In the last week we have learned that:
1) Fed is planning 15-fold increase in us monetary base
2) U.N. panel says world should ditch dollar
3) Zimbabwe has ditched the US dollar in favor of the rand
4) China and Russia rethinking the dollar's status as world's reserve currency
With the US monetary base expanding at a breathtaking pace and nations around the world worrying about the value of their US holdings, the dollar looks virtually guaranteed to lose its status as the international reserve currency. This begs the question: how big a deal is the loss of the dollar's reserve status?
To answer this question, lets first calculate just how large are the dollar holdings of foreign governments. From the CIA's world Factbook, below is a ranking of countries by reserves of foreign exchange.
(amounts in billions)
Foreign Exchange Reserves
United Arab Emirates
According to Wikipedia, at the end of 2007, 63.90% of the identified official foreign exchange reserves were held in United States dollars. Therefore, total dollar reserves at the beginning of 2008 were about $4,408 billion (63.90% of $6,898 billion). However that is not the end of the story, as we still need to account for stabilization funds or Sovereign Wealth Funds. Wikipedia explains:
Foreign exchange reserves are important indicators of ability to repay foreign debt and for currency defense, and are used to determine credit ratings of nations, however, other government funds that are counted as liquid assets that can be applied to liabilities in times of crisis include stabilization funds, otherwise known as sovereign wealth funds. If those were included, Norway and Persian Gulf States would rank higher on these lists, and UAE's $1.3 trillion Abu Dhabi Investment Authority would be second after China. Singapore also has significant government funds including Temasek Holdings and GIC. India is also planning to create its own investment firm from its foreign exchange reserves.
For more, the Market Oracle explains sovereign wealth funds.
Sovereign Wealth Funds
June 30th, 2007
Central banks have traditionally kept their reserves in relatively low-yielding, highly liquid government securities, agency debt, money-market instruments and bank deposits. The most current official IMF figure for official worldwide foreign currency reserves is US$5.89 trillion [Worldwide foreign currency reserves increased by about 1 trillion over 2007]. At US$1.35 trillion, China holds the world's largest pool of official reserves, followed by Japan with US$911 billion and Russia with US$403 billion.
In addition to these reserves, market estimates for the total value of Sovereign Wealth Funds (SWF) run as high as US$2.5 trillion. This compares to US1.6 trillion for hedge funds. These are state-owned and operated funds, comprising of financial assets such as stocks, bonds, or property not included in the IMF figures. The use of these funds enables large reserve holders to invest in higher yielding instruments.
With around 40 percent of stabilization funds invested in the US, the dollar holdings of sovereign wealth funds are around $1,000 billion (40% of $2,500 billion). After combining the numbers from foreign exchange reserves and stabilization funds, the dollar holdings of foreign governments are about $5,385 billion. Meanwhile, as you might have noticed from the CIA's ranking above, the United States holdings of foreign currencies is around $71 billion.
Implications of the loss of the dollar's reserve status
As the dollar loses its reserves status, at least half of the world's $5,385 billion dollar reserves will be sold off and replaced with other currencies (yuan, euro, khaleeji, gold, rand, etc...). The US, with its $71 foreign reserves, will not be able to do anything to counteract this mass exodus from the dollar. With outflows of this magnitude, the dollar's value will collapse to a fraction of where it is now.
The process of foreign nations extracting themselves from the dollar is not going to be pretty. The likely impacts are:
1) The dollar's value will plunge as investors see the writing on the wall and jump ship.
2) US credit markets will collapse. As the dollar fall, a mass exodus from credit market will begin. Investors sitting on toxic securities will sell at firesale prices to escape the currency depreciation.
3) The fed's balance sheet will explode beyond all reason. In response to the mass exodus from credit markets, the fed will buy trillions worth debt in a desperate attempt to hold interest rates down. Unfortunately, the more debt the fed buys, the more quickly the dollar will fall, and the more panicked the credit selloff will become.
4) US interest rates will soar, despite (or because of) the fed's efforts.
5) Countries around the world will be hurt badly by the dollar's decline. These countries include:
A) Nations which are heavily dependent on US exports: Japan, Mexico, etc...
B) Nations with large dollar reserves: Japan, China, Gulf oil states, etc...
C) Nations which receive large amount of US foreign aid: Israel, Egypt, etc...
D) Nations which rely on remittances from citizens working in the US: Mexico, India, etc...
E) Nations which use dollars as their official currency: Liberia, Panama, etc...
F) Nations which have large amounts of dollars in circulation: Central and South America (especially Argentina), Eastern Europe, etc...
6) Some nations will see benefits from the dollar's decline. These countries include:
A) Nations with large gold reserves: EU zone, Switzerland, etc...
B) Nations which owe dollar denominated debt will see that debt wiped out: Iceland, African nations, etc...
C) Nations who stable currencies: EU zone, Switzerland, China, etc...
7) World politics will be greatly altered. There will be considerable anger at the US from nations hurt by dollar's fall. The US will lose influence to Asia (mainly China).
8) US retailers will get crushed. As the dollar falls, the cost of imports for retailers will increase, but the American consumer will be unable to afford to these higher prices. Competition between desperate retailers will force them the sell inventory at below cost, creating massive losses. Retailers most heavily dependent on imports (ie: Wal-Mart) will be the first to go under. Eventually as more and more retailers go bankrupt, the few survivors will be able to raise prices enough to cover costs, and the sector will stabilize at a fraction of its current size.
9) American lifestyles will change radically. The end of cheap oil, low interest rates, and deficit spending will mean a lower quality of life and higher taxes.
10) The price of gold and other precious metals will explode.
11) US will experience hyperinflation.