US Dollar plunge could lead to full-blown financial crisis

The Straits Times ^ | 01.17.04 | William Choong

[Beck_isright]

If confidence goes, lenders will pull loans and cause dollar to crash

By William Choong
TECHNOLOGY REPORTER

YEARS before the Asian financial crisis of 1997, many Asian countries had become hooked on a dangerous concept - credit.

Economic growth was chugging along nicely, and in countries such as Thailand, the middle-class was indulging in a consumer frenzy, buying branded goods, holidaying abroad and sending their children to overseas schools.

But Thailand's trade deficit - the amount by which imports exceed exports - was growing, financed by massive short-term loans from foreigners.

When investors lost confidence, however, a sudden flight of capital brought the kingdom to its knees.

The odd thing is, this year, the United States - once the world's biggest creditor nation - is also experiencing a credit- fuelled consumer spending spree.

There are fears the American appetite for Japanese cars, Chinese clothing and Malaysian electronics could cause a global financial crisis sparked by a run on the US dollar.

This has led to a massive current account deficit of more than US$500 billion (S$850 billion) - a far cry from 10 years ago, when the US enjoyed a trade surplus of US$82 billion.

Its budget deficit could hit US$450 billion this year - another record, and a dramatic turnaround from 2001, when government coffers were in the black.

This has led commentators to lament how America's twin deficits could grow into a 'full-blown, Third World-style financial crisis'.

The logic is simple.

Like Thailand, America's deficits are financed largely by foreigners, particularly Asian central banks that want to keep their currencies weak against the greenback to boost their country's exports.

Any crisis of confidence would see them withdrawing their loans, triggering a fall in American financial markets and then a run on the greenback.

The writing is already on the wall.

In the past year, the greenback has racked up losses of more than 20 per cent against the euro - falling to a seven-year low of around 80 US cents to the euro. Against the yen, it has shed 11 per cent to hit a three-year low of 105 yen to the dollar.

'On a scale of one to 10, for (the chances of) a dollar rout against the euro, I'd say we are at eight,' Mr Peter Morici, a business don at the University of Maryland, told Dow Jones.

A weaker dollar reduces America's debt, gives a leg-up to US exporters and slashes the current account deficit.

But a weaker dollar is a double-edged sword: It could lead to dearer imports and raise inflation - the bugbear of industrial economies.

This would hamper the world economy's preeminent engine of growth - the average American's propensity to spend.

Abroad, a weaker dollar would lead to competitive devaluations as other countries find their US-bound exports relatively expensive.

There is a growing chorus of voices stressing the possibility of a greenback plunge.

The International Monetary Fund has lashed out at the US, arguing that its massive debt could wreak havoc on the US dollar and global exchange rates.

In a paper presented earlier this month, three analysts - including former US treasury secretary Robert Rubin - argued that Washington's twin deficits could amount to what some have termed a 'full-blown, Third World-style financial crisis'.

Mr Paul Krugman, a prominent economist who foresaw the 1997 Asian financial crisis, drew the conclusion as early as last October.

In a New York Times column, he said the US economy was approaching a 'Wile E. Coyote' moment - when the coyote in the famous Road Runner cartoon runs off a cliff, only to realise at the last minute - too late - that it is about to plunge to the bottom.

'What will the plunge look like? It will certainly involve a sharp fall in the dollar and sharp rise in interest rates,' he wrote.

'In the worst-case scenario, the government's access to borrowing will be cut off, creating a cash crisis that throws the nation into chaos.'

Such views, however, have been derided by members of the Bush administration, who have pledged to halve America's budget deficit in five years.

What is probably high on their minds is how, in the 1980s, the world's largest economy under former president Ronald Reagan managed to grow despite similar deficits.

That was thanks - again - to a weak dollar and booming demand in Germany and Japan.

But the raising of US interest rates will affect Europe, the exports of which have become more expensive, just when the region is showing signs of faster growth.

