Thread: EL-ERIAN: 'DOLLAR COULD LOSE IT'S RESERVE CURRENCY STATUS

EL-ERIAN: 'DOLLAR COULD LOSE IT'S RESERVE CURRENCY STATUS' 2-22-2011

http://www.youtube.com/watch?v=ImXkRdLx ... r_embedded

Monday, February 28, 2011 6:50 PM

US Dollar About to Lose Reserve Currency Status - Fact or Fantasy?

A number of sites are commenting on a Bloomberg video in which El-Erian, PIMCO Co-CEO says "Dollar could lose its reserve currency status".

Bloomberg: "Mohammad what does a weak dollar signal to you, a dollar that can't jump up here on a day like we've seen today?"

El-Erian: "It is a warning shot to America that we cannot simply assume flight to quality, flight to safety. That people are starting to worry about the fiscal situation in the U.S. They are starting to worry about the level of debt. They are starting to worry about what they hear about states and municipalities. So, I would take this as a warning shot that we cannot assume that we will maintain the standing of the reserve currency as we have in the past."

Reserve Currency Definition

Before we can debate whether or not the US will lose reserve currency standing, we must first define what it means.

Investopedia defines Reserve Currency as follows. http://www.investopedia.com/terms/r/reservecurrency.asp

"A foreign currency held by central banks and other major financial institutions as a means to pay off international debt obligations, or to influence their domestic exchange rate."

I accept that definition. Unfortunately Investopedia rambles on with nonsense about the implications: "A large percentage of commodities, such as gold and oil, are usually priced in the reserve currency, causing other countries to hold this currency to pay for these goods."

That sentence is a widely believed fallacy. The reality is no country is obligated to hold dollars to buy goods denominated in dollars.

Currencies are Fungible

Currencies other that illiquid currencies with low or no trading volume (think of Yap Island stones or the Cuban Peso) are fungible. It is a trivial process to switch from one currency to another.

You can buy gold or silver in any country, and I assure you those transactions do not all take place in dollars. Thus, just because a commodity is widely priced in dollars does not mean it only trades in dollars.

That holds true for oil as well.

I keep pointing this out, unfortunately to no avail, that oil trades in Euros right now. There is no selling of Euros to buy dollars on the front causing the oil producers to trade dollars for euros on the back end. The oil states simply sell oil for a price in Euros and then hold Euros in their Forex reserves.

Fact and Fantasy

The first part of what El-Erian said is factual. Here it is again for convenience. "People are starting to worry about the fiscal situation in the U.S. They are starting to worry about the level of debt. They are starting to worry about what they hear about states and municipalities."

Those are true statements. Unfortunately, his "warning shot" regarding reserve currency status is fallacious.

To understand why, let's return to the definition of reserve currency: "A foreign currency held by central banks and other major financial institutions as a means to pay off international debt obligations, or to influence their domestic exchange rate."

Foreign Currency Reserve Factors

1. Trade Volumes
2. Trade Deficits
3. Currency Manipulation
4. Hot Money

Trade Volumes and Trade Deficit

The US happens to be at or near the top of nearly every country's trading partners. The US runs a trade deficit with most of them. Those trading partners accumulate dollars as a simple function of math. We run a deficit, someone else runs a surplus.

Some wonder why the surplus countries do not buy oil or commodities with their accumulated dollars. OK, what does Saudi Arabia, Iran, or Venezuela do with the dollars then?

Does Iran or Venezuela even hold dollars now? Think of the implications of that answer in light of the widely viewed fallacy that one needs dollars to buy oil.

Regardless, of where the dollars end up, those US dollars will eventually return home. Recall that Dubai tried to buy a US port and China tried to buy Unocal. Both were rejected for security reasons. However, those dollars will return home, with China, Japan, and the oil states buying various US assets.

Currency Manipulation

Most US trading partners do not want their currencies to rise, especially China and Japan.

Consider the Yuan which does not float. To suppress the value of the Yuan, China takes US dollars and exchanges them for Yuan at a pegged rate. China does this hoping to create job and boost exports.

The US calls this currency manipulation and it is. However, it is no more manipulative than Bernanke flooding the markets with US dollars hoping to weaken the US dollar and stimulate growth.

Hot Money

Hedge funds and other speculators have moved money to China banking on currency appreciation.

China needs to maintain currency reserves to allow for the repatriation of those US dollars. Michael Pettis at China Financial Markets points out that most of the hot money inflows into China are done by Chinese businesses that understand how to get around rules and regulations regarding currency inflows.

