going up?”

“Oh that’s not been going up because right now investors are ready to buy financial securities issued by the US government. They feel the US government security is the safest thing going around. But that is likely to change. Let me explain why. Oil exporters are a major buyer of US government securities As of September 2008, they owned $182.2 billion of US government securities or around 6.37% of the total. Now you know that the price of oil has fallen from around $150/barrel to currently around $45/barrel. So the oil exporting countries, which had been buying up the US government financial securities at low rates of return will not have enough money going around to continue buying. Also, China, which has reserves of $585 billion, or 20.5% of the total, and has invested in US government financial securities, is entering into a slowdown. This means, all the dollars they were earning through exports will come down. And when that happens, they cannot continue to buy US government securities,” I said.

“So the demand for US government securities will come down?”

“Yes. And when the demand comes down, the return on investing in US government securities will have to go up. That would also mean that the US government will have to pay more interest on the financial securities it issues, than it currently does. So that will worsen the financial position of the US government even more.”

“But what’s all this got to do with the dollar?” she asked.

“See, one reason other countries buy dollars is that it is the international reserve currency. Now, as the US Fed prints more dollars and the US government raises more and more debt, investors in US government financial securities will start to question the creditworthiness of the US government. And when that happens, they will want to sell the US government securities. When they sell the US government securities, they will get US dollars in return. They will sell the US dollar, get the currency they want to and repatriate that money to their own countries. When all that dollar-selling hits the market, the US dollar will depreciate, i.e., it will lose value against other currencies. Now, as I have explained already, when the currency of the country whose financial securities you have invested in depreciates in value against your currency, you lose money. Also, as the US Fed prints more dollars, the supply of dollars in the market increases, this again adds to the value of the dollar against other currencies going down,” I said.

“I think I understand it now. As the dollar depreciates, the value of the US government securities held by various countries will go down. This may make them want to sell these securities. And this, in turn, will put further pressure on the US dollar. In fact, in the recent past, foreign central banks have already sold $120 billion of US government debt,” she said.

“So what’s your doomsday prediction?”

“You see, the US till now has had a big advantage, which most countries don’t have. The US can raise an international loan in its own currency. This is because the US dollar is the international reserve currency. So countries, which have US dollar reserves are ready to invest in US government securities at very low rates of interest.”

“But if things pan out as I feel they should, central banks and governments around the world wouldn’t want to invest in US government securities. And when that happens, the chances of the US dollar continuing to be the international reserve currency are bleak.”
If and when that happens, the US will have to probably start borrowing in other currencies. In order to repay those loans, they wouldn’t really have the option of just printing dollars. That money will have to be earned.”

(The example is hypothetical)

k_vivek@dnaindia.net

References: ‘Don’t be surprised if the US government defaults on debt’, Satyajit Das, September 16,2008, DNA  ‘US dollar: The Next Bubble to Pop’, Jack Towne, www.seekingalpa.com