Walrus said:
You have tried to oversimplify a very complex mechanism. Currency trading is more than simply commodity trading. The exchange rates reflect the relative supply and demand for the currencies they represent. That being said they can be manipulated by speculators, but this represents only a fraction of their mechanism.
It was meant to be oversimplified as a person who admitedly didn't know much about economics asked what would happen in OPEC used Euros instead of dollars as the exchange currency. I explained what would happen in this example. Currencies can be manipulated by speculators, but the effects of speculators are overstated, esepcially for currencies in deep liquid markets.
Walrus said:
The $US/Euro debate significance is over whether the Euro will take over the role of the World's reserve currency. Presently about 80% of all the trade transactions in the world are conducted in $US. This means that in order for a country, like Canada, to buy commodities overseas we have to buy $US using $Can and then buy those commodities on the world market. When we sell finished products on the World market we receive $US and then would convert them back to $Can. Now under the rules of supply and demand this would mean that the value $Can vs the $US should be reflected by the value of the trade deficit between our two countries, but since all of trade is done in $US this means that rather than just taking the US/Canada trade into account we have to take the whole World/Canada trade balance into consideration. Since most countries keep a reserve of $US in order to facilitate this world trade that means that there is a huge demand for $US. Conversely , the fact that the US currently runs a huge Trade and Current Accounts deficit means that the supply of $US is also huge. The effects of the supply and demand of $US is reflected not by the $US/Euro comparison but by comparing the $US to all the other currencies. Doing this, you will see the real weakness of the $US.
Currency valuations are also reflective of investment opportunities, and thus capital flows. This is critically important. In theory, what you have written is correct. In practice, it is correct but only to a point. One of the reasons why the US has for many years been able to run a current account deficit and have a rising currency - remember the loonie at 62 cents? - is because investors see the US as, on whole, the best place in the world to invest. So capital flowed prodigiously into the US throughout the 1980s and 1990s. Now the trade and fiscal deficits have grown tremendously, which has been the impetous for the recent weakness in the greenback. so the trade deficit is exerting pressure on the dollar, as you have written and as one would expect. But on the other hand, the trade deficit is being financed with Asian savings, primarily through the central banks of Japan and China. These countries hold large trade surpluses with the US and they've been turning around and re-investing their surpluses back into the dollar which is a source of demand for the dollar. The reason why they do this is essentially mercantilist - they don't want currency appreciation because their economies are based on exports, not consumption, whereas the US ecomomy is based on consumption. Last year, China ran a $125 billion surplus with the US, the highest by any country ever. But if the yuan appreciated signficantly against the dollar, China's growth would almost certainly slow. So the authorities want the merry-go-round to continue. What's a bit scary is that the US deficits are not being financed by private savings but rather central bank buying. Central banks respond to pressures different from private investors, i.e. keeping the currency pegged. Its also interesting that the balance in profit remittances on capital is only a fraction of the size of the trade deficit. You would think with a $600 billion trade deficit, the net interest outflow from the US would be $40-$50 billion, but its not. Its something like $3-4 billion (I can't remember the exact number.) That's because most of the buying of US securities by foreigners recently has been by central banks purchasing US treasury paper yielding little while US foreign investment profit remittances arise from foreign direct investment. However, this arrangement is not tenable in the long run and will probably require and/or trigger a recession to wash things out. Finally, currency are also determined by interest rates. The current 10-year T-bond yields 4%. The Deutsche bunds yield 3.2%. That would contribute to selling Euros and buying dollars - which has been happening the last few months.
Walrus said:
Now, back to the effect of the Euro replacing the $US as the world's reserve currency. If the same trading market which requires $US to conduct all of its business decided instead to use Euros you would see a huge demand for Euros and a huge lack of demand for $US. You would see everyone getting rid of their reserves of $US and converting to Euros. This would in effect crash the $US and cause hyperinflation in the US - requiring wheelbarrows of money to buy a loaf of bread. At the same time this would cause massive dislocations among those countries with large reserves of $US because those reserves would be worthless. Since it is obvious that it is everybody's interest to prevent this from happening this scenario is very unlikely. What you will most likely see instead is for countires to quietly liquidate their reserves of $US in order to prevent a panic and a slow conversion to another currency as the reserve currency. Since the rejection of the European constitution by France and the Netherlands, the faith that the euro will provide this option has been shaken and thus you see the restored position of the $US. Look at the Asian markets and you will see that the Yen has actually stayed steady.