That argument make perfect sense, but the math remains the same regardless of where the hot money comes from.

Global Beggar-Thy-Neighbor Policies

It is pretty pale to suggest the end of the US dollar as a reserve currency when countries hold dollars as a function of math, then hold still more dollars to suppress their currencies, hoping to keep their exports up to "stimulate growth".

Mathematical Impossibility

Another mathematical relationship says the dollar, the pound, the Yen, and the Yuan cannot all be weak at the same time (relative to each other). Yet that is precisely what every country wants. It's mathematically impossible.

You can see the effect in rising commodity prices.

If commodity prices were a function of the US dollar alone, then they would be rising in US dollar terms alone. Instead there is upward pressure on commodities in all currencies.

At some point the desirability to hoard commodities will peak.

Zero Hedge Comments

Zero Hedge commented on reserve currency status about a week ago. http://www.zerohedge.com/article/mohame ... ncy-status

Regarding El-Erian's statement: "I would take this as a warning shot that we cannot assume that we will maintain the standing of the reserve currency as we have in the past"

Zero Hedge quipped:

That's a given - the question however remains, which fiat currency, if any, is willing and ready to step in and replace the USD? With all eyes continuing to be look at the CNY, how long before China finally takes the plunge to find out just who is the real reserve currency in the world?

Will Another Fiat Currency Replace the Dollar?

For starters, Zero Hedge ignored the essential trade deficit math. The US runs a trade deficit, someone else must run a trade surplus.

Second, Canadian dollar and the Swiss Franc do not have enough trading volume. More importantly, there are not enough Canadian Dollars or Swiss Francs to go around. Look at what happened to Iceland when too many plunged into the Icelandic króna.

The Canadian and Swiss economies are simply not big enough for them to be global reserve currencies. In regards to the Euro, is Europe in a better fundamental situation than the US? Would it matter even if it was? To answer the second question, please remember trade deficit math.

As for the Yuan, it is complete silliness to suggest the currency of a command-economy dictator-led country that will not even float its currency will be some sort of major reserve currency.

To the extent that China trades with Russia, South Korea, etc., local reserves in varying currencies can happen (and are happening already), but the global significance of it is wildly overstated. The amounts in question are tiny, as a simple function of math.

Will the dollar remain the global reserve currency forever? Of course not. However, it is highly unlikely any of the presumed leading Fiat candidates including the Yuan and the Keynesian wet-dream IMF SDRs (Special Drawing Rights), will take the dollar's place. SDRs are essentially a basket of currencies.

The concept of trading in baskets of currencies backed by nothing is even more ridiculous than the existing setup. People do not buy goods and services in baskets of currencies.

What can replace the dollar?

Gold, or a mechanism like gold that would impose a hard restrictions on perpetual deficits is what its takes to restore sanity. However, we may not see a significant move towards gold until there is a massive currency crisis or revolt against fiat currencies in general, not just the US dollar.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com

http://globaleconomicanalysis.blogspot. ... serve.html

Mohamed El-Erian Says We Can Not Assume The Dollar Will Retain Its Reserve Currency Status

by Tyler Durden on 02/22/2011 15:02 -0500

Mohamed El-Erian made one of his regular media appearances today (in addition to his almost daily Op-Ed, released earlier) appearing on Bloomberg Surveillance with Tom Keene and talking the developments in the Maghreb. While the full highlights are presented below, there are two items of note. El-Erian once again hits on what we believe will be the keyword of 2011: stagflation. To wit: "we have to appreciate that in the west, what is happening in Egypt and North Africa results in stagflation in the short term. So higher inflation and lower growth because of higher oil prices that take away purchasing power and transfer wealth somewhere else; because of higher geopolitical risk, which tends to diminish animal spirit and therefore impact investment; and let's not forget that the Middle East is a market, particularly for European exports. So from an economic perspective, it is important for the west to understand that these are stagflationary winds that have been added to the global economy." It is important, but not necessary: as long as the manipulated, liquidity glutted market continues to misrepresent the true state of the economy, nobody will care until it is too late. And speaking of "too late", validating our sarcastic observations over the past several weeks that the dollar is no longer the "flight to safety" currency (that would be the PM complex, and the swiss franc if anything), is the Pimco CIO's suddenly very dour outlook on the weakening US Dollar: "It is a warning shot to America that we cannot simply assume flight to quality, flight to safety. That people are starting to worry about the fiscal situation in the U.S., worrying about the level of debt and what they're hearing about states and municipalities. I would take this as a warning shot that we cannot assume that we will maintain the standing of the reserve currency as we have in the past." That's a given - the question however remains, which fiat currency, if any, is willing and ready to step in and replace the USD? With all eyes continuing to be look at the CNY, how long before China finally takes the plunge to find out just who is the real reserve currency in the world?

