Mr. Dollar, the good old days are gone – maybe forever

On a recent business trip to Asia and the Middle East, where I met with investment bankers, private equity players and real estate developers, the conversation almost always turned to the weakening dollar and its impact on the Asian and Gulf markets. I certainly wasn’t surprised to know that these individuals and companies were interested in the US greenback, especially when the US dollar is at its all-time lows against the euro and Japanese yen, but even then the scale and depth of the conversation surprised me me.

As US trading partners, the impact of the weakening dollar on these nations is easy to understand, but it has become more than just a trade issue. Historically, the US dollar has held its ground against major currencies; and as a result, many nations, our allies and enemies alike, viewed it as a safe investment. What many Americans don’t know is that because of this historic strength, many US allies around the world have pegged their currencies to the US dollar and have felt pressured by the falling dollar in recent years.

Recently, some of these countries have begun to reconsider their decision to continue this practice. The Kuwaiti government, one of America’s staunchest allies, after many years of faithfully following the dollar, has decided to instead peg its dinar to a basket of currencies; The US dollar will no longer have the sole distinctive character. The idea is to provide a weighted average of the different currencies in the basket based on their importance to the country’s international trade. For some of these nations, the US is no longer the only preferred trading partner.

In the case of Kuwait; As trade with China and India grows, their currencies will have more weight in the so-called basket. This doesn’t seem like a big deal on the surface; but it is. The Kuwaitis might just be the leading indicators of things to come; The importance of the US dollar is declining amid historically low prices and dwindling US influence around the world. The young euro, once a weakling against the young dollar, has quickly become the £800 gorilla as the dollar continues to lose ground. In the coming years, the Chinese yuan, Indian rupee and proposed common Gulf currency are sure to challenge the once buoyant dollar even more.

According to a recent IMF report, Kuwaiti’s decision to shift gears is fully justified. The report suggests that the currencies of six Gulf countries under the umbrella of the GCC lost more than 12 percent of their value over the period 2003-2006. The IMF attributed this decline to the dollar’s decline against other major currencies. In fact, the latest Kuwaiti decision is not the first of its kind, and the Kuwaiti government had to realign its currency, the dinar, by 1% against the dollar once before in 2006.

Again, this does not bode well for Mr. Dollar as the opportunity for interest rate arbitrage is enormous in these conditions and to avoid such occurrences dollar-pegged currencies must follow the US lead in interest rate movements. For those who don’t understand arbitrage, it’s a very simple concept; as easy as buying cheap and selling high. Sometimes the markets create opportunities through imbalances, for example if you buy a dollar for 3.50 dinars in Kuwait and then you can sell those dollars back for 3.6 dinars in the international market, you have just arbitraged.

There are other concerns about the US economy that seem to be resonating in the Middle East and perhaps around the world; These include the rapid increase in global inflation, the exploding trade deficits and, last but not least, the decline in the real estate market.

One of the views that surprised me was the notion and belief that the US government’s core inflation numbers don’t really reflect the inflation picture. On the surface, this might seem like a completely absurd idea, but actually it isn’t. Since the 1970’s, the US government has calculated core inflation excluding energy and food costs, which is really nonsense because US consumers use a lot of energy and don’t like fasting very much; so they eat.

In fact, US households have the highest per capita energy consumption of any other nation on the planet, combine this with historically high fuel prices and the true picture is very clear. Government figures show inflation rates between 2-3%, but according to The Economist magazine and others who have tracked inflation including energy and food costs, the actual number is somewhere between 3-5% (it fluctuates due to changing energy costs). To put this in perspective, if you got a 4% raise from your boss last year, that would actually be a 1% reduction in your pocketbook, as everything costs up to 5% more due to inflation.

The only positive side of the weakening dollar could be an increase in US exports; The weakening dollar makes US goods and services cheaper in the world market and could help reduce the trade deficit. The trade deficit with China alone amounted to an impressive 232 billion dollars in 2006.

The true impact of world markets diversifying out of the dollar, inflation and the growing trade deficit may not materialize for years or even decades, but the outlook for the US economy and the US dollar is no longer so bright like in old times. The power of the US dollar could erode as other nations and currencies take on more prominent roles in the global economy. One thing is for sure, the good old days for the US dollar could be gone forever.