About 65% of the world's reserves are in US dollars while the US economy is about 40% of the world's GDP. The US has been deliberately depreciating its dollar to avoid a deep recession due to the fall-out of the technology bubble collapse. This means that other central banks have been taking a bath on their large US dollar holdings. The central banks should be diversifying their US dollar holdings. The problem is that there are only two other viable alternatives - the yen and the euro. The yen is not seen as a viable alternative because the country has been in a deflationary funk for the last 15 years. Banks want the Euro to work - if for any other reason to have an alternative to the dollar so they don't get soaked like they have been - but the problem is confidence. The Euro is only 15 years old. The terms of the Euro pact are being violated by members of the Eurozone themselves - Germany and France running fiscal deficits above 3%. Europe's social model is a drag on economic growth. Investor's generally want to own faster growing assets. Finally, the defeat of the European constitution at least delays the deepening of the European economies. All of these make it more difficult for the Euro to replace the dollar.
America derives an enormous benefit by having the reserve currency of the world. The demand for its bonds lowers the interest rates the US has to pay on everything. That is why if we suddenly switched from the dollar to the Euro, you wouldn't have hyperinflation. There would be no hyperinflation. Central banks don't actually hold US currency. Well they do, but just a tiny bit. What most own are US government bonds. Dumping dollars means selling US bonds. Selling US bonds means rising US interest rates (because there is an inverse correlation between the value of a bond and its yield). Rising interest rates slows the economy, which sucks currency out of the financial system. Currency coming out of the system is deflationary, not inflationary. The problem in the world right now is that there is too much money floating around. That excess liquidity is causing inflation, not in product prices, but in asset prices, particularly real estate and bonds. Thus the effect of central banks dumping dollars would be a deflationary recession in the US. That's what investors worry about.
Walrus said:
A careful study of the whole situation will reveal to you that the $US is on very shakey ground. China and Japan have not only stopped buying $US but they, and other Asian nations, have been reducing their reserves of $US. Russia has already decided that all their trades in oil will be conducted in Euros. Cuba, a small player, has decided to end the defacto use of $US in their country. The ripples of change are widening.
China and Japan have not stopped buying US dollars. What they have been doing is slowing their purchases. But this is prudent for reasons mentioned above. Cuba halted the inflow of dollars because the dollar economy was growing in Cuba. Castro said the reason why there were doing this was because some Cubans were benefitting more than others and was in violation of the Cuban revolution. This is a remarkably stupid thing to do, unless he's going to allow Euros.
Walrus said:
One other note to watch is the dispute between the US and China regarding the fixing of the Yuan to the $US. The US Congress is pressing China to revaluate the Yuan because they believe that it is unfairly matched to the $US and is depressing American trade. The interesting part of this is that if China revaluates the Yuan it will mean that the Chinese will lose billions on their $US reserve - effectively writing off the US debt to China (can't see any sane Chinese making that move). In addition to that if the Yuan rises against the $US, this effectively deflates the price of oil for the Chinese and, since their demand is second only to the US, this would probably lead to the oil suppliers raising their prices (in $US) or to a oil shortage in the US since China would use their $US reserve to buy the oil. This would be true for all the other commodities as well and would represent either a huge rise in inflation or a equally strong collapse of the $US versus the main export currencies.
I have only scratched the surface of possibilities. I first began looking at this about a year and a half ago so I am not an expert by any stretch. The exploration of this subject has revealed that it is very complex and is akin to predicting the weather for next month.
Eventually the Chinese must revalue their currency. The imbalances in the global economy are partly due to China. China is experiencing rapid asset (real estate) inflation becuase of it and it threatens to derail the Chinese economy. But its delicate and very, very complex.
The US should look at its own economy instead slapping tariffs on the Chinese. The trade deficit is the fault of the US, not anyone else's. Consumers are hooked on low interest rates, which has been driving excess consumption.
