What Happens If the Dollar Crashes - BusinessWeek

What Happens If the Dollar Crashes

Trade wars could break out. Overexposed banks might collapse. And that's just for starters The financial crisis taught us that markets can drop further and faster than anyone expects. Housing prices, for example, fell for three straight years starting in 2006, even though the conventional wisdom right up until the bust began was that prices would not fall even a little bit.

Let's apply some of our hard-won knowledge to the dollar, which is also supposed to be resistant to a bust. After weakening gradually since 2002, the greenback rose during the financial crisis last year. It has fallen roughly 15% since March as investors moved to higher-yielding currencies. The conventional wisdom is that at these levels the dollar is cheap and, if anything, due for a rebound. "Currencies don't go much more than 20% from their long-term averages in real [inflation-adjusted] terms. We're there already," says Michael Dooley, an economist who is co-founder and research chief of Cabezon Capital Management, a San Francisco investment firm.

But it's worth at least thinking about the possibility of a dollar bust. The reason the housing bust had such devastating consequences was a failure of imagination: Lenders, regulators, credit raters, and others simply couldn't believe that house prices would ever fall the way they did, so they were blindsided.

Bank Blowups Possible

Let's imagine the dollar quickly dropped by a further 25% against each major world currency, roughly parallel to housing's unprecedented 30% decline. That would mean it would take $2 to buy a single euro. On the good side, U.S. manufacturers would find it easier to compete globally, and foreign tourism would boom in the U.S. On the bad side, inflation in the U.S. would zoom because of the rising cost of imported products. Americans would have even more trouble getting a loan as foreign buyers pull out of the debt market.

Abroad, the cheap dollar would make it harder for other nations to export to the U.S., hurting their growth. China could face social unrest. Trade wars could break out. And there could be blowups at overexposed banks whose risk managers were sure no such dollar bust could happen. As investor Warren Buffett once said: "You only find out who is swimming naked when the tide goes out."

Federal regulators are monitoring banks for a wide variety of risks, including the threat of a dollar bust: "We're not looking quarter to quarter, we're looking hour to hour and minute to minute at what those risks are," says one regulator who requested anonymity.

From its spring peak, the dollar is down 11% against the Japanese yen, 16% against the euro, 21% against the Canadian dollar, and about 30% against the Brazilian and Australian currencies, which are benefiting from a commodity price spike. Against a broad market basket of all U.S. trading partners, and adjusted for inflation, the dollar has fallen 15% from its spring high.

Deficits Depress Dollar

Behind the dollar's weakness are near-zero short-term U.S. interest rates. As they once did with yen, investors are borrowing dollars cheaply, then selling them to buy currencies of countries whose stocks and bonds promise better returns. The Federal Reserve is keeping the federal funds rate at a rock-bottom zero to 0.25% to stimulate the U.S. economy and heal the banks, but a side result is the dollar has turned into the preferred fuel for an international speculative play that is weighing down the greenback.

Another force driving down the dollar: continued U.S. trade deficits, which the U.S. is paying for by borrowing from the rest of the world. Some economists and traders believe that eventually the U.S. will be forced to devalue its own currency to make its global debt more affordable. While the trade gap has narrowed to less than 3% of gross domestic product in the second quarter from 6% at its peak in 2006, it is still high by historical standards.

Now, some of the foreign central banks that have propped up the dollar seem to be getting cold feet. Instead of buying just dollars for their foreign-exchange reserves, they're diversifying into other currencies. The countries that reveal the composition of their reserve holdings put 63% of their new reserves into euros and yen in the second quarter, according to an analysis by Barclays Capital (BCS). Says Steven Englander, Barclays' chief U.S. currency strategist: "Their incentive is to try to do stealth diversification, not 'get me out of here at any price.' " (China, with more than $2 trillion worth of reserves, doesn't reveal what currencies in which it holds the funds.)

via businessweek.com

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