Dollar Diversification Dilemma

Monday, January 09, 2006

Remembering the often used phrase "anecdotal evidence" in the FOMC minutes here comes one example that spells a bad future for the dollar. Friends of mine who have a holiday residence in the Dominican Republic just returned from their vacation there and told me that the kids are not asking anymore "you have a dollar, sir" as they did in the past. Nowadays they want Euros!
While the streetkids new appetite for the common currency may not be exactly the reason why the dollar experienced its biggest one-day decline since 9/11 last week, opinions voiced by Chinese economists may have done the trick. China should think about new ways where to direct its huge trade surplus to, it could be read in Chinese media which mentioned oil and gold as viable alternatives to the backed-by-nothing greenback.


To pay off the total US debt of $40.1 trillion $ (public and private debts) it would need 40,100 of these $1 billion notes.
The idea that China could become a less dominant force in US Treasury auctions sends shudders down the spines of dollar investors as this would lead to even higher rates on the short end, inverting the presently flat yield curve even more. This is because the Treasury would have to offer a higher risk premium (=interest rates) in order to attract future capital inflows.
It appears there are worldwide a lot more thoughts about getting out of the dollar than there is official talk about such a move that will in the end hurt everybody since 75% of the world's savings are denominated in the ailing greenback.
Richard Nixon once said "the dollar is our currency but your problem." Things were entirely different then. From a creditor nation with a strong export economy the USA has since turned into the biggest debtor who has outsourced so much of its industrial production that the value of the dollar has become a dilemma from whatever perspective you take.
As the US national debt has zoomed past the $8-trillion mark and will in a matter of weeks hit the legal debt ceiling at $8.18 trillion it would be most comfortable for the government to inflate its way out of the biggest financial debt any nation has ever encountered.
But while this might help to get rid of the debts the easy way it creates another problem unprecedented in history.
As the country cannot fulfill its consumption needs from domestic production anymore American citizens would find out the hard way that whatever they want to buy has climbed out of their financial reach.
A nation that became spoiled by buying Japanese cars, Korean flatscreens, Chinese textiles and toys, oil from the OPEC members, soy beans from Brazil and luxury goods from Europe, all thanks to the credit it has been enjoying until now, could suddenly find itself at the mercy of their trading partners if they lose their appetite for dollar denominated paper.
Some of the former investors the US could count are obviously bailing out already. OPEC members, who currently enjoy oil revenues in excess of $500 billion annually must be putting their money elsewhere. The Treasury Inflow Capital data show a mere $63.8 billion US debt in the hands of the oil exporters.
Is gold the answer? I take today's new 25-year record price of the yellow metal as an indication that Arabs are diversifying into gold. So do Argentina, Russia, South Africa while the gold sales of the Eurozone central banks have been slowing in recent weeks.
If You Have An Answer Apply For A Top-Job At The Fed
The big question is: What will the USA do? Remaining with a strong dollar policy in order to have enough paper in hand to buy whatever is not produced in the USA anymore? Or inflating the dollar to pay back its unprecedented debt cheaply, as Germany did by the way of hyper inflation in the 1920s? One way will let the debts grow even faster becauser of higher interest rates. The other way could turn the country into a poorhouse.
If you have a realistic answer to this conundrum please post in in comments (all ironies are welcome too) or apply for one of the many vacant positions in the Federal Reserve (see this post.) They could need you.
Investment-wise I want to add that it is still a good time to enter the gold train although I see even more potential in silver these days. Ah, I guess right now it does not matter which precious metal you are interested in, as long as you are long.
UPDATE: Japan's Ministry of Finance has just announced that it will intervene of currency movements get out of line, my broker informed me. The dollar has traded between 113,77 and 116,27 Yen or a range of 2.2% in the last 30 hours of trading. The February gold futures has today moved up 3.1% from its day's low at $535.60 to a contract record of $553 in less than 4 hours.
Thrilling times indeed.


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