Thursday, 21 June 2012

The inevitable currency collapse

Is it possible to predict how bad things will get with the current bank and sovereign debt crises? If you look at the free market, this should have caused the value of currencies between all the different trading nations around the world over the last century or so to even out over time. In some ways I guess it has, for example when the Soviet Union collapsed and started to trade its currency - the Ruble on the open market, its value increased 300 fold, no doubt because of all the gas and oil Russia now exports to western countries. It now costs $2 for a cup of coffee in Russia instead of much less than a cent. But in other places things still have not changed, western currencies are still 10 times as expensive as those in places like China and India where people are lucky if they earn more than a $1 a day. The following map shows how much people earn in the different countries around the world:

The thing I don't understand is why the UK Pound is still so strong, when we import so much stuff and export so little? I think the answer might come from Iceland, whose currency increased tenfold between 2003 to 2007, as can been seen in this graph:

This appeared to happen because in 2003 two Icelandic banks were privatized. From 2003 to 2008 the Banks assets (Loans) increased 10 fold to an unprecedented level of around 10 times Iceland's GDP. Iceland's banks had over borrowed to buy expensive assets around the world which were worth a fraction of their price after the financial downturn. When a company borrows from a foreign country, this leads to capital inflow, which causes the currency to appreciate. This would appear to account for most of the increase and then decline in Iceland’s currency between 2003 & 2009.

The question is, with the UK Banks in debt to the tune of 600% of UK GDP who are they in debt to? At the height of the financial crisis, British banks borrowed more than a trillion U.S. dollars - that's 100% of our GDP and according to a few sources on the web most of the rest is in the form of foreign denominated loans. This means that should the EU collapse and the world enter another great depression our currency could potentially collapse by at least 6 fold just for starters, we would then have the problem of a sovereign default by our governments, the extra burden in lost revenue from EU exports and a sell off of the Pound on international currency exchanges. So it seems we would be lucky if the Pound still had as much value as the Indian rupee!

But then this raises some important questions, if the American Fed which lent out $12 Trillion to countries all around the world in the year 2008, including china has been causing currencies all around the world to appreciate, then what happens to the Dollar when all those countries like in Europe default on their debt? I guess you only need to look at Greece, where they say "if Greece defaults or restructures its debt, the single currency could trade as low as $1.10-$1.15", in other words any country defaulting on American debt will devalue the dollar. But then why do most countries prefer to borrow dollars? The dollar is known as the world's reserve currency because many countries prefer to hold dollars, like China, Japan and the OPEC Nations which have been storing trillions of dollars to prevent the Dollar from being devalued, this helps to keep their exports to America strong. But when you have other countries all around the world holding onto your currency, then to prevent a decline in the circulation of money called deflation and the consequence of a prolonged recession, it's necessary to lower interest rates and lend more money out to foreign countries to lower the value of that currency. It also makes more sense for foreign countries to borrow in Dollars when the interest rates are low, though now they have actually hit rock bottom at 0% and cannot get any lower. So it probably makes more sense to think of the Dollar, more on an international level, where they are getting the rest of the world into debt, than to think about the debt they have got their own people into as a single entity. Either way when both people, international corporations, the US government and other sovereign nations, have all got into too much debt and the Fed has run out of options like lowering interest rate to help everyone refinance their debt obligations, then its value should start to fall, once this happens it should trigger a sell off as China, Japan and OPEC try to avoid any further losses by selling the
trillions in Dollar Bonds they hold. There are reports that Chinese Banks are already hedging or betting against the Dollar to avoid the consiquences of the Dollar collapse.

As I said at the start, western currencies are 10 times as expensive as those in places like China and the OPEC nations which deliberately avoid converting Dollars to their own currencies to avoid their own currencies from appreciating which would weaken their exports relative to their competitors. There are reports of China buying oil from Iran with Gold and it dose makes sense that the country would try to avoid the appreciation of its currency by swapping those dollars directly into commodities such as Gold. Western nations on the other hand appear to embrace the high value of their currencies, buying lots of goods from Asia and producing or exporting very few goods. We forget that the Dollar only has value, because trillions are being held in reserve by foreign nations which allow other western nations to borrow from American and also enjoy living in the debt bubble. When it all implodes, it would seem inevitable that it should lose at least 10 times its value, putting an end to all those cheap imports.

Notice those countries with the most debt, also have the highest earnings:

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