Mr. Dollar, The good old days are gone, perhaps forever

On a recent business trip to Asia and the Middle East meeting with investment bankers, Private Equity players and Real Estate developers the conversation almost always made its way to the weakening dollar and its impact on the Asian and Gulf markets. I was certainly not surprised to know that these individuals and companies were interested in the US green back especially when the US dollar is at its all time low compared to the Euro and the Japanese Yen, but even then, the extent and the verbosity of the conversations took me by surprise. As US trade partners, the effect of the weakening dollar is easily understandable by these nations, but it has become more than just a question of trade. Historically the US dollar has held its own against major currencies; and as a result many nations, our allies and foes alike considered it to be a safe and secure investment. What many Americans don’t realize is that as a result of this historic strength many US allies around the world have pegged their currencies to the US dollar and are feeling squeezed in recent years as a result of the declining Dollar.

Recently, some of these countries have started to re evaluate their decision to continue this practice. The Kuwaiti government, one of the staunchest American allies has decided after many years of faithfully following the dollar to instead peg it’s Dinar against a basket of currencies; The US dollar will no longer have the sole distinction. The idea is to provide weighted average to different currencies in the basket, based on their importance to the country’s international trade. For some of these nations the U.S is no longer the only preferred trade partner. In Kuwait’s case; as trade grows with China and India their currencies will hold more weight in the so called basket. This on the surface does not seem like a big deal; but it is. The Kuwaitis might just be the leading indicators of things to come; the importance of the US dollar is diminishing in the face of historically low prices and waning U.S influence around the globe. The young Euro, once a weakling against the fledgling dollar has quickly become the 800lb gorilla while the dollar continues to lose its footing. In coming years the Chinese Yuan, the Indian Rupee and the proposed single Gulf currency will all surely pose even more challenges to the once vibrant Dollar.

According to a recent IMF report, Kuwaitis decision to shift gears is fully justified, the report suggests that the currencies of six gulf nations under the umbrella of GCC lost more than 12 percent of their value during the 2003-2006 period. The IMF attributed this decline to the decline of the dollar against other major currencies. In fact, the recent Kuwaiti decision is not the first of its kind and the Kuwaiti government has once before had to readjust its currency the Dinar against the Dollar by 1% in 2006. This does not bode well for Mr. Dollar once again because the opportunity for interest rate arbitrage is tremendous under these conditions and in order to avoid such occurrences, currencies pegged to the dollar must follow the US lead on interest rate movement. For those who don’t understand arbitrage, it’s a very simple concept; as simple as buy low and sell high. Sometimes the markets create opportunities through imbalances, for example, if you can buy a dollar for 3.50 dinars in Kuwait and then sell back these Dollars for 3.6 dinars in the international market you have just performed arbitrage.

There are other concerns about the US economy that seem to be reverberating throughout the Middle East and perhaps around the world; these include the rampant rise in Global inflation, ballooning trade deficits and last but not least the housing market decline.

One of the views that surprised me was the notion and belief that the U.S government’s Core inflation numbers are not a true reflection of the Inflation picture. This on the surface would seem to be an utterly absurd idea, but actually it’s not. Since the 70’s the US government calculates Core inflation excluding energy and food costs, which is truly nonsense because the U.S consumers use gobs of energy and are not very fond of fasting so they eat. In fact US households have the highest per capita energy consumption compared to any other nation on the planet, combine that with historically high fuel prices and the true picture starts to emerge very clearly. The govt. numbers show inflation rates between 2-3% but according to “The Economist” magazine and others who has been tracking inflation including the energy and food costs, the actual number lies somewhere between 3-5% (It fluctuates due to changing energy costs). To put this in perspective, if you received a 4% raise from your boss last year it would actually be a 1% reduction on your pocket book because everything costs up to 5% more due to inflation.

The one upside to the weakening dollar could be a rise in US exports; the weakening dollar makes U.S goods and Services cheaper in the world market and could help reduce the trade deficit. The trade deficit with china alone was a hefty $232B in 2006.

The true effects of world markets diversifying out of the dollar, inflation and the growing trade deficit might not manifest for years or even decades, but the outlook is not as peachy for the US economy and the US Dollar as it once was. The might of the American Dollar may be dissipating as other nations and currencies take more prominent roles in the world economy. One thing is for sure, for the U.S Dollar the good old days may be gone forever.