US Dollar future trend prediction (2 December 2008)

My first post on Finance in nearly 2 years. Let's get warmed up with some current facts on US dollar.

First, USA owes more than USD 10 trillion dollars to foreign lenders currently, and the figure is increasing rapidly with the increasing budget deficit, as well as the planned rescue plan from the President-elect Barack Obama, which will likely cost upwards of USD 2 trillion all up. Below's a picture taken from my recent NY trip. I'm sure you'd identify the number on the counter straight away:

In case you still didn't manage to guess what the numbers represent, read the paragraph above again. Oh btw, the Americans added a full stop after the first number because they obviously didn't expect the deficit to grow THIS HUGE and they couldn't even fit in the figures anymore, so the first number (1) with the full stop represents 10 instead. Well who can blame them really?

(Side note: we came back to the same spot an hour later and the figure has increased by roughly 6 million! How cool is that?)

Second, the USD has rebounded almost to its highest point in 2 years against all major currencies after its rapid depreciation last year.

Now, conventional Finance theory tells us that it is impossible. When a government needs to spend money, it will do what no other institution can peform: printing money to fund its expenditures. As the current monetary policy of almost all the nations are NOT backed by gold bullions in their respective central banks like in the old days, one word remains as the holy grail for all currency holders: faith.

Yes, faith is the sole word for any currencies in the world right now. It is the faith that the government of whichever currency you're holding will not blow its budget and spend irrationally, hence keeping its fiscal policy constant and not overblowing its budget or at least maintaining a budget neutrality (read; income equals spending), which theoretically means that all other things equal, its currency should not be depreciating against any other currencies.

When government expands its expenditures, either to fund its fiscal policy (ie. increasing spendign on infrastructure, etc) or to pay interests due to its huge foreign debts, it will print more money. This is a common trick that can only be performed by the Central Bank, as the cost of printing money to the country is just those pieces of paper you're holding in your hand right now. The more money it prints, the more worthless the piece of paper in your hand becomes.

Let's illustrate this point using some figures. Imagine USA's economy as a VERY large pie (worth USD 13.7 trillion in 2007). This large pie is divided among the many people that own a very small piece of the economy (the paper money you're holding in your hand). There are 4 different scenarios that can happen, holding all other things constant:

1) Pie size grows bigger (equivalent of an economy boom): the paper money you hold in your hand becomes more valuable, because you now own a larger piece of the economy in absolute term, even though the percentage is the same.

2) Paper money supply increases (equivalent to government printing more money for the reasons explained above): You now own a smaller piece of the economy, because there are more 'shareholders' in the economy even though the pie size remains the same.

3) Pie size grows smaller (equivalent of a recession): You now own a smaller piece of the economy in absolute term, for the opposite reason described in (1).

4) Paper money supply decreases (government collects excess money from public): The same pie is divided into smaller number of people, hence making your share more valuable.

The current situation happening right now would be a combination of (2) and (3), following the analogy above. Government prints more money to boost spending and service its debt, which increases the paper money supply. At the same time, the economy shrinks, hence making the pie size smaller. In effect, you have the double combo of getting more 'shareholders' in a shrinking economy, which effectively makes your paper money worth much less than in normal times!

To be fair, government is increasing the spending to 'enlarge' the size of the pie, so to speak, hoping for a multiplier effect in the economy (ie. businesses start spending again following the lead from the government). Basically in the short term, the public sentiments might not follow that of the government and hence there's little effect, but in medium to long term it just might boost spending from the private sector again, provided government keeps leading the way and not run out of budget midway.

Returning to the topic of exchange rate, following the analogy above we should have the USD depreciating rapidly against other currency, NOT appreciating as it is doing currently. To get to this point, we might have to add in another model on monetary policy, as this is what central banks around the world does in modern days to stimulate the economy, rather than traditionally restrictive fiscal policy, for the exact reason described above. Basically monetary policy revolves around increasing or cutting interest rate to either cool or boost the economy respectively.

