When Currencies Falter

This article appeared in the June 2009 issue of Forbes.
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Want to know where the real actionwill be over the coming months? Forget stocks,think foreign exchange. There are tectonicmoves afoot in the currency markets these days.During the past year the Polish zloty has fallenby 23% against the euro and 11% the Hungarian forint. Now bothcountries are talking about replacing their currencies with the euro. The International Monetary Fund likes this idea and wants otherEuropean countries to "euroize" as fast as possible.

The Chinese are wringing their hands over the U.S. FederalReserve's ballooning balance sheet. Beijing is threatening to haltits Treasury buying if the dollar slides and has suggested thatIMF Special Drawing Rights (SDR) replace the greenback as theworld's premier reserve currency. A United Nations panel hasseconded China's motion, but just in case it doesn't happen,China is buying gold.

Currently, dollar-denominated assets account for 64% of theworld's official foreign reserves, and the euro accounts for 27%of the total. The British pound and yen account for only 4.1%and 3.3%, respectively. In terms of the international reachof paper money, the dollar dominates, with 60% to 70% of allfolding currency held overseas. The comparable figure for thesecond-place euro is only 10% to 15%. When it comes to foreignexchange trading, the dollar is involved in 88% of all trades.

Will the euro ever challenge the dollar's supremacy? Notlikely. Poland and Hungary want to go euro, but the EuropeanCommission and the European Central Bank are dragging theirfeet. So it's not surprising that the European Union (of whichPoland and Hungary are members) is openly hostile towardnon-EU countries trying to adopt the euro. It is exactly thispathological insularity that I think will keep the euro from posinga threat to dollar dominance anytime soon.

One caveat relates to the experience of Montenegro, a non-EUcountry that is currently euroized. In late 1999 former presidentand current Prime Minister Milo Djukanovic (whom I wasadvising at the time) dumped the Yugoslav dinar and replacedit with the German mark. The mark morphed into the euro,and now Montenegrins use the euro. Indeed, this currency shiftwas a linchpin in Montenegro's drive for independence in June2006, an event followed in April of this year by the approval ofMontenegro's candidacy for EU membership.

It's a lesson for other countries wanting to euroize. The key is tolimit the role of indigenous currencies while facilitating euro use.Panama has successfully followed this strategy for a century.Most people doing business and banking in Panama think theU.S. dollar is Panama's national currency. But it's not. Panama'scurrency is the balboa. One balboa is equal to one dollar. Andwhile Panama issues balboa-denominated coins, it does not issuepaper money. Thus Panamanians break out balboas only forsmall transactions requiring coins. The greenback is used foreverything else.

The SDR as a dollar contender has its backers. ZhouXiaochuan, governor of the People's Bank of China, recentlyannounced that Beijing wanted a new international reserve currencythat would be "disconnected from economic conditionsand sovereign interests of any single country." Translation: Wewant a viable U.S. dollar alternative, possibly the SDR (which consistsof 0.6 U.S. dollars, 0.4 euros, 18.4 yen and 0.09 Britishpounds). Its value fluctuates with exchange rates, and today oneSDR is equal to 1.5 U.S. dollars.

But the SDR is not a tangiblemedium of exchange or a claimon one. It's simply an accountingmetric the IMF uses to balance itsbooks. It has no real commercialapplication. So don't look for it todisplace the dollar soon.

I don't blame Beijing for frettingover the state of the internationalfiat money "system." It has$2 trillion in official foreignexchange reserves at risk. Sostocking up on gold bullion is asmart move.

As currencies fluctuate over the coming months, youradvisors may soon be calling you to get into the new slate ofexchange-traded currency funds that have hit the market. WisdomTree recently announced ETFs for theyuan, rupee and Brazilian real. Rydex has ETFs tracking theMexican peso, Russian ruble and Swedish krona. My advice: Stickto the shiny yellow metal, conveniently available via a number ofETFs. Unlike fiat money, it isn't controlled by politicians andcentral bankers.