May 13, 2010
Ask yourself an important question: how will you know when the proverbial fat lady is about to sing?
In our regular conversations, we talk a lot about the importance of being prepared… history is full of examples of pigs that got slaughtered for not being prepared, for not heeding the warning signs, and for waiting until it was too late.
For example, we may be able to agree that major currencies like the dollar, pound, euro, and yen are all ‘headed to zero.’ Much is written in the financial blogosphere about the fundamental weaknesses of these currencies, and of the massive, untenable debts that their governments have assumed.
But what does it actually mean when a major currency ‘goes to zero’? How will the world function afterward? And most importantly, how will we know when it’s happening?
As we have discussed before, institutional wealth is generally held and denominated in one of the three major currencies– the dollar, euro, and yen. Why? Because they are the only ones large enough to consistently absorb institutional capital flows.
To put it more clearly, if $50 billion moves into the Costa Rican colon, the colon will spike. If $50 billion moves into the yen, it will barely register a blip.
These three currencies effectively represent the three dominant economies in the world– the Eurozone, the United States, and Japan. As you’re undoubtedly aware, these are also the places with the most debt, hence the largest bond markets where capital can freely flow in and out of.
Each day, however, it appears that investors are losing confidence in these struggling economies. Europe has been the first on the chopping block, and I suspect that Japan won’t be too far behind.
As Europe and Japan fall out of favor, the US bond market is the ‘winner’ by default, at least for the short-term. Investors require a highly liquid, low risk medium to park their capital, and the US dollar is simply the “least worst” of the three major currencies.
Make no mistake, though, institutional investors are looking for an alternative.
This is one of the reasons why gold has been going through the roof, and will likely continue to do so– investors are now starting to choose the gold market to store their wealth rather than rely on suspect bond markets.
The gold market is so much smaller than the major sovereign debt markets, though, so it is not a viable alternative. Gold prices will certainly benefit
So what else is out there? Is there another country with trillions upon trillions of dollars worth of currency units whose large, growing economy inspires the confidence of global investors?
Almost, but not quite… though I think China could be there in a few years.
China is already one of the world’s largest economies, and will likely become THE largest economy by the end of the decade. Furthermore, its substantial pool of savings and ability to produce (rather than compulsively consume and import) certainly inspires the confidence of investors.
Like other governments, Chinese policymakers have inflated their currency; there are trillions of renminbi circulating in their economy. At the moment, though China has some of the world’s tightest exchange controls, and these are what prevent China from being a viable alternative right now.
The Chinese government presently fixes its currency, the renminbi, to the US dollar; they also do not allow the free flow of capital across borders, which is an absolute requirement for investors.
Over the next few years as China’s economy continues to grow, though, the prospect of a more free renminbi is quite likely, and I suspect that the government will slowly take steps to achieve this.
In the long run, the government wants China (and Shanghai in particular) to be the world’s #1 financial center, and they know this requires an open currency and a highly liquid bond market.
Furthermore, as the Chinese economy shifts away from the Asia export model towards domestic consumption, the government will welcome a stronger currency in order to keep imports cheap and inflation under control.
When this happens, you can be sure that global institutional investors will quickly embrace the renminbi as a new reserve currency, and dump the dollar along the way.
This will be the official end of the dollar as the world’s dominant currency, and you’ll know it’s here when you read in the paper about a major Wall Street firm selling renminbi-denominated bonds for a US company’s debt issuance.
At this point, the dollar will truly have become a worthless piece of paper, and all of the world’s wealth will likely have migrated to Asian financial markets. This is when all confidence in the dollar will collapse, and inflation could spiral out of control.
In other words, the fat lady will be hitting her high note.
I suspect these events could take several years to transpire; in the meantime, though, the major signs to watch for will be significant changes in China’s policy towards a more open currency regime.
Next week we’ll talk more about what you can start doing today to protect yourself and your wealth from a sudden currency crisis.