Games Currencies Play

Posted On Thursday, Jun 30, 2011

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"All work and no play makes Jack a dull boy", so says a common adage. Now, we all have taken our playtime seriously as we grew up - skinned our knees and flaunted the bruises. As mature adults we may smile nostalgically upon these fond memories, but even today, games are a very significant part of our lives. Only, we now have a more fancy sounding term for it - Competition. In the hustle of daily life, we are competing with our peers, our colleagues and friends for the place at the top, aren`t we?


And we are not alone in playing games. In fact, major currencies of the world are involved in a game of their own as well. The currency game is a relative value game, which means that when the value of one currency increases, the value of the other drops. This is because the relative strength of a currency is higher in comparison to the other. Post the financial crisis; there has been a constant clash between the two biggest world currencies: the Dollar and the Euro. The US and the Euro-zone, two world power houses, have been struggling in vain to find a solution to their economic problems. Depending on the market reading about which currency between the two looks less ugly than the other at a particular point of time, the value of that currency rises against the unfortunate other.


The US dollar may appear to be in a terminal decline but the collapse of the Euro is shifting the limelight from the Dollar. As the financial crisis situation in the Euro-zone intensifies, the US dollar is rebounding back to its earlier value. But, it is quite evident that the counter rally in the Dollar is not because of strong fundamentals but rather because of the weak Euro.

The graph below shows the Euro and the Dollar trend, and even though they may appear to rise or fall, the fact remains that they are both in secular long-term downtrends fuelled by debt problems.

Chart: Euro dollar
Euro dollar
Source:Bloomberg

The Euro Story

The Euro, once rendered as a strong currency, is on the verge of being dissolved.


The Euro came into existence in order to bring nations with diverse economics and political structures under one concrete currency and under the control of a common central bank - The ECB. However, while the central bank can regulate the money injected into its economy, it cannot control the debt created by the nations. The financial crisis drained out liquidity from the economy and put highly leveraged banks under pressure. This in turn led to bailouts by the government. But, how does the government get funds for a bailout?


Unfortunately, the weaker nations driven by reckless and erroneous policies are being kept afloat by nations that are less frugal and have stronger policies in place. These measures have embedded moral hazard in the very structure of the entire system. Bailouts are not the solution to a crisis; it only provides temporary relief by buying some time and postpones the reality. With every such postponement, the problem just grows and worsens. Every profligate European country feels that it is too big to fail, and hence enjoys presumed access to the financial resources of other states in the EU. The result is the ongoing and worsening bailouts which lead to total bankruptcy. It is believed that if Portugal files for bankruptcy, Spain and Italy could be the next two European countries to follow. This could cause a domino effect, bringing down the whole financial structure, first in Europe, then in the UK, and finally in the United States.


The entire European finance system and its monetary arrangements lie broken and such scenarios give politicians an opportunity to write proposals and plans in paper rather than confront the situation. There is far more at stake than just Greece or Portugal. The ECB has been trying to work out bailouts but all in vain. Doling out cash is not going to solve these fundamental issues. This can`t continue forever, the bailouts only buy some time and probably worsen the problem. Eventually, the solution to the problem needs a fix in terms by way of a hard currency or else the Euro will end as a failed experiment as a monetary unit.


Every nation in the European region is crumbling under the monetary requirements for survival, and as the bailouts continue, austerity measures are forced upon its people causing revolts in different parts of Europe against their government(s). Along with this, the simultaneous downgrading by rating agencies added pressure on the Euro, causing it to decline.


The drop in Euro`s value has boosted the Dollar, as these two currencies are the main constituents of this basket of currencies worldwide. But, it is not difficult to see that both the Dollar and Euro are in an equally in dismal state!


A quick look at the Dollar`s condition


The US has already hit its debt limit and has been warned of a credit downgrade. US Treasury Secretary Timothy Geithner, told Congress that if the US issues $72 billion in bonds and notes, they would be pushing the deficit to its legal threshold, which would cause him to suspend deposits into federal pension funds so that the borrowing is reduced. Although Congress has increased the debt ceiling dozens of times over the years, this time around, Republicans and some Democrats are demanding that a hike in the ceiling be accompanied by measures to cut debt and slash spending. This comes in the wake of President Obama`s warning that, if the ceiling does not increase, the country could be hit by an even worse recession than the recent downturn.


The fundamental problem is that the US already has too much of debt and it continues to run more deficits. Large unfunded future liabilities are indeed a cause for worry!

Let`s see the debts created by the US till date:

  • What about $4.5 trillion in deficits over the last 3 years?

  • How about tripling the Fed`s balance sheet holdings since the end of `08?

  • Where are they headed on Troubled Asset Relief Program (TARP), Term Asset-Backed Securities Loan Facility (TALF), Quantitative easing QE1, QE2... and zero interest rates?

