Why one shouldn't bet on the US dollar in 2012-13

The surprise currencies of 2011 were the US dollar and the Japanese yen. Despite a weak economic recovery and an S&P downgrade, the dollar showed resilience. Despite Fukushima and burgeoning debt (over 200 percent of GDP, which would put Greece to shame), the yen strengthened against the dollar.

Why are these two currencies defying the laws of economics? The answer is not that the US and Japan did something right, but that Europe got many things wrong - especially the euro and sovereign debt. The resultant panic drove every risk-averse investor back to the dollar.

There is a strong possibility that this trend will continue in the initial months of 2012, but don’t bet on it continuing indefinitely.

There are four reasons why one should not count on the dollar as the super asset.

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[caption id=“attachment_168455” align=“alignleft” width=“380” caption=“The long-term secular trend of moving away from dollar reserves is strengthening in Asia. AFP”]  [/caption]

First, a strong dollar actually works against the US economy as it weakens export growth, expands the trade deficit, and slows down the economy. This is the last thing the US needs, when it is struggling to speed up the recovery. This is why the US Treasury, in its semi-annual report on foreign exchange, criticised Japan for trying to weaken the yen, and accused China of keeping the yuan undervalued.

Second, the long-term secular trend of moving away from dollar reserves is strengthening in Asia. Last year, India bought 200 tonnes of gold to diversify away from the dollar. Between 2001 and this year, the world’s holdings of dollars fell from 73 percent to 61 percent. Now, it could fall faster.

Third, by the second half of 2012, the euro crisis should either have been licked or the eurozone will split up. Either way, the euro itself or its successor currency - especially the one Germany will back - will start gaining ground against the dollar.

Fourth, and most important, China is steadily promoting the yuan in international trade. According to a report in The Wall Street Journal, yuan settled trade has already risen from 1 percent of total trade to 10 percent in just one year. Next year it will be 15 percent.

Earlier this week, China and Japan - the world’s No 2 and No 3 economies, and also the world two largest holders of US dollars - announced a deal to promote trade directly in yuan and yen rather than dollar. Japan also plans to invest $10 billion in yuan bonds.

“Japan is looking to diversify risks amid the eurozone debt crisis, as it currently holds most of its reserves in US dollars and euros,” says China’s Global Times, quoting Liu Dongliang, a currency analyst at China Merchants Bank.

And China has begun extending the yuan area, little by little. Says The Wall Street Journal: “The People’s Bank of China, the country’s central bank, has also been using so-called currency swap deals with other central banks so that foreign banks could supply more yuan to their customers. Currently, the PBOC has such deals with a dozen foreign central banks, including Thailand, South Korea and New Zealand, totalling 1.2 trillion yuan.”

India has not been slow off the mark either. On 28 December, India and Japan signed a $15 billion currency swap agreement to help both countries manage short-term currency volatility.

Though this deal ostensibly brings the dollar back into play, what it really means is that if India seeks dollars to meet its exchange needs, it will swap dollars for rupee. Japan will be holding rupees in its kitty till the dollars are returned.

However, there is good reason for Japan to hold rupees as rupees once it starts investing in India in a big way - whether it is in the Delhi-Mumbai Industrial Corridor or other infrastructural or industrial ventures. Given the rise and rise of the yen, Japan would prefer to sell dollars rather than hoard it. Moreover, manufacturing is becoming expensive in Japan and holding rupee funds will help it enlarge the pool available for investment in India.

The $15 billion India-Japan arrangement is a stepping stone to a future yen-rupee swap arrangement that can cut out the dollar - but this would depend on how the Indo-Japanese economic partnership expands.

Clearly, the long-term macro trends are against the dollar.

If I were the betting type, I would suggest that by the end of 2012, the dollar will be a diminished currency of final refuge. Its value should be much lower than Rs 53-54 level it has been touching of late.