The Dollar may recover, but the world will be different

Hamish McRae
Blink
17 November 2007

The US economy is shrinking whilst China and India’s economies are growing. The US economy also has a current account deficit of 6% of its GDP. Next year, China will pass Germany to become the world’s third largest economy after the US and Japan and, on present trends, will pass Japan within a decade. So while the US will retain the title of the world’s largest economy for another generation, it no longer dominates the world in the way it used to.

It is fun that supermodels don’t want to be paid in dollars but it is not what matters. What really matters is where investors want to put their savings and, currently, the answer seems to be anywhere but the US. The dollar has been weak before and has eventually recovered. So too, it needs to be recognised, has sterling – we know how to run a weak currency here.

And so, too, has the euro. Four years ago, the dollar was riding high and it was the euro that was on the ropes. The issue is whether this time things are different: that this time the dollar will find it harder to recover its position as the world’s main currency.

There are three main reasons why this period of dollar weakness may persist. The first is that there is a rival currency covering an economic zone of comparable size to the US, the euro. Even since the currency was created, the eurozone has grown more slowly than the US. This year it looks like changing, with Europe growing faster. That inevitably creates a demand for the currency, for people want to invest in a place that is doing well.

The second is that the current account deficit of the US is larger relative to GDP than in any previous bout of dollar weakness. It is improving a little but is still about 6 per cent of GDP and that is huge.

Foreigners don’t need to take money out of the US to put pressure on the dollar; they don’t even need to stop investing; they merely need to stop putting so much money in. That is what has been happening in recent months, particularly since the summer.

And the third is that the relative size of the US economy has been shrinking, while the Asian economies – China of course but also India – have been gaining ground every year. Next year, China will pass Germany to become the world’s third largest economy after the US and Japan and, on present trends, will pass Japan within a decade. So while the US will retain the title of the world’s largest economy for another generation, it no longer dominates the world in the way it used to.

So what will happen? Currencies generally overshoot their true underlying value. Why that should happen is bound up in the mists of market psychology. The dollar is probably already undervalued but that does not mean that it will not become more so. Its reputation is being chipped away by a series of events, small in themselves but large in total.

They include the story this week that the United Arab Emirates may cut the link with the dollar, as Kuwait already has done. If there were a general loss of confidence then the dollar could fall quite a lot more. Eventually there will be a floor – there always is – but the collapse would be disruptive, not least to the European economy, where exporters are suffering from the surge in the euro.

If things really get out of hand, there may have to be some dollar rescue but that – for the moment at least – seems some way off. The big point is even when the dollar does recover the world will be different. Maybe we will still price oil in dollars but a lot more people around the world will think – and place their assets – in