The GRC Weekly opinion: Why the Gulf countries continue to embrace the doomed dollar

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The dollar is to decline in value, and an exclusive currency peg to it, as in the Gulf Cooperation Council (GCC) countries, is unwise. Given the accumulated US deficits and imbalances in international trade, this analysis is such a no-brainer that reiterations of it, including those by my humble self, have become a bit boring. Thus, at this stage let us ask the contrarian question: why has the dollar – although stumbling – still held its ground as a worldwide reserve currency instead of falling like a stone, and why have the Gulf countries so far paid only lip service to a necessary diversification of their currency holdings?

Total US debt, including that of households and public agencies, has been ballooning since the 1980s. It now amounts to $44 trillion – 350 percent higher than the US' GDP. To make matters worse, most of that money is spent on consumption, while investments and jobs are moving to China and elsewhere. Thus, with a dwindling economic base, this debt has effectively become too high to be repaid. Either there will be a default in payments or, more likely, the dollar will be devalued by inflationary policies to such an extent that it will not hurt to 'pay' it back. Currently, five dollars of additional debt buy only one dollar of GDP growth, the net asset position of the US has been increasingly negative since 1985, and the trade deficit has spiraled out of control. There is no doubt that the US dollar is financial radioactive waste, and it is not really clear why anybody would like to hold it or tie their fate to this doomed currency. And yet, the US, which needs to attract 80 percent of worldwide savings to finance its current account deficit, still manages to do so. Rather than worldwide investors being suicidal, this is a problem of size and a lack of alternatives. When you have a debt of one million, you have a problem, but when you have a debt of one billion, your bank has a problem – the latter does not want to write off its assets, and will continue to throw good money after bad, just to keep you afloat. That is the position of the US, which is well aware of it; John Conolly, treasury secretary in the Nixon Administration, put it bluntly in 1971 when the US decoupled the dollar from gold: “The dollar is our currency but their problem.”

After the oil shock of the 1970s, the OPEC countries were awash with cash and were obvious candidates to balance the US deficit. Saudi Arabia, in particular, was courted by the US administration to buy US securities, and was given special tranches of treasury bills that did not go through the normal competitive auctioning process. In the 1980s, low oil prices made the current account surpluses of OPEC countries a thing of the past and Germany and Japan stepped into the gap, with the latter obtaining the special tranches that Saudi Arabia had received in the 1970s. With German reunification and Japan’s recession, the US’ financiers changed once again, as the role was partly taken up by China and other emerging markets. Recently, with the resurgence in oil prices, OPEC countries have come into the spotlight again, as they have current account surpluses of approximately 35 percent of the US deficit, while the corresponding figure for Asia is 49 percent.

Recently it has indeed been the oil-exporting countries that have kept the US dollar afloat, despite occasional announcements to the contrary. Between September 2005 and April 2006, the treasury holdings of the biggest holder, Japan, declined from $672 billion to $639 billion, while the number two, China, continued to increase its holdings from $306 billion to $323 billion, but did so reluctantly, amidst calls by senior officials for currency diversification. The oil-exporting countries and the UK, however, increased their holdings massively from $66 billion to $99 billion and from $96 billion to $167 billion respectively. The increase in UK holdings has been attributed largely to Arab buying out of London.

In light of these plain numbers, GCC announcements of currency diversification appear to be mere rhetoric. The 1 percent change in Kuwait's currency peg last month was rather modest, and other GCC countries, like Saudi Arabia, Oman, and Bahrain, were quick to deny that they would follow suit in making changes to the status quo. The plan of the UAE central bank to increase its share of euros from a meager 2 percent to only 10 percent of overall currency reserves has been postponed repeatedly, and has not yet been implemented. As its announcement on the matter came shortly after the US refused to let Dubai Ports World handle the management of American ports in the wake of the P&O takeover, the announcement might have been no more than a warning of retribution. Qatar’s position – holding up to 40 percent of currency reserves in euros and up to 90 percent in dollars – seems to have been the most courageous one so far, but in general, one can attest that the special relationship between the US and the Gulf countries is still intact. Most importantly, plans are still in place to peg the unified GCC currency to the US dollar in 2010. Even neighboring Iran, an outspoken advocate of diversifying in favor of the euro, and a country hardly known for its endorsement of US foreign policy, recently shunned Hugo Chavez’s proposal at the OPEC summit in Caracas to price oil in euros, instead announcing that it would stick to pricing oil in dollars at its planned oil exchange on Kish island.

