Henry M. Paulson Jr., who once served as US Secretary
of the Treasury wrote an article in which he discusses the future of the
dollar. The title of the article came as: “U.S. Financial Power Depends on Washington,
Not Beijing,” published on May 19, 2020 in Foreign Affairs.
What is notable about the article is that Henry
Paulson recognizes that the future of the dollar will depend on how well it
will compete against the renminbi (RMB) which is the Chinese currency.
Apparently trying to become the reserve currency of the world, RMB is
challenging the dollar which is currently enjoying that status. What is
puzzling about the article, however, is that Paulson does not elaborate on the
point he made, but uses much of the space to discuss the financial innovations
done in America and China as if they will determine which of the two currencies
will win the competition.
But the fact is that a “reserve” currency is used as
reserve by the central banks of the world. These banks are the institutions
that determine what percentage of the reserves they hold will be in dollars,
and what percentage will be in other currencies, including gold. As to the
innovations in financial transactions, they are mostly used at the retail
level, which is what transacts between the public and the institutions that
sell goods and services to them. The truth is that these instruments and the
transactions done through them, have a negligible impact if any on the value of
the reserve currency.
So the question is this: what is it that might cause a
central bank to change the percentages it has allocated to the currencies it
holds as reserve? And the answer is that there are two factors at play here:
The technical and the fundamental. And you know what, my friend? These are the
same factors that play a role in determining which stocks to buy on the stock
exchange, and which to sell.
All of that boils down to this: On the technical side,
the traders are concerned with the here and now. They don't care whether the
stock is worth 10 pennies or 10 dollars. If it is now trading at 1 penny,
they'll buy and sell it at around that price. If it is now trading at 100
dollars they'll buy and sell it at around that price. And the traders will
continue to buy and sell at these prices till something happens that changes
the pattern. In fact, the change will come when based on the fundamentals,
someone will decide what the true value of the stock is now, or will be in the
near future.
What happens then is that if the stock is trading at
10 dollars but fundamentally valued at 10 pennies, someone will short it, and
make a ton of money while the price of the stock tumbles. However, if the stock
is trading at 10 dollars but fundamentally valued at 100 dollars, someone will
start accumulating it at 10 dollars and higher as the stock moves up. In either
case––shorted or accumulated––other traders will jump on the bandwagon and
churn the stock into elevated daily volumes at the mention of real news or
false rumors thought to affect the stock or the group in which it belongs.
Seeing the parallel between the stock market and the
currency market, it makes sense to ask if the American dollar is being churned
–– not by the retail clients or the central banks –– but by those who sit
between the two. These would be the hedge funds and the investment banks who
play the role of jobbers in the financial services industry. They have the
financial clout and wherewithal to affect the value of a currency in a
substantial way, something they do to the consternation of the central bank
that issued that currency.
There is no doubt that what moves the dollar these
days are the technical considerations. Sooner or later, the fundamentals will
kick in and impose themselves on the market. It is why we need to ask the
following question: What fundamental value are the central banks quietly
assigning to the dollar? Is it higher or lower? Will one of the central banks
determine that the dollar is dangerously overvalued and dump it, thus begin the
cascade? Or will the spoiler be one of the jobbers, such as a hedge fund or an
investment bank?
When all is said and done, a scenario unfolding in
that manner is what will determine the value of the dollar in the future. It
will happen spontaneously, and there will not be one government or one central
bank or one institution that can stop the trend. Not even the concerted effort
of several actors working together will be able to stop the cascade of the
dollar before it has run its course.
What must be done to avoid the catastrophe is prepare
for it now. The best way to do it is for America to sit with the major holders
of dollars and work out an orderly plan to soak up and repatriate the dollars
by selling hard American assets to their holders while encouraging everybody to
diversify their currency reserves.