Compared to Europe, Asia looks set to be hit harder - simply because the region is more dependent on exports to the US.

There have been calls for the Chinese yuan, which has been pegged, or fixed, at a constant rate to the US dollar, to be revalued to a stronger level, perhaps by as much as 20 per cent.

For a long time, market watchers said the unit was undervalued at around 8.3 to the US dollar, leading to a massive US$100 billion trade surplus with America - a quarter of the US' total trade deficit.

'It's not a question of if, but when,' Mr Craig Chan, head of Asian research at Forecast, a London-based research firm, told The Straits Times.

The effects of a yuan appreciation, however, would be fairly significant.

Close to 200,000 state-owned enterprises, which are less efficient at producing exports than private firms, would suffer, leading to heavy job losses.

Its financial sector - still in the midst of reform - would also take a hit, said analysts.

In Japan, a falling dollar would derail a recovery that only started kicking in last year.

For the rest of Asia, a plunge in the US dollar would spell trouble.

In the second half of the 1980s and the late 1990s, the greenback's strength fuelled exports from Thailand, Malaysia and Singapore.

A weak dollar, however, would affect American purchasing power and slam the brakes on Asian exports, lowering growth all round.

This can be seen in Japan's experience in the early 1990s, when the economy tanked after the Plaza Accord of 1985.

Under the accord, a group of developed countries engineered a sustained fall in the greenback along with rises in the German mark and Japanese yen.

Speaking at a regional conference in Singapore last week, respected Malaysian economist K.S. Jomo noted that there have been calls for a second Plaza Accord.

The world's three currency blocs - Europe, Japan and the US - were carrying out competitive devaluations, he said.

'This would lead to an inability to coordinate exchange rates and monetary instability at a global level.'

There is, however, not much hope going forward that there will be enough global coordination.

Last September, the G-7 group of developed countries called for 'more flexibility' in exchange rates. This, however, was interpreted by markets to be telling the Japanese and Chinese to let their currencies rise, thus allowing the US dollar to fall.

Ultimately, whether the US dollar would, in Mr Krugman's words, suffer a Wile E. Coyote moment depends on investor confidence.

For a long time, Asian central banks had, through the purchase of low-yield US Treasury bonds, been the key financiers of America's deficits.

Currently, the US Federal Reserve holds US$1.1 trillion of such debt for foreign central banks, many of them Asian.

Therein lies what could be called the Harvey Norman effect - whereby a seller makes credit readily available to a buyer so the latter can buy more.

As French economist Jacques Rueff said: 'If I had an agreement with my tailor that whatever money I pay him returns to me the very same day as a loan, I would have no objection at all to ordering more suits from him.'

The key: When another crisis of confidence hits US markets, foreign lenders - particularly Asian lenders to the US - might pull the plug on their US loans.

And that would be the crucial tipping point which brings the whole house of cards that is the world economy crashing down, just like the unsuspecting coyote.

[waterstraat]

Especially when the price is lower than domestic producer costs. Free market/free suits bump.

Are you saying that since Nike uses cheap foreign labor that Nike shoes are cheap?

The "free trade" that we have in place has nothing to do with lowering the prices of products that we buy, it has to do with lowering costs of production to increase profits. The intent of the "free trade " legislation is not to lower prices for the consumer.

[jonatron]

In 1997 the Euro was $0.80

[Beck_isright]

" When will that be???"

2005.

[demlosers]

The US$ to Euro has plunged from about $1.29US to $1.23US per one Euro within the last week. That's a 5% change in the direction of a stronger dollar. I trade currencies and I don't follow this guy.....

They're just the doom and gloomers.

You beat me to it that the dollar is on the upswing. Since Germany announced they had a recession last yr. at -0.1 of GDP, and the EU finance guys said they are concerned about the recent strength of the Euro.