Only 10 percent of GCC imports come from the US, while roughly one-third apiece comes from Europe and Asia respectively. At the same time, two-thirds of the region's energy exports go to Asia. Thus, from a trade-weighted perspective, an exclusive currency peg to the dollar does not make sense, and one could speculate about whether the GCC countries’ dollar allegiance is not economic in nature, but politically motivated, as the GCC states depend heavily on the US for security in an unstable region. There are, of course, a number of economic reasons to hold on to the dollar, although they are quite different from the ones suggested by the textbook wisdom of mainstream economics. The first is that the dollar may be in bad shape, but that other currencies do not look much better. Compared to their GDPs, budget deficits in the EU are on average comparable to that of the US; Japan's is actually much higher. The only difference is the more balanced foreign trade position that the two have.

As the GDP and the number of inhabitants of Euroland are comparable to those of the US, or even surpass it, the dollar is facing real competition for the first time, in terms of transaction domain. Formerly, the thinness of markets for hard currencies like the yen, the Swiss franc, the deutsche mark, and gold limited movements out of the dollar because of the lack of sizable alternatives.

However, apart from the limited political and military power of Euroland, the euro is not yet sizable enough to be an alternative – the market capitalizations of its bond and equity markets still lag far behind those of the US. It thus remains to be seen whether the euro can acquire a status as an international reserve currency on equal footing with the dollar by 2010, as expected by Nobel economic laureate Robert Mundell. This is all the more true for China – if it can avoid a hard landing for its overheated economy and develops the political and military clout to solve its growing energy problem, it might be able to become a second competitor to the dollar in 10 or 20 years. However, so far the Chinese yuan is not even fully convertible, and China’s opaque capital markets are only a tiny fraction of the size of their American counterparts.

Thus, the dollar is illiquid because there are so many of it. For countries that want to diversify, there are simply not enough assets denominated in other currencies, and the gravity of established contractual obligations and trading platforms denominated in dollars is causing a dollar attraction, which is completely independent of the US economy and its abysmal deficit.

To grasp what is going on with the dollar, one has to look at it as a world currency that is fuelling global commerce, not as the currency of an isolated nation-state. Since its beginning in the 16th century, capitalism has always had a hegemonic power that has acted as the central banker of the world and has supplied it with the liquidity it has needed. First this was the Spaniards, then it was the Dutch, and next it was the British, once they rid themselves of Napoleon. The demise of the British pound began with World War I, and after World War II, the dollar finally took over within the framework of the Bretton Woods system. At that time, the US was by far the biggest oil producer in the world, and accounted for more than 50 percent of global industrial production.

Aside from the military might of a superpower, the dollar was backed by US current account surpluses and by gold. Today, only military might is left. Since 1971, the US has essentially been paying for its imports with printed paper, without a need to export goods and earn foreign currency or gold to pay for this. No other nation has this privilege.

Nevertheless, the dollar debt juggernaut fuels the world economy, and everybody is happy with it. It goes without saying that the US housing and consumer markets benefit, but the Japanese love it as well – the yen carry trade has enabled them to stabilize their shaky financial system with a zero interest rate policy and without inflation. China and Southeast Asia still have not developed domestic alternatives for their export-oriented industrialization, and the Europeans are content to sail in the geopolitical and economic wake of the US.

Thus, with no clear alternative in sight, the financial health of other countries and currencies is heavily dependent on the US dollar Ponzi scheme. If the dollar goes down, they go with it, and as with the prisoner's dilemma, everybody is afraid to make the first move – the first one to abandon the dollar could set off a chain reaction that would backfire and affect them as well. Thus, the dollar's demise might take a bit longer than common sense would suggest, as everybody is trying to evade the unpopular repercussions. Nevertheless, it is inevitable, and that is why the GCC countries need to contemplate a diversification into other currencies and gold sooner rather than later.

© 2006 Al Bawaba (www.albawaba.com)