Many argue that these steps were taken as emergency responses to the crisis of `07-`09 and were required from the point of economic stability. However, the fact remains that the nation`s unnerving descent into debt began a decade ago with a choice, not because of a crisis.


Chart: US Budget Surplus/Deficit as a percentage of GDP
US Budget Surplus/Deficit as a percentage of GDP
Source:Bloomberg


For three years until 2000, the US ran a budget surplus. The outlook for US finances looked rosy and the Congressional Budget Office (CBO) forecasted ever larger annual surpluses for the future. Now, instead of sitting on heaps of Dollars in reserves, the US possibly owes more than $10 trillion estimated debt to foreign investors by the end of 2011.


According to the above graph, except for the period after World War II, the national debt has been the highest lately, as a percentage of the economy than at any time in US history. Even the CBO forecasts show huge deficits that are likely to run for a long period.


There are a lot of questions yet to be answered:

How will the Fed cover this debt when it continues to create more by still running deficits?

How are they going to fund the huge unfunded liabilities on hand?

Do you think they will break promises, cut spending, raise taxes, and increase interest rates?


If you feel that the future looks optimistic and your answer to all the above questions is a yes, then you should not own gold. If there were answers to these issues, the price of gold would go down and the dollar`s value would rise. However, it is not so easy and the intent to bring reforms is completely missing.

A country that was once predicted to hoard bags full of cash is now close to being virtually bankrupt because it is unable to fulfill its obligations without printing new money. Economic depression and high unemployment are making things worse. It is highly likely that the dollar might soon face a crisis of confidence. The only saving grace for the dollar today is that it is the backbone of the global economy whose intensity will leave an empty space or void in the financial system.

This is an important question for which the world has found no answer. What if the dollar dies tomorrow? Is there any other currency capable of replacing the dollar as the world reserve currency?


We have already seen the Euro`s performance and can conclude that it does not seem to be in a position to serve the purpose of a reserve currency since it is struggling for its own survival. It has already been severed by the burden of just a few nations, so it is difficult to imagine the Euro to remain stable when it is stretched across hundreds of countries.


Let us look if there are other contenders as well.


Experts mention the Chinese Renminbi and Japanese Yen are possible choices to become the next reserve currency. We believe that both these currencies have their own reasons to serve as world reserve currencies. For being a reserve currency, it should be freely convertible with no exchange restrictions and have a highly transparent system.


Chinese Yuan is not freely convertible and is manipulated to prop up exports. The Chinese government has been taking steps like bilateral trades but there have to be a lot more reforms before the Yuan comes even close to becoming a global currency. On the other hand, Japan is under very high debt and therefore brings with it, the similar challenges as the US. Many argue that Japan has been running trade surpluses and most of the debt has been internally funded, making the Yen a likely replacement for the dollar.


However, it seems that the Yen may not make it as a world reserve currency because firstly, it is not a stable monetary unit and secondly the Japanese economy is highly export dependent. It needs a weaker Yen to sustain exports, and any move towards making Yen a reserve currency would instill a run to buy the currency which would lead to an appreciating Yen. From an economic stance, this would not be tolerated as exports would be hit by the appreciating currency.

By now, it is easy to figure out that we have still not found a suitable replacement for the dollar. There is no other currency that fits the bill, and the situation of the dollar is increasingly getting precarious.


As people realize such a situation many would turn towards gold which happens to be a historically time tested, stable form of money which promises to store value over long time periods. The race to the bottom between the fiat currencies will continue as each sovereign state believes that a weaker currency will boost exports and ultimately will get them out of this mess. It is amusing to see that those involved in the currency devaluation, have not noticed that each round of currency devaluation negates the previous one.

Measures such as printing fiat money, devaluation and borrowing in order to force spending, are all at the end of the day, a futile and counterproductive exercise. It is time that nations learn that a country can grow only when money is spent on objects that help increase productivity of labor, such that the standard of living of people increases.


Pushing the public to spend money will only result in speculative activities, and obviously it would be easier to bet on rising gold and other commodity prices than to risk setting up a new company/business and hiring new people. Soaring deficits don`t create new demand; they only create fears of future tax hikes and devalue the purchasing power of the money you own.

Bouts of dollar strength may bring about corrections in gold as the `short dollar long gold trades` unwind, and the Euro looks nowhere close to rising in value. These would be opportune times to add more gold to your portfolio.



Disclaimer:

The views expressed in this article are the personal views of the Fund Manager of Quantum Gold Fund. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. This information is meant for general reading purpose only and is not meant to serve as a professional guide/investment advice for the readers. This article has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. Readers are advised to seek independent professional advice and arrive at an informed investment decision before making any investments.Please visit – www.quantumamc.com/disclaimer to read scheme specific risk factors.

Above article is authored by Quantum.

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