In the past few weeks, I have written several articles about the United States dollar and the driving forces behind the ongoing devaluation of it. After being the world’s main reserve currency for many decades, the game is finally changing, and it has far-reaching consequences for the world and your investment strategy.
In my previous articles, I wrote extensively about the reasons why there is a perfect storm building for the U.S. dollar and in the last few weeks the greenback has been losing further ground against other major currencies. It’s even weakening even against the euro.
We are witnessing the late stage of a U.S. dollar dominated global currency system, a system that is changing quickly. It remains to be seen whether there is going to be a smooth transition to a new global currency regime or an outright collapse of the current system.
In Europe, we are dealing with a currency crisis already and, despite the efforts to cut spending and fix government balance sheets, the bailout packages for countries like Greece and Portugal are causing longer-term damage to the creditability of the euro. Creditability, or better, a lack thereof, is also adding further pressure on the U.S. dollar.
Last week, U.S. Treasury Secretary Timothy Geithner said that a strong currency is and has always been in the interest of the U.S. and that the country will never embrace a strategy to weaken the dollar. At about the same time that Geithner made his statement, the U.S. dollar hit fresh all-time lows against a number of major currencies, a clear indication that the market doesn’t believe him. The lack of creditability and trust in the U.S. fiscal and monetary policy is driving an increasing number of foreign investors away from the dollar and it seems that this process is still in a relatively early stage and could continue for years to come.
This became obvious last month when the leaders of BRICS nations gathered in China for a one day summit. BRICS is an abbreviation for the five countries: Brazil, Russia, India, China and South Africa. They are seen as the dominant emerging markets today and discussions between them are important for various reasons, primarily because these meetings take place without any representation or influence from the U.S. or Europe.
The five BRICS nations make up about 42 percent of world population and almost 20 percent of global gross domestic product and these numbers are growing, making what they discuss very important. To make the numbers look even more impressive we should also say here that these five nations hold more than 40 percent of the world’s currency reserves.
The term “BRIC” was originally defined by Jim O’Neill an economist at Goldman Sachs. Currently, it is projected that the BRICS nations will be the dominant country block by 2050, with their economies expected to grow significantly in the next four decades. The following chart shows how the size of their individual economies will develop in the next 40 years, with China becoming by far the largest economy on the planet.
The 10 largest economies in the world in 2050, measured in GDP nominal (millions of USD), according to Goldman Sachs.
At their summit in Sanya, China last month, the leaders of the five BRICS nations discussed their involvement in world affairs. The main topic at this year’s summit was clearly their discussions about the future role of the U.S. dollar as the world’s main reserve currency and there was mutual agreement that their U.S. dollar dependence should be reduced going forward. This needs to be seen as another step away from the U.S. dollar as the main reserve currency.
The participating nations expressed their concern about the U.S. economy and the fiscal situation, which might become a large risk for BRICS nations that not only hold a lot of U.S. dollar reserves but also do a lot of their business and trade in U.S. dollars.
The chart above shows how the currencies of the five BRICS countries have performed in the last 12 months. The downward sloping lines mean that the U.S. dollar has been weakening against all of the BRICS currencies. This trend is expected to continue as trading restrictions are expected to diminish over time, making these currencies “real” currency alternatives for investors worldwide.
A good example here is the Chinese yuan, which is currently not freely convertible. However, it is not a question of “if” but “when” it will become freely tradable. We might still be a couple of years away from a freely floating Chinese currency, but the day will come and this will attract further capital flows away from the U.S. dollar.
The BRICS are now calling for a new global currency system to be established with a broader range of currencies involved in order to provide the necessary stability. This joint call for a new world currency reserve system only comes a few weeks after Chinese President Hu Jintao said, when visiting the U.S., that the days of U.S. dollar as the world’s dominant currency are over.
The participating nations also agreed to grant each other credit lines for trade between each other, and those credit lines are now held in local currency and not in U.S. dollars anymore.
We think that it is really important that people understand the potential long-term implications of this. The currencies of Europe and the U.S. make up about 90 percent of the world’s currency reserves but a growing number of countries, like the BRICS, are viewing them as weak partners because of their large debts and the monetization of those debts, therefore forcing a devaluation of their currencies. This acts as an extra tax on everybody holding euros and U.S. dollars.
It is almost a perfect storm brewing for the U.S. dollar here, with the fiscal deficit and debt situation being out of control, rating agencies finally willing to consider downgrading the credit quality of the U.S. and the BRICS wanting to diversify away from the U.S. dollar. Also the increased talk about the U.S. debt limit and its potential implications is adding more uncertainty.
There has been a lot of talk about the European sovereign debt crisis during the past 12 months. The chances are increasing that the next big market theme will be the U.S. dollar crisis, and this would have a much larger impact on markets than the European debt crisis.