5 alternatives to the world's riskiest asset - the US dollar

The US dollar is the traditional safe haven. But is it? Sooner or later, the dollar will have to downsize and countries that don't start making the switch away from it will be left holding the sack.

R Jagannathan August 02, 2011 15:11:35 IST
5 alternatives to the world's riskiest asset - the US dollar

The possibility of the US defaulting on its debt may have been averted by a last-day compromise, but no one should be fooled into believing that this is a happy ending. Not for the US, not for the world.

The fundamental challenge the US faces is one of living within its means. It hasn't done so for decades now. This will not be solved by a debt deal that first increases the debt ceiling and then asks for a similar cut over the next decade to bring it down.

In theory, no one should be able to live beyond one's means unless someone is willing to let them. The US can do so because the rest of the world is willing to lend it money indefinitely. And the rest of the world is doing so because giving the money helps US consumers buy from them. China lends money so that the US can buy its manufactured products. We do so because they can then buy our software and other services at high margins for our Infosyses and TCSes.

When a country consumes more than it spends, its currency must depreciate since it needs to borrow more. The dollar has so far been spared this problem since Uncle Sam simply prints more dollar bills and hands them over to the rest of the world as payment. The world has excess dollars, and that is another reason for the currency to lose value.

5 alternatives to the worlds riskiest asset  the US dollar

The dollar is the world's biggest risk going today. Mark Wilson/Getty Images

But it doesn't, because the world - to protect the value of the dollars it holds - lends the US even more money to prevent a default. The inflow of cash to the US also holds the dollar's value up - well beyond its real worth. The US is thus running the greatest Ponzi scheme on earth, by borrowing even more to consume and repay old debts. It will all end when the music stops.

Put another way, the world is as responsible for letting the US live beyond its means as the US itself. Just as the solution to drug addiction is not to give the addict more hash, the solution to the US debt problem does not lie in giving it even more debt. We have instead to invest in its potential.

What does this mean? It means, first, that the big lenders - China, Japan, Russia, Saudi Arabia, Taiwan, Brazil and India - must slowly reduce their investments in US government bonds, at least incrementally. Instead, we should invest in real assets in the US and financial assets elsewhere (China, rest of Asia, etc - places which are growing and booming).

Here are five alternative avenues for investment instead of the dollar:

1. Currencies in growth areas - mostly Asia and Latin America, including China.

2. Real assets like businesses - either through shares or index funds or mutual funds.

3. Commodities like gold and energy assets.

4. Our own infrastructure - funded by foreign exchange assets.

5. Real estate in downbeat countries (including the US, for now).

To do all this, countries obviously need to look at their currency assets as risk-assets that need management. This means fund management needs to be separated from monetary policy. The central banks have to manage monetary policy, not currency assets. They know little about fund management. So, as a start, a portion of our foreign exchange assets needs to be managed by a professional fund management company (or companies).

Before we expand on that, let's look at the world's current predicament. China holds $3.2 trillion ($3,200 billion) in reserves, the bulk of it in US dollar-denominated assets. India holds $317 billion, of which nearly 60 percent is in dollar-related assets.

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If the US dollar goes down the tube - as it should in due course - we (and China, Russia, etc) will lose the bulk of our external wealth. The remaining portion of our foreign currency assets is not any safer. They may be invested in the euro or yen, which are not exactly in the pink of health.

The problem lies in our risk-averse mindset - and this holds for all the big investors in dollar assets. They think the dollar is unsinkable, because it has been the world's only reserve currency so far.

But in doing so, we are actually courting an even bigger risk: of the dollar going phut suddenly. If the dollar plunges, or if US inflation soars, Uncle Sam will be happy to return your dollars by printing more money - a debased one with lower intrinsic value.

India's experience also shows that hoarding greenback is injurious to our financial health. According to the Reserve Bank of India, in 2009-10, the last year for which complete data are available, our foreign currency assets and gold yielded us a princely return of 2 percent - yes, two percent. In terms of rupees, our earnings on foreign currency assets actually dropped 50 percent from Rs 50,796 crore in 2008-09 to Rs 25,102 crore last year. The situation is unlikely to be much better in 2010-11.

Sure, we will always need to hold some dollars, but only to manage transactions. Holding "risk-free" dollars as assets is clearly risky. It's costing us.

Philip Schellekens, a senior economist at the World Bank, was recently quoted by Bloomberg as saying: "There is a cost to having an overly large stock of foreign exchange. It doesn't earn you a lot of money to hold liquid forms of foreign currency. There are better ways to invest those."

Just imagine how many other avenues there are in the world that can earn more than two percent return per annum? Gold, commodities, businesses, stock markets - there is no shortage of avenues for the deployment of our excess cash. The dollar should be the investment of the last resort.

Consider the actual returns on a few standard benchmarks over the last one year: the US S&P 500 - 3.44 percent; gold - 36 percent; US real estate - 14.2 percent. Any combo would have earned the Reserve Bank much more than the measly two percent it earned by staying risk-averse. Of course, gold, real estate and S&P can also fall in value, but so can the dollar.

Which brings me to the larger point: investing in the potential of the US, rather than the dollar.

The US is quite simply the world's most dynamic economy, with the world's best known way of financing good ideas and innovation. If one looks at how the best US companies and institutions are faring - from Apple to Google to the Ivy League education system - we know what makes the US tick.

It is these things we need to invest in, not the dollar, which is a dumb investment. This is where we must invest our foreign currency assets while the greenback is still alive and kicking. We can't wait till the Ponzi scheme ends.

Of course, we will still need dollars for transactions.

One may ask: how can the Reserve Bank invest in all these things? As the country's central bank it has to play safe. It cannot afford to invest in companies, or stocks, or Ivy League institutions.

This is partly true. The RBI cannot do this directly, unless its charter is changed. But we can do the same; our companies can do the same. And it will amount to the same thing. When we invest in US or other foreign assets ourselves, the RBI's dollar hoard reduces. The RBI will have fewer reserves to invest in the dollar.

It's a good place to begin. The RBI will follow. If we leave too much money in the RBI's hands, it will face the usual moral hazard of investing in the wrong places at the wrong time in the name of low-risk.

The dollar is the world's biggest risk going today.

Updated Date:

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