THE DOLLAR AS THE GLOBAL RESERVE CURRENCY
At the beginning of the 1900s, the US Dollar began the long, drawn-out process of becoming the world’s single dominant global currency. By early 2001, our Dollar had achieved an unrivaled position as the sole and universally-accepted global reserve currency. But then the decline began. From early 2001 through late 2007, the trade-weighted US Dollar fell by -41% . The global financial debacle that began in December 2007, put a temporary stop to the Dollar’s decline as investors poured money (several trillion) into US Treasury bonds. From late 2007 through year-end 2012, the trade-weight US Dollar rose +12%. But now with the global macroeconomic healing process having begun and the US Federal Reserve’s history-making efforts to inflate the domestic economy through the printing of money, the Dollar has once again begun its long march down.
THE GREAT DOLLAR DECLINE IS ABOUT TO BEGIN
We have now embarked on an episodic or secular decline in the US Dollar. This decline will persist for many years (if not decades) and will entail a remarkable decline in the value of our currency. We will experience both a large decline and a long-lasting one. The causes underlying this prospective decline are neither obscure nor difficult to understand. In a nutshell, as an economy we have established profound and rapidly growing imbalances, while at the same time we have lost a significant measure of our competitiveness. Here are the data:
- In 1966, federal government spending accounted for 16.5% of the economy. By 2000, it had grown to 18.8%. Today, federal spending occupies 23.8% of the US economy. We are continuing an uninterrupted march away from capitalism and towards a semi-socialist economic structure.
- Federal government deficits and borrowing are running out of control:
- Net borrowing by the federal government from the public was $1,170 billion for the 12-months ending 11/30/12,
- The federal government budgetary deficit as a percent of nominal GDP was an unsustainable -7.4% of GDP as of 11/30/12, and
- Just paying the net interest on the outstanding federal debt consumed 6% of the federal budget as of 11/30/12. Imagine what will happen when interest rates increase from their current 1% level to perhaps 3% or 4%. When interest rates rise, as they inevitably will, the portion of the federal budget consumed by just paying interest on the debt will increase many fold – squeezing out all other federal programs.
- But this is only the beginning. We have made promises in terms of existing entitlement programs that can never be met:
- Medicare and social security today consume 8.7% of our nation’s total GDP and
- As these two programs are currently structured, they will consume an impossible 12.8% of the total economy by 2086. Such a 50% proportionate increase in the cost of these two entitlement programs would rive our economy into a state of perpetual zero economic growth – resulting in massive social upheaval.
- Our demographic trends are working against us:
- Today the portion of our population consisting of productive (working) individuals, those aged 20 to 64 is 59.4%. By 2050, this percentage will have fallen to 54.1%.
- But worse yet, the portion of those over 65 years of age today stands at 13.6%, but is projected to rise to 20.2% by 2050.
- These demographic trends will reduce savings, significantly undermine productivity, and generate a massive increase in the cost of entitlement programs. All of which our economy has no capacity to absorb.
- Unfortunately, to date, the US has been unable to respond to these forces with increased competitiveness. In fact, our relative ability to compete on a global basis has declined:
- The US trade balance for goods over the 12-months ending 10/31/12 was running at a deficit of -5% of GDP and
- Worse yet, to pay off the foreigners who have invested in the US economy, we would have to give them 27% of our GDP (i.e., the US net international investment position stands at -27% of GDP as of 12/31/11).
- Finally, the US has benefited from the virtuous cycle resulting from the planet’s adoption of the US Dollar as the sole and exclusive global reserve currency. In essence, this has allowed us to simply print many many trillions of Dollars and just give them to foreigners in exchange for valuable goods and services. Unfortunately, this process can and always has also run in reverse. The so-called vicious cycle:
- During the inevitable vicious cycle, the foreign nations that hold those many trillions of US Dollars will exchange them for stable or appreciating currencies – thus serving to further compound and accelerate the Dollar’s decline.
- This vicious cycle will unfold as nations slowly and gradually over a period of a couple of decades abandon the Dollar as a the global reserve currency.
- As of 10/31/12 China held $1.2 trillion of US Treasuries, Japan held $1.1 trillion, and OPEC, Brazil, and the UK combined held an additional $0.7 trillion.
- The process of abandoning the Dollar as the exclusive reserve currency will place a profound downward pressure on Dollar exchange rates.
DRY POWDER CURRENCIES BENEFIT
Of course if the US Dollar is to decline then other currencies must appreciate. But which ones? The most likely currencies to benefit will be those of the so-called dry powder countries. These are the countries around that globe that are, in part or in total, unencumbered by our long-cycle headwinds. These are the countries that generally have:
- Positive currency reserves,
- Trade surpluses,
- Attractive demographics – their working age populations are growing both in absolute terms and as a percentage of their total populations,
- Growing middle class,
- The ability to adopt and otherwise transfer new technologies from other countries and to incorporate them into their own economies,
- No or limited entitlement programs,
- Minimal or non-existent federal government deficits,
- Minimal or limited outstanding government debt, and
- The capacity to increase public expenditures on public infrastructure (water, sewer, schools, hospitals, etc.).
Countries such as Malaysia, Korea, Turkey, Mexico, Argentina, Poland, and Norway, could potentially be on this list.
A BETTER TRADE
So how does the investor benefit from a large and long lasting decline in the US Dollar? One approach would be to gain exposure to the emerging country currencies through a long position in a suitable ETF such as the WisdomTree Dreyfus Emerging Currency (CEW). If the investor also sought modest exposure to greater interest rate and credit risk, then they might instead take a long position in WisdomTree Emerging Markets Local Debt (ELD) – thus seeking a higher expected return and higher expected risk position. In any event, a decline in the US Dollar on the order of -45% to -50% would be realistic. Such a decline will certainly not be linear and one-directional. But it is likely to extend over many, many years.