Day by day, the currency wars continue to heat up. With the European Central Bank’s Quantitative Easing program now underway and the end of the euro in sight, many other countries around the world have joined the race to the bottom.
Central Banks have been deliberately devaluing their own currencies in order to stimulate their economies. It might seem strange that a country would want a weaker currency, but it can be beneficial. That’s because when a country’s currency is weak, their exports tend to increase.
But a problem arises when so many countries try to do it at the same time. It doesn’t work. If one country devalues their currency and all of the other countries follow suit, they are all back where they started– except now their currencies have less purchasing power.
As the European Central Bank begins its bond buyback program, non-euro countries have already started to feel the pinch. In January, in advance of the ECB’s announcement of Quantitative Easing, Switzerland de-pegged the Swiss Franc from the euro and sparked a 15 percent spike in the Swiss Franc’s value overnight. It caused ATMs to run out of euros because Swiss citizens were using their now-more-valuable francs to buy 15 percent more euros than they could the day before.
And just last month, on the flip side, the Danish Krone started crumbling because the head of the Denmark Economic Council announced that they would NOT de-peg and would institute currency controls to maintain it. Many forex traders were betting on the Krone de-pegging and hoping for the same subsequent spike that the Swiss Franc experienced. After the announcement, those traders dumped the currency en-masse.
The decision to defend the peg could help Denmark and the eurozone’s exports in the short term, but it is likely to have unintended global consequences.
The International Monetary Fund’s Special Drawing Rights is essentially the IMF’s “reserve currency” –used to finance emerging market economies and as an alternative when the dollar is weak– but it’s actually a basket of currencies whose value is determined by the aggregate value of the dollar, euro, pound, and yen. 80% of that value however, comes from just the dollar and the euro.
So when the euro weakens, naturally, the dollar strengthens which leads to a decline in U.S. exports. While the ECB has been trying to stimulate the eurozone economy, it has had the unintended effect of pushing the U.S. right back into a recession. U.S. factory orders have declined for the past six months straight.
That might sound like bad news for the U.S., but it’s even worse for the rest of the world. Since the dollar is currently the global reserve currency, it makes up for around 95 percent of cross-border financial transactions. It is believed that nearly 80 percent of international debt is denominated in dollars. That means a stronger dollar equals increased debt burdens for all of those countries with dollar-denominated debt (i.e. everyone).
Not surprisingly, over the past few years there has been an increasing effort by many countries to “de-dollarize” and distance themselves from the dollar’s dominance as world reserve currency. The BRICS countries (Brazil, Russia, India, China, and South Africa) account for more than 50 percent of the global population and recently ratified a New Development Bank to rival the IMF and act as an alternative to the dollar-dominated SDR.
Just yesterday, Kazakhstan announced that they were developing a plan to de-dollarize their economy in an effort to reduce macroeconomic instability.
Russia has been frantically exchanging its dollar reserves for gold while at the same time making currency swap deals with nearly everyone so that international transactions can be conducted in local currencies instead of the dollar.
Venezuela has also made recent moves towards de-dollarization by strengthening their trade partnerships with China. Venezuela is currently dealing with hyper-inflation. Oil accounts for nearly 95 percent of the country’s annual revenue and 15 percent of its GDP. With the recent crash in oil prices, the Venezuelan Bolivar has seen inflation of more than 60 percent. The worry that the currency will continue to fall has led to bank runs and scarcity of goods. Just like in Ukraine and Russia, Venezuelans want to spend their Bolivars as fast as they can before they lose further value.
Since the abolition of the gold standard in 1971, the value of the dollar has been determined by the perception of the United States’ ability to repay its debts. The demand has been propped up by its use as the “petrodollar”. President Richard Nixon made a deal with Saudi Arabia and other OPEC nations that in exchange for weapons and protection, all oil transactions must be conducted using U.S. dollars. This led to a perpetual international demand for dollars and required countries to continue to hold large amounts of the currency in reserve despite the fact that it was no longer backed by gold.
Recently there has been a number of reports of secret agreements between OPEC and other countries of the world to begin exchanging oil for currencies other than the dollar. In November, BNP Paribas reported that for the first time in 18 years, petrodollar recycling didn’t happen. Petrodollar recycling is what happens when an oil exporting country makes more dollars than it can feasibly invest in its own economy, so it tends to “recycle” those dollars back into global markets and increase liquidity. The fall in gas prices combined with the new oil-currency-swap agreements has caused a massive drop in the demand for dollars.
Historically, the global reserve currency has been determined by the country with the biggest GDP. Take a look at the chart below:
Now take a look at this picture of a Bank of China billboard that was snapped this week in Bangkok:
It may be true. The head of China’s Central Bank stated in October that some countries were already using the renminbi as a reserve currency. Some analysts believe that China’s recent dramatic accumulation of gold means that the country is planning to back the renminbi with gold. If that happens and the petrodollar is actually being circumvented, there would be a mass international exodus from the dollar to the renminbi and likely be the final nail in the coffin of the dollar.