Will the Dollar crash?
February 15th, 2006 | by Digvijay Lamba |Hi,
In a recent discussion I talked about how Currencies work and what the issue behind all the worry regarding the Dollar falling is as per me. Those of you with more knowledge … (MBA/Economics)… please correct me If I am wrong. The question I want you to answer after reading the essay is…. What would you suggest China and US should do???
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Hi Everyone,
To Add to the analysis that Sachin just posted.
What
he summarized was the theoretical way to define the value of the
currency. It is also how the currency essentially has any value at all.
In
addition, how the actual exchange rates work is most simply understood
(And here I am removing most of the complications for simplicity) by
taking the example of the Stock Market.
The currency market is like a stock market. Each
country/entity behaves like an individual. Countries need to pay each
other for a variety of purposes every day. A healthy cash balance means
a healthy economy just like it would for any business. If you have cash
in bank and liquid assets you can afford to buy necessary stuff (like
oil) for a long period even under duress.
Now the way countries do this is that they have a net positive
balance of currency. Right now gold is used as another invariable
liquid asset. The question here is which currency should they keep?
Given that the currencies change values, this is like asking if you
could make all saving in stocks, which stock or stocks would you keep?
As the US is a healthy economy, the Dollar has come to become the
standard currency which countries store. This, over a period of time
has led to a lot of countries (Specially Asian) storing a lot of
Dollars.
The actual exchange price of the currency depends on how it is
selling in the market. Which is basic Demand/Supply economics.
Countries like UK keep a tight control on the Pound and and maintain a
high exchange rate. If I were to suddenly give a trillion trillion
pounds on the market for peanuts the Pound would fall in value just
like selling stocks on the stock market.
Also, just like the stock market the International market for
currencies has certain regulations which everyone abides by to avoid
sudden bumps and jerks.
Before we come back to the dollar, there
is one more thing to understand. A countries capability to control the
price of their currency depends heavily on their fiscal policy. If my
annual cash flow was heavily positive, I have a huge positive cash flow
allowing me a LOT of leeway to buy out my currency from the
international market and control the price. I AM in control. However,
if I have a high deficit, I am printing currency to cover that deficit
and the moment people stop wanting to buy it from me, I have nothing
else to offer.
As
of today, US can afford to keep printing money to cover their deficit
because the world believes that the underlying value of the dollar
makes it a safe investment even now. Just like in the stock market, I
could keep taking out public issues of my stock and the issue would
still sell at a decent price, (probably even a higher price than the
market price) if people believed that the stock (even though it’s being
diluted by the public issue) still has a value higher than what it’s
selling at.
However, there is a danger here. US has an ever increasing
deficit running into huge figures essentially because they buy lots of
stuff from other countries and pay for in Dollars. The other countries
have nowhere else to sell to and their economy will crash if US doesn’t
buy, so they keep selling to the US. However, this is a vicious circle
that results in a large number of dollars and erodes the value per
dollar.
Imagine you are a player in the stock market, a big company
like ONGC keeps bring out a lot of public issues. You being a major
holder in ONGC (say you own 30%) of the stock, have no option but to
keep buying, else your share dilutes and you loose out. Selling is also
a bad option for you, because if you sell so many stocks and try to
move to another stock, the market, knowing that such a huge supply of
the stock is coming will devalue the stock. You will loose a huge
amount of money if you dumped the 30% of the stock.
In the same way, China, Japan and other countries cannot just
dump all the dollars without a huge impact to their economies. This is
a safety valve here. In addition, US is their market so it’s not just
about loosing money on the dollars but loosing a huge amount of
business. Thus it’s a (debatable but) safe stalemate.
However, as time goes on and situation worsens, the chances of
a dollar crash increase and the risk in holding dollars increases. The
day governments start thinking that risk in holding on to the dollars
is higher than the risk and the loss in dumping it is the day they’ll
start dumping the dollars. That is what the hoopla is all about.
How
is the US tackling it? One, by asking China to revalue it’s currency.
Chinese currency is artificially linked to the US currency. They have
fixed it with Dollar and trade it at that fixed price. However, with
time the Chinese currency has grown in intrinsic value. US is
pressurizing China to increase the value of their currency which will
effectively reduce the burden on the Dollar as China is a huge player
in Asian economy and suddenly, the Dollar is weaker as compared to the
Yuan and thus has MUCH less selling power against China effectively
eroding it’s value to the world without really changing it’s ratio to
the worlds currencies. (There will be some correction of course)
It’s not so good for China though as Oil and other major
imports of China suddenly become expensive for the Chinese and there is
rampant inflation in China which will negatively impact their economy.
Holding on to the current trend isn’t very good either, as to maintain
it China has led itself into a very big and artificial banking bubble
and most of their Banks aren’t really solvent. Their domestic fiscal
situation becomes weak to maintain a low priced Yuan. The west is
telling China that some day, this poor fiscal policy will hit their
economy and make it crash and so it’s better for them to revalue Yuan
in a phased manner.
Sorry if that was long. You can read more and see links on my Blog at http://blog.dslamba.net
If anyone had the patience to read through… please do correct me if I am wrong and add to it.
Regards
Digvijay
Technorati Tags: MacroEconomics, Currency Exchange, Fiscal Policy, Curreny, Dollar, Yuan
Tags: Dollar Crash, Economics, Issues
2 Responses to “Will the Dollar crash?”
By AB on Feb 15, 2006 | Reply
Hi Digvijay,
You are such a smart guy. Gen Next.
Curious bout you.
Where are you working right now.
And who is Abhishek Goyal ?
Abhijit
By dlamba on Feb 15, 2006 | Reply
Hi Abhijeet… I work in the Valley in CA, USA. You can see Abhishek’s blog linkin my Blogroll. How about you? Do you have a blog?