I think the dollar will gain 5 to 10 cents more on the Euro before the rates becomes stable. If the U.S. economy maintains a decent growth rate, and the $ interest[FED] rates increases, then the dollar will break above the 1 to 1 barrier by about 10 cents.

[Jaysun]

I looked at the USD only, couldn't find a symbol for the Euro. So let's assume they are 1:1. I see a reversal of the USD of just a little more than 3%. That's pretty small for a reversal for me (pretty dicey for me to make a reversal call) but then I don't play currencies.
Since you're now short the Euro, how much of a reversal magnitude did you use in reversing your position. And, obviously since this reversal magnitude is small compared to what I use for trading, is this small reversal magnitude typical with currency trading ?


The reason that it isn't making a lot of sense is because currencies are a bit different that stocks. In currencies you trade in "pairs". All trades result in the buying of one currency and the selling of another, simultaneously. The objective of currency trading is to exchange one currency for another with the expectation that the market you have bought has appreciated in value relative to the rate or price will change such that the currency pair currency you have sold. If the currency you have bought appreciates in value and you close your open position by selling this currency, or effectively buying the currency that you originally sold, then you are locking in a profit. If the currency depreciates in value and you close your open position by selling this currency, or effectively buying the currency you have sold, then you are realizing a loss. Sounds complicated, but it isn't. Now, the "pair" in dealing with Euro and US$ is EUR/USD. The currency on the left is the "base" currency. So If I want to short Euro I would sell EUR/USD.

The opportunity comes in by virtue of the fact that the currencies are priced down to the ten-thousandth of a cent. This doesn't sound like much, but you trade on margin in currency trading. Each ten-thousandth of a cent is a PIP (or point). So in your example of 3% the EUR/USD might move from 1.2200 (each Euro - the base - is worth 1.22 USD) to 1.1834 which is 366 points! That's good! If I'm on the right side of that, I utilize my margin, and I invest $3,000 of my own cash for the trade, each point would be worth $3.00 - So such a movement would have profited me $1,098.00 US Dollars. That's not too uncommon in a day. The Euro moved down 242 points on Jan 16.

The market in which currencies are traded is called FOREX. It's instant, 24 hrs a day (except for a short time on Sat), you can buy/sell anytime you'd like, and it's worldwide. The Forex Market Moves about $40 trillion Dollars per day - so it's MUCH bigger than NYSE. Why don't you check it out? You can go to the company in which I trade and set up a real time market account with $100,000 PLAY MONEY for free. Then you can practice and see if you like it. The main site is:

http://www.oanda.com

I like them because they have no minimum initial deposit, and no minimum buy/sell amount. You can invest one dollar if you'd like.

[the invisib1e hand]

blah blah blah blah blah yadda yadda blah.

say it with me, students: you WANT a lower dollar when you're in debt. it's cheaper to pay it back....

[Jaysun]

Understood. Do you ever hold over a weekend ? This also explains that you would have to have a smaller reversal number than I use which is in the 5.5% neighborhood as the smallest threshold for reversal. Are you playing actual cash or an index ? Not planning on trading myself but I wanted to get a feel for the dynamics. Using your 1.19-1.20 for the Euro I get the USD under .84 best case. So I would guess that there is not an arithmetic direct relationship. Where does that place the USD in pure numbers.

In currency trading, a 5.5% move is friggen huge. You can look at post 45 for some details, and for a website where you can play around with it for free. You trade the currency in pairs so in the case of 1.19 the reality would be that the USD is worth one dollar and the Euro is worth 1.19 dollars. The pair for that situation would be EUR/USD. I trade in cash. I guess the overall concept would be this: If I had $1,000 Euros and I sent them to the US to exchange them for dollars while the dollar was weak, I'd have maybe $1,300 Dollars. If I then held onto that $1,300 until the dollar became strong again and traded it back into Euro, I'd scrape away the difference. That's basically it, except the prices move in real time down to the 5 second ticker on my trading platform, and can move several hundred points per day. Several hundred points can translate into several thousand dollars.

