Expert View: This is the beginning of the end for the all-powerful dollar

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The Independent Online

There was a riot in Tesco's last week. Several people were trampled in a scramble for cooking oil. At another supermarket (belonging to a different chain), three people were killed. Once more we are in the investor wonderland of contemporary China, where the pressures in the world's economy find frightening release. Inflation, the dollar and the credit blow-ups are creating a perfect storm. In a related story, the Governor of the UAE's central bank twice questioned the dirham's dollar peg last week, leading to a big move in a supposedly fixed exchange. Whisper it quietly, the markets are wondering, "Is this the end of the dollar as the world's reserve currency?"

Take the yen. In a matter of hours on Monday it suddenly went ballistic, bursting through 110 against the dollar, and rising an excruciating 4.4 per cent against the Australian dollar. This provoked Mr Fakuda, the new Japanese Prime Minister, into an appeal for calm. Come the end of the week, Mervyn King's Damascene conversion to the dangers of a UK slowdown decimated sterling. But underlying all of these convulsions has been one accepted fact. The dollar is on a one-way ticket – down.

There are plenty of sound economic reasons for the dollar's decline. The twin US deficits are appalling. The latest long-term projections for the cost to the Treasury of US operations in Iraq and Afghanistan have sailed through the $1 trillion mark. But the latest step in the dollar's decline is due to two factors that have crystallised as 2007 has progressed. First, because of the US housing meltdown and associated credit blow-ups, the Federal Reserve has cut interest rates dramatically, leaving some fearing inflation has not been securely vanquished. Second, the more currency markets reach the conclusion that the dollar is a one-way bet, the more questioning there is of the currency's role as the reserve currency and peg.

This is especially so in those economies where dollar pegging is cutting interest rates at the very moