Why the dollar keeps dropping

A more expensive yuan would make Chinese goods more expensive to U.S. buyers in particular and to global customers in general. In China, that would cut the economy's growth rate, slow job creation and almost certainly mean the loss of jobs in the least efficient of the state-owned companies that still employ millions of workers. In effect, the Chinese and other governments have opted to spend some of the dollars that their economies earned in trade on subsidizing jobs for their work forces.

They'll stick with dollars for now

Despite saber rattling by the world's central banks, there's little evidence that of any of them are abandoning U.S. dollars even as the currency tests new lows. The International Monetary Fund's numbers show a slight shift from dollars into euros, with the dollar share falling to 64.2% of all global reserves in the first quarter of 2007 from 64.6% in the last quarter of 2006.

But much of that shift is a result of an appreciation in the euro holdings of these central banks and the depreciation of the dollar. Certainly, the Federal Reserve's more recent balance sheet of Treasury and agency bonds doesn't show a big shift out of dollars. Foreign central banks held $1.995 trillion of this paper at the end of September, up from $1.673 trillion in September 2006.

To the degree that any asset shifting has taken place in 2007 by central banks, it was out of Treasurys and into higher yielding paper such as mortgage-backed debt, or buyout loans or derivatives based on those assets. The move came just in time for these banks to take a beating in this summer's meltdown in those markets. I suspect that for the moment, these banks aren't overly eager to take on more risk.

The pain will grow

Still, I think after a relatively short breathing space, the world's central banks will start looking for a solution again because the problem is too big to ignore. Subsidizing domestic jobs is all well and good, but a falling dollar makes it increasingly expensive.

An 11.6% decline in the dollar against the euro means that every dollar in China's $1.2 trillion foreign-exchange reserve -- and dollars make up something like 70% of that reserve -- are worth that much less when the country goes to buy anything from the European Union, China's second-largest trading partner. That's not an insignificant issue when you're importing about $90 billion in goods from Europe annually.

Same goes for Russia and Saudi Arabia, where the biggest exports are denominated in dollars but many imports have to be paid for in euros.

The overseas central banks -- or more accurately, the governments behind them that decide on how many jobs to buy by spending reserves to keep their currency from appreciating versus the dollar -- have a pretty high threshold of financial pain. But it's not infinite.

Looking elsewhere for investments

The conventional argument has long been that these banks would support the dollar no matter what because they didn't have a choice. What currency could replace the dollar?

But that argument looks out of date. The countries with huge reserves may still need to keep dollars for trade, but, increasingly, they're looking elsewhere for their investments. The new vehicle is the sovereign investment fund, with capital provided from national reserves for investment in assets around the globe. The models here are the investment funds of Norway and Singapore that have bought stakes in foreign telecommunications companies, airlines and financial companies.

And those investments look pretty attractive now that developing countries' stock markets are beating the returns from investing in the United States. Why buy more of the risky assets that just blew up when you can earn a better return in India or Brazil or the Philippines?

Developing markets will get the cash

Where does that leave the United States? In a tough competitive position on the currency front.

The recent blowup in the U.S. mortgage- and buyout-loan markets couldn't have come at a worse time competitively. Big losses in these dollar-denominated investments eroded some of the edge that dollar investments had in the minds of investors over investments in developing markets. The bigger the losses in that debacle, the longer it takes to work out and the less transparent that market remains, the more overseas central banks will look to developing markets for the gains they can't get in U.S. dollar assets.

That doesn't add up to a quick stampede out of dollars. Instead, look for the decline in the dollar to continue at a gradual pace as developing markets win more of the world's cash.

Continued: Performance for Jubak's Picks

< previous |  1 | 2 | 3 | next >