The logic lies in if the interest rate is high (ie. when government feels economy is overheating and needs to cool it down), businesses would rather keep their money in the bank and enjoy the high interest rate without taking additional risks in business, hence slowing down new investments. At the opposite end, with the low interest rates businesses would rather borrow from the banks to invest and earn a higher return as there is no point keeping their money in the bank.

With the high interest rate policy, government aims to collect the public money in banks & keep it in reserve, preventing oversupply and therefore propping up the value of the currency. The opposite is also true as when government wants to circulate more money in the market to boost the economy by handing out cheap loans to businesses. When this happens, currency will drop in value.

There are a few other models to consider such as carry trade, etc, but for the moment it is sufficient to just consider the impacts on the models described above. As per our prediction, USD should depreciate, and yet it is doing exactly the opposite right now. Why is that so?

Firstly, USD is unlike any other normal currency as it is still the holding currency of choice for international trade, accounting for more than 65% of transactions worldwide. Many important commodities are priced in USD, and therefore the effect on this status is still unknown compared to a normal currency.

Secondly, with the relative size of USA's economy at close to USD 14 trillion, even a debt of 11 trillion doesn't sound that daunting currently. However, as the budget deficit keeps growing, the debt will soon reach parity with the GDP, and that will be when foreign holders of government debt will start to panic & doubt whether their loans can be repaid. As they say, 'when it rains, it pours', and once public gets words that huge bond holders are dumping their US bonds, they are bound to follow suit and the equivalent of a financial stampede will occur. US government will find it hard to refinance and in the worst case scenario, it might announce its bankruptcy.

IMPORTANT!

Up to this stage, all the predictions above are made according to the books, ie. using conventional finance theory. However, my instinct has been telling me that the brilliant minds of the many economic Nobel Laureates currently in the payroll of USA government would have noticed this impending disaster before anyone else even had a sniff of it, and therefore if they're not panicking right now it should mean there are some unknown elements that are alien to normal people on the street right?

Some very well-known businessmen has been criticizing the US government on the deficit and publicly stated they will move their assets out of US as they predicted the same result as the model above, ie. impending collapse of USD. These people include Bill Gates, and also Jim Rogers, c0-founder of Soros funds, who is moving all his assets to RMB as he predicts it will continue to appreciate over the next 2 decades. As market is driven by public sentiments, regardless of whether the economic basis is true or not, should we or should we not follow the prediction of these successful businessmen? after all, they have obviously seen the opportunities that many didn't, and in the process made themselves obscenely rich?

It is a big dilemma, and one that I can't possibly solve on my own. However, I do have some insights into how this may play out, and it will depend on the next term of the presidential race, NOT the impending Obama administration.

Given that increasing government spending is a must over the next 2-3 years of the 4-year Obama reign, it is unlikely that the long term future of USD will be decided at the current term. Obama still has to be prudent in managing the economy and not increase deficit by too much while trying to rescue the economy in order to let the next President (who might well still be Obama as he qualifies for a second term if he does a good one in the first) work his way out of the deficit as economy recovers. As economy recovers, taxes from the companies returning to profitability will increase substantially, and therefore the deficit might be lowered and with luck, turned into surplus at the next administration.

The last time US economy has been in budget surplus was in Bill Clinton's reign, a democrat, and obviously it would be nothing short of a miracle if Obama manages to turn it around in his first term, with the huge deficit created by the incumbent Bush administration. Obama does have the support of the many prominent US businessmen and economists, including Warren Buffett and CEOs from the Fortune 500 companies. How he tailors his policy according to recommendation from his economic team will be key to the reversal of USA's fortune, and the central issue will be to at least turn a budget surplus within his first four years in order to regain confidence of foreign bond holders.

The same philosophy that works on capital flight will also retaining those investors, and once the largest bond holders are convinced US bonds will not default, then the whole market will regain its confidence too. At the same time, the economy should be recovering after all the government stimulus, and extra tax revenues mean the possibility of reaching budget surplus also increases.

With luck, if the plan works out, USA will have its own pie.. well a BIGGER pie and eat it too!