The Dollar

The U.S. Dollar (USD) seems to have stabilized against most major floating currencies. This includes the British Pound, The Euro, The Canadian, Aussie and New Zealand Dollar, the Swiss Franc and the Japanese Yen. However, many market participants hedge funds included, do not think the USD’s fall has been stopped. What is most worrisome at this moment for the USD are the pegged currencies of Asia and the Middle East, in particular China and Saudi Arabia.

China and Saudi Arabia have their currencies pegged to the USD despite the fact that much of their international trade is done with other countries. However, because of the USD’s fall against the major floating currencies, those currencies pegged to the USD are also falling relative to most other currencies. The net effect of this fall is inflation. The central banks in Saudi Arabia and China must buy USDs on the open market and print their own local currency with which to buy those USDs. This is inflationary. Both China and Saudi Arabia are now experiencing inflation above 8%.

Speculation amongst hedge funds is that Saudi Arabia, in particular, will drop the USD peg and move to a peg against a basket of currencies. Last year, Kuwait, experiencing much of the same problem, terminated its USD peg last. China has moved to an accelerated peg crawl against the USD in order to stem inflation. However, the net effect of a free float or pegging to a basket by Saudi Arabia and China will be to reduce demand for USD assets, particularly treasury securities, thus pushing up long-term U.S. Interest rates. Ultimately, long-term interest rates in the United States are so low because foreign central banks like Saudi Arabia’s, China’s and Japan’s are buying dollars on the foreign currency markets. If this changes, the U.S. will feel some very painful economic effects. U.S. citizens will experience a fall in their standard of living as well. Anyone who has traveled to Europe since the USD’s fall there understands this point.

In the end, this may well be the unfortunate outcome of having one’s economic growth depend on the kindness of strangers.

Sources
Dollarization and fixed exchange rates, Wikipedia
Northern Trust’s Paul Kasriel’s interview with Bloomberg News, Bloomberg News (mp3 file)