What you need to know if you want to trade currencies. Also, will the dollar collapse?
In this podcast, you’ll learn:
- Why investing in currencies is so complicated.
- Who are the major players in currency trading that individuals who trade compete against.
- What is the best way to exchange currencies when traveling.
- Why you need a point of view when investing.
- Why I no longer trade currencies.
- What does it mean for a currency to collapse.
- What is the petrodollar system.
- Why so many exporters price their goods in dollars.
- What currency has taken over the dollar as the preferred currency for foreign trade.
- Why the dollar won’t collapse.
Annual survey of top players in foreign exchange. 2014 Greenwich Leaders: Global Foreign Exchange Services
World Trade Organization study on currencies used in foreign trade. Page 10 has a graph showing the currencies used in foreign trade. Use of Currencies In International Trade. Any Changes in the Picture?
Why The Dollar Remains King
The U.S. dollar is the dominant global currency. Not only is a large percentage of international trade conducted in U.S. dollars, but 75% of all $100 bills are held overseas and half of all $50 bills.
According to the International Monetary Fund, 60% of foreign currency reserves held by central banks are comprised of U.S. dollars. 90 countries still peg their currency exchange rate to the dollar and 85% of all transactions in the foreign exchange markets involve the U.S. dollar.
Why is the dollar so prevalent?
The Petrodollar Theory
One theory (let’s call it the petrodollar theory) suggests the dollar is dominant because oil exporters sell oil only in dollars. Because oil exporters only take dollars, the theory suggests the rest of the trade activity involving the dollar exists so that countries have enough dollars to buy oil.
The petrodollar theory then goes on to say if oil exporters stopped selling in dollars, then the artificial demand for the currency would collapse, flooding the U.S. with the dollars countries no longer needed to buy oil, which would lead to hyperinflation in the U.S. and skyrocketing interest rates.
That is a lot of power supposedly concentrated in the hands of a few oil exporters.
Most global economic trends are the result of bottom-up decisions made by millions of individuals acting independently as opposed to top-down decisions made by a few.
Consequently, I am skeptical when a global phenomena such as the widespread use of the dollar in trade and foreign reserves is attributed to a decision made by a few individuals.
Why Companies Price Their Exports In Dollars
According to the World Trade Organization, just under 19% of all merchandise trade is related to fuel and oils. Over 80% is non-fuel related products, such as agriculture, manufactured items, textiles, chemicals, etc.
No one demands these exporters price their goods in dollars or any other currency when trading, but many do.
Why do they use dollars? There are several reasons.
First, exporting companies don’t like to see their product prices fluctuate relative to their competitors because it can be confusing to customers.
If a company’s competitors are pricing their products in dollars, and the company chooses to price its products in the euro, then as the exchange rate between the dollar and the euro fluctuates, the company’s product prices would be constantly changing relative to its competitors’ product prices.
Second, the U.S. is the largest economy in the world and for many years it was the largest exporter. As a result, the dollar became the established currency for trade in the decades following World War II. Even though the U.S. is no longer the largest exporter, the dollar remains a preferred currency for trade because that is what many companies already use. New entrants to markets are less likely to price their products in a different currency for the reason I mentioned earlier. So there is a level of inertia.
Finally, not only is the U.S. the largest economy in the world, but it has the largest and most liquid financial markets, and it remains the dominant military and political power. It also runs a large trade deficit. That means there is a steady of supply of dollars flowing into the world each year to facilitate trade. It also means foreign holders of U.S. dollars have a deep and liquid market hosted by a stable country in which to invest.
The Rising Euro
Despite these reasons, the euro now rivals the dollar in foreign trade with approximately 38% of trade priced in euros and 35% in dollars, according to the World Trade Organization. The euro has jumped in usage because 35% of global trade exports are from Europe versus 13% for the U.S.
Think about that. Over the past decade the euro has surpassed the dollar in usage in international trade, yet the dollar hasn’t collapsed, inflation remains in check and interest rates haven’t skyrocketed.
There has been a gradual diminishing of the dollar’s preeminence without the grave economic consequences many warned about.
The dollar will not be dethroned as a global currency anytime soon, but that doesn’t mean it can’t share the throne with other global currencies.
Are Dollars Safe?
Last week, I wrote about why the dollar as a global currency is used extensively in international trade along with the euro.
Over the past two decades, much of trade has transitioned to the euro without a devastating collapse of the dollar. It is an example of how currencies adjust gradually based on bottom up decisions made by millions of companies and individuals around the world.
If The Dollar Started To Crash
But what would happen if oil exporters decided to stop taking dollars for oil and the dollar started to significantly weaken?
If the dollar weakens that means each dollar is worth less in euros, the Japanese yen or the Chinese yuan. In other words, when the dollar weakens, the euro, the yen and the yuan strengthen.
In practical terms, a weakening dollar means if you travel overseas, your dollar wouldn’t go as far in buying things in those countries after you converted your dollars to the home currency.
A weakening dollar also means countries that export goods to the U.S. would have to raise their prices in order to make the same amount of profit from each sale. If they raise their prices, then their products would be less competitively priced in the U.S. compared to domestic made goods so their sales would drop.
Conversely, U.S. made goods would be less expensive for overseas consumers to purchase so U.S. exports would increase.
A significantly weakening dollar would harm economies in Europe, Japan and China that export tremendous amounts of goods to the U.S.
In order to prevent this, these countries’ central banks, most likely in coordination with the Federal Reserve, would intervene in the foreign exchange markets to support the dollar.
This market intervention by central banks would continue until panic in the currency markets subsided and the dollar stabilized.
Perhaps you politically detest the idea of central banks intervening in foreign exchange markets. That’s fine, but when it comes to explaining how the economy and markets works, my focus is on what would happen in practice not what I think should happen from a philosophical standpoint.
Bottom line, the risk of a dollar collapse is low.
The Real Risk With Dollars and Other Currencies
But that doesn’t mean it’s safe to keep your investments sitting in cash.
The most pernicious risk to the dollar is how inflation eats into its purchasing power each and every year.
Inflation or an overall rise in prices occurs because the supply of money flowing through the economy increases at a faster rate than the supply of goods and services available for sale.
When banks lend and when the federal government spends more than it receives in taxes (i.e. runs a budget deficit), the supply of money flowing into the economy increases.
Modern economies are structured in a way that a modest amount of inflation is the norm. But just because it is the norm, doesn’t mean inflation can’t be harmful.
At an annual inflation rate of 3%, $100 today would only be worth $75 in ten years in terms of its purchasing power. That means if you kept that $100 in cash, at the end of 10 years, you would only be able to buy about 75% of what you could buy today with that same $100.
In 25 years, assuming an annual inflation rate of 3% that $100 would only be worth $47 in terms of its purchasing power.
Protecting Against Inflation
The only way to protect against inflation is to invest in real resources that appreciate at a rate greater than or equal to the rate of inflation.
Real resources are investments that generate income and have historically appreciated in value over time, such as real estate and stocks. They are inflation hedges.
If you invested $100 in a real resource that returned 3% a year, our assumed rate of inflation, then at the end of 10 years you would have $134. That $134 would allow you to purchase an amount of goods that you could buy for $100 today, thus protecting your money from inflation.
Inflation is a known and real threat that you should protect against by investing in real resources. Meanwhile, a collapsing currency is a remote and unlikely occurrence, but if you so choose, you can also protect against it by purchasing monetary substitutes such as gold or silver.