Bill Emmott - International Author & Adviser


Don´t despair about the dollar
Exame - January 2008

One of the most famous sayings about investment came from one of the founders of the Rothschild banking family, Baron Nathan Rothschild. In the early 19th century, at the time when Europe was riven by war, he said that "the time to buy is when blood is running in the streets".

Fortunately, most investors do not spend their days looking out for blood. But his essential point applies during peace as well as war: it is that markets are emotional entities, and that the best time to get a bargain is when pessimism is at its height, for prices will overshoot at such moments.

In the early 21st century world, this observation is especially relevant to the dollar. In the past two years, the dollar has fallen in value against the euro by a fifth, and by a similar amount against the real. Against a trade-weighted basket of currencies, it has fallen by 6% merely since August 2007.

A chorus of commentators and even policy makers is now warning of an imminent collapse in the dollar and of the end of the greenback’s status as the world’s leading reserve currency. Some of this is based on what in German is called Schadenfreude—pleasure at the misfortunes of others. But some is also based on true economic concerns. Nevertheless, those concerns look misplaced, at least to this commentator.

There is one fairly plausible argument for why the dollar could fall further in value, even for why it could fall rapidly. But it is equally plausible to argue that, against virtually all currencies except those of China, Japan and the oil producers, the dollar’s fall has gone as far as it is likely to.

Admittedly, predicting currency movements is a dangerous game, as so many complex factors are involved. The second fear is easier to deal with: this period of decline will not end the dollar’s status as the leading reserve currency, though it will surely diminish it. Yet such a diminution of the dollar’s dominance would be good news, both for the world and for the United States itself.

A cheaper dollar is a healthier dollar

The one plausible argument that the dollar’s slide might turn into a crash is based on the fact that central banks in Asia and the oil producing countries are holding vast piles of foreign-exchange reserves that are chiefly denominated in dollars. China has $1.4 trillion in reserves and Japan has more than $900 billion. Other Asian countries have a further trillion dollars between them. The dollar’s decline is eroding the value of those reserves, which could tempt central banks to sell dollar assets and buy other currencies instead. If so, central banks would want to get in first, in order to get better prices than the others, and there could be a stampede.

In principle, this could happen. In practice, however, it is unlikely to. The reason why those central banks have accumulated such huge reserves is that their governments have wanted to prevent their currencies from appreciating in value against the dollar. So a stampede to sell dollars would also mean a rapid appreciation of the Chinese, Japanese and other currencies, which their governments would oppose. Central banks care about the value of their reserves, but they are not profit-maximising investors. They have other goals in mind, especially financial stability.

In fact, it would be better for the world if Asian currencies, and those of the oil producers, did now appreciate more rapidly against the dollar, as long as the movement was not too violent. Some relaxation of the central banks’ recent policies would help remedy the huge financial imbalances that have built up in recent years, between America with its big current-account deficit and the big current-account surpluses in China, East Asia and the Middle East. In such circumstances, the dollar might rise against the euro but fall against the yen and the Chinese renminbi.

If this adjustment does take place during 2008, it will be good news. It is also likely to mean that the share of world foreign-exchange reserves held in dollars will decline from its current level of 65%. But this would not mean "the end of dollar hegemony", as some would say. It too would be a healthy development.

During the 1980s, the share of foreign reserves held in dollars declined to less than 50% as central banks increased the amounts they were holding in yen and in Deutschmarks. It rose back again to its current level as the dollar’s value rose, as Japan’s economy and trading significance went into decline, and as uncertainty grew about the new euro currency. Now, the dollar’s share could well fall back towards 50% or below. But the question is: why should this matter to anyone except the statisticians?

The answer is that it won’t matter at all. The status quo, with 65% of reserves held in one currency, is anomalous and surely unwise: Baron Rothschild would never have advised investors to hold such a big proportion of their portfolio in one currency, and central banks should not do so either. They should hold more in euros, in yen and, once the Chinese currency is made convertible, in renminbi too.

This will reduce the dollar’s "hegemony". But it will not damage the hegemon—America—at all. America gets no real benefit from having its currency make up such a large proportion of global reserves. The only benefit the American government gets from the dollar’s reserve role is the ability to borrow money in dollars rather than in foreign currencies, avoiding any currency risk on its debt.

But that will still be the case if the dollar’s role declines in order to make up 50% or even 40% of world foreign reserves. America would only have to start borrowing in foreign currencies if other countries refused to hold dollars altogether—and that remains unthinkable, whatever the world’s many critics of America might hope. A smaller role in world reserves would mean that fewer other countries chose to peg their currencies to the dollar and to follow American interest rates, which might well help American trade to adjust more smoothly to market conditions and would remove a constraint (admittedly a small one) on the monetary policy of the Federal Reserve.

So there is really no need to worry about the dollar. Pessimism about it may have reached Baron Rothschild’s peak. But even if it hasn’t, and a further decline occurs, it will not be a disaster. The economic story of 2008 is likely to be an American recession or sharp slowdown, with consequent pressures for adjustment in China and other big exporting countries. Compared with that, the dollar’s fate is largely a sideshow.


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