How the Coming Crash in the Dollar Will Unfold

Bloomberg
Dollar Supremacy Bloomberg | James Alexander Michie

The dollar’s supremacy is threatened. Photographer: China Photos/Getty Images

Scorn has long been heaped on those daring to question the supremacy of the U.S. dollar as the world’s dominant reserve currency. I certainly received more than my fair share in reaction to a column I recently wrote for Bloomberg Opinion on the likelihood of a sharp decline in the greenback. The counter-arguments were strong and highly political, basically boiling down to the so-called TINA defense — that when it comes to the dollar, “there is no alternative.”

That argument is very important in one critical sense: The dollar, like any foreign-exchange rate, is a relative price. As such, it encapsulates a broad constellation of a nation’s value proposition — economic, financial, social, and political — as viewed against comparable characterizations of other nations. It follows that shifts in foreign-exchange rates capture changes in these relative comparisons — the U.S. versus Europe, the U.S. versus Japan, the U.S. versus China, and so on.

My forecast that a 35% decline in the value of dollar could well be in the offing is couched in terms of the comparison between the U.S. and the currencies of a broad basket of America’s trading partners. Individual components in this basket are weighted by country-specific trade shares with the U.S. and expressed in real terms to capture shifting inflation differentials. As an economist, I care most about currency-related shifts in international competitiveness. The real effective exchange rate, or REER as calculated monthly by the Bank for International Settlements, is particularly well suited for this task.

In dissecting the TINA critique of the weak-dollar forecast, it helps to start with the weighting structure embedded in the REER to get a sense of which of the some 58 country-by-country relative comparisons might matter the most in pushing the BIS construct of the broad dollar index lower. Based on cross-border manufacturing trade flows, the BIS assigns the largest weights to China (23%), the euro area (17%), Mexico (13%), Canada (12%), and Japan (7%). These five countries (region in the case of the euro area) account for 72% of the total trade weights in the broad U.S. dollar index. An additional 13% comes from countries six through 10: South Korea, the U.K., Taiwan, India and Switzerland. Weights of the top 10 account for 85% of America’s cross-border trade.

On this basis, a forecast of a weaker dollar requires some combination of a strengthening in China’s renminbi and the euro. The currencies of America’s USMCA partners (formerly NAFTA) — Mexico and Canada — also matter a good deal in that they account for 25% of U.S. manufacturing trade. The yen is now of little consequence to movements in the broad dollar index, given its sharply reduced trade weight.

The China call is very contentious. From the trade war to the coronavirus war to the distinct possibility of a new Cold War, the negative case for China has never been stronger in the U.S. than it is today. Notwithstanding these concerns, the broad renminbi index constructed by the BIS is up 53% from its December 2004 lows in real effective terms. As long as China stays the course of structural reform — shifting from manufacturing to services, from investment- and export-led growth to consumer-led growth — and embraces a further liberalization of its financial system, the case for further currency appreciation remains compelling, even in the face an increasingly fraught relationship with the U.S.

The call on the euro is also counterintuitive, especially for a broad consensus of congenital euro-skeptics like me. That goes back to my Morgan Stanley days when I argued that an incomplete currency union — especially the lack of a pan-European fiscal transfer mechanism — could not withstand the inevitable stress of asymmetrical shocks.

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Source: Stephen Roach | Bloomberg

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