[Jaysun]

At what time will this price be paid by Joe six pack is what should be addressed... When will that be???

As soon as Joe six pack trades in some US Dollars for Euro to go on vacation. Other than that, a weak dollar is really a good thing short term. It makes our exports MUCH more attractive, it makes travel to the US MUCH more attractive. Nevertheless, the dollar is on the rise. Joe six pack could safely become Joe twelve pack without causing a lot of financial strain to his toothless wife and kids. :o)

[Jaysun]

I think the dollar will gain 5 to 10 cents more on the Euro before the rates becomes stable. If the U.S. economy maintains a decent growth rate, and the $ interest[FED] rates increases, then the dollar will break above the 1 to 1 barrier by about 10 cents.

I'm with you. I think that the dollar is going to continue to rise for a decent period of time. The thing is, everyone except for those involved in international trade will never know the difference anyway.

[dr_who_2]

Never mind that. Let's go to Mars and add prescription drug coverage to Medicare!

[dr_who_2]

Never mind that. Let's go to Mars and add prescription drug coverage to Medicare!

[Jaysun]

Going to Mars isn't fair to the other planets or to those who won't be going to Mars. Prescription drug coverage isn't fair to those who don't take prescription drugs.

[imawit]

Really appreciate you getting back to me. I always want to learn more. I'll study this in detail.

Now. Man is that a tight trading range. I'd wind up glued to my screen 24hrs a day. I woulda expected trading at the top of the food chain to be more calm and sedate. Looks to me like there'd be a lotta jumpin and jive'n second by second, tick by tick.

[dr_who_2]

Wierdo alert.

[ninenot]

Aside from the flight to gold--what might the Chinamen and Nipponese do? Burn their T-Bonds? Demand gold?

I suspect that at this point, the rise in the Euro's value is about over. The Euro was undervalued to the dollar two years ago (read Agora's old stuff) and gold was undervalued, as well.

The problem for all those other guys is that there is really no substitute for the dollar, and as long as the US economy is picking up (which the Admin steadfastly tells us is the case,) the Bond-holders will wait.

What else can they do?

[ninenot]

Agreed.

The only (and it is significant) blockage to growth under your scenario is oil and some other critical minerals which are not available from US mines/wells.

But limiting imports of all other goods while re-employing US citizens to manufacture for export or for in-country consumption is the fastest way to national debt reduction.

[Beck_isright]

"blah blah blah blah blah yadda yadda blah.

say it with me, students: you WANT a lower dollar when you're in debt. it's cheaper to pay it back...."

Absolutely. It's worked great for Argentina!

[Jaysun]

Really appreciate you getting back to me. I always want to learn more. I'll study this in detail. Now. Man is that a tight trading range. I'd wind up glued to my screen 24hrs a day. I woulda expected trading at the top of the food chain to be more calm and sedate. Looks to me like there'd be a lotta jumpin and jive'n second by second, tick by tick.

It's not that bad now. You should look at it tomorrow morning when NY opens up. Each Country is represented by their respective Federal Reserve Banks. The trading follows the international date line. First Bank to open is New Zealand at 7:00 ? Sunday. Then Europe, and blah blah blah. That's why it's going 24 hours a day. It "closes" on Friday evening and then starts the whole thing again on Sunday. The movements aren't that bad. Although I did get my lunch eaten by the damned Aussies (sorry guys) last year. In a matter of an hour I'd sent about $3,000 greenbacks to Australia. You can always use a stop loss. Anywho, it's fun and you can make some change.

[Elliott Jackalope]

It's also working a treat for Zimbabwe. The Zim dollar is worth, what, about .001 cents now? It's a new golden age for Zimbabwe!

[ninenot]

But about 2 years ago it was $0.85 (the Euro...)

I maintain that $1.25 will be the approx price for the next couple of years.