From Bloomberg TV:

On unrest in the Middle East:

"I think that a common factor that's been driving all of that is a combination of youth unemployment, high food prices, and political repression. But as you say, Libya is different. The revolutions in Tunisia and Egypt were relatively peaceful. Libya is far from being relatively peaceful. There is a tremendous amount of human suffering and casualties there, making this protest more unpredictable and more dangerous. In addition, Libya is a major oil exporter, so suddenly developments in North Africa and the Middle East have a systemic impact on the economy."

On other oil producers in the region:

"Everyone in the Middle East and beyond understands that this is a movement that has to be taken seriously. That it is better to be ahead of the curve rather than behind the curve. The story of Egypt, Tunisia and Libya have been regimes that have been consistently behind the curve. The lesson that has gone out to not only other Middle Eastern countries but to the whole world, is take seriously these economic and political issues."

On political and economic intelligence for Libya:

"On the economic side, the data that you can confirm on the other side, particularly trade data where there is a trading partner and therefore you get another number, tends to be pretty good. It tells you that Libya is an export of about 1.5 million barrels per day, which is not insignificant. This is one of the top 10 or 11 oil exporters. When it comes to internal data--GDP numbers, inflation numbers--then it becomes more difficult. On the political aspects, what we have learned is that western intelligence has been behind the curve in terms of understanding the dynamics in those."

On what the western world can do over the next 48 hours regarding the unrest in Libya:

"Three elements. One is the reality that in countries like Libya, the rest of the world cannot do very much other than condemn and try to put pressure, but ultimately that's not going to bear very much. Second, In countries that have gone to the first phase of revolution--Tunisia and Egypt--the west is able and willing to step in to help the process towards democracy. It is encouraging that the British prime minister went to Egypt yesterday. Thirdly, we have to appreciate that in the west, what is happening in Egypt and North Africa results in stagflation in the short term. So higher inflation and lower growth because of higher oil prices that take away purchasing power and transfer wealth somewhere else; because of higher geopolitical risk, which tends to diminish animal spirit and therefore impact investment; and let's not forget that the Middle East is a market, particularly for European exports. So for an economic perspective, it is important for the west to understand that these are stagflationary winds that have been added to the global economy."

On persistent stagflation as the new normal:

"The new normal is just a recognition that the western world is not going to grow as rapidly as before. That unemployment will be a persistent issue. That social safety nets will be very stretched. And that government intervention will continue in the economy. What we're getting on top of that now are headwinds from higher oil prices, higher geopolitical risk, and a concern that one of the reactions to higher commodity prices will be for consumers to stockpile. So I suspect that right now a lot of airlines are likely saying that with oil where it is now, should we be hedging now? What you get is an overshoot, just like we saw in 2008. That is a concern in terms of the stagflation headwinds."

On Pimco's strategy and how to react to unrest as an investor:

"Last week, Friday in particular, when the crisis started impacting countries like Bahrain, we recognize that things were morphing. That it would impact commodity prices and oil prices in particular. We identified a process of morphing that went on. When the crisis was focused on Egypt and Tunisia, when those countries were going to their peaceful revolution, they were not systemic in nature. The influence on the global economy was limited. They were not large economies. They were not major exporters of commodities. And they did not owe anyone lots of money. When the crisis and turmoil started to hit Libya and Bahrain, this whole phenomenon has morphed. And it has morphed into something that in the short term means higher oil prices, greater risk aversion, and a somewhat flight to quality. Although it's interesting to see that the dollar has not benefitted that much."

On higher oil prices:

"The global economies are going to have to live with these for a while. That is just a reality of the world we are living in today."

On the events in Egypt over the past week:

"They have taken important steps. You've seen ministerial changes, you've seen a timeline announced. And most importantly, you've seen the protest movement saying that we will be the check and balance. We're going to make sure that this revolution that was started will end up with democracy and greater individual freedom. We're seeing progress. It's a bumpy road that does not happen overnight. But every day we are seeing progress."

On what the weak dollar is signaling:

"It is a warning shot to America that we cannot simply assume flight to quality, flight to safety. That people are starting to worry about the fiscal situation in the U.S., worrying about the level of debt and what they're hearing about states and municipalities. I would take this as a warning shot that we cannot assume that we will maintain the standing of the reserve currency as we have in the past."

http://www.zerohedge.com/article/mohame ... ncy-status