As I had mentioned 3 years back here in my blog the underlying asset to Dollar is Confidence and not Gold as it should be. And as you know the confidence is a very fickle asset, you don’t know when it disappears.
Newsweek: "Americans are glum at the moment. No, I mean really glum. In April, a new poll revealed that 81 percent of the American people believe that the country is on the "wrong track." In the 25 years that pollsters have asked this question, last month's response was by far the most negative. Other polls, asking similar questions, found levels of gloom that were even more alarming, often at 30- and 40-year highs………… "
Dollar is the prime currency today and is the standard for international trade. Almost all of international Crude Oil trade happens in Dollar. Most of the trillion dollar reserve held by China is in Dollar and same is true for more than 300 billion dollar reserve of India.
For decades now dollar has been the acceptable standard and nobody ever questioned it. After the Bretton Woods Agreement in 1944 when dollar became the international standard for trade, USA was supposed to keep Gold as underlying asset. However, in 1971 USA, unilaterally, has done away with that practice and has been happily printing Dollar ever since with Confidence as the only underlying asset. Till date Confidence has been an appreciating asset all the while with USA companies ruling the world economics. But with the turn of events over the last 12 months – Housing price crash, subprime, Credit crisis, bankruptcy of banks and financial institutions, bankruptcy of automobile companies - USA looks much more venerable today. This bubble has built up over the years as USA kept borrowing from the world to meet the domestic consumption bill of its nationals. CDOs etc had managed to delay the inevitable by creating fake confidence, but then it can only delay.
I believe the current government will continue to delay the inevitable will all kind of financial jugglery just to keep Republican chance alive in the next election. But the new government will have to clean the house and we can expect Dollar Crash prediction coming true around that period. In the meanwhile like Indian Government, USA government will keep on increasing the deficit bill (by off balance sheet items) impact of which will be felt with a lag only after the elections.
Frankly all countries will get adversely impacted by the Dollar Crash in the short term but for the long term general good it’s high time that World practices some “currency diversification”. Few major impacts against which countries & companies should guard against are:
1. Holding all or substantial part of Foreign exchange reserve in Dollar or Dollar denominated US government securities. India and China both are running this risk and I believe many more country is doing the same. It’s high time that we diversify.
2. International trade in critical items like crude only in dollar is another big risk. You don’t know when exactly the music will stop and you should guard against being caught with the parcel when the music stops.
3. Financial instruments which increase your exposure to Dollar. In the current world of financial derivatives, carry trade etc there may be many financial bombs hidden in your treasury department which you might not be aware. Its time to check your cupboards.
4. There are other risk like too much dependence on USA for exports which is difficult to diversify in the short term (IT companies face major risk here)
Sudden move by countries like China and India to diversify there foreign exchange reserve risk or move towards crude trading in currency other than dollar can trigger the crash but we don’t have any other option but to walk the thin ice. Sooner than later the ice will melt.
USA Government and especially Fed are trying to avoid the inevitable. Now it’s a matter of your confidence in their capability to tide over this crisis. I don’t have the confidence and hence I suggest diversification. (Note even if the dollar crash doesn’t happen there is nothing to loose by diversification. Diversification to currency like Euro will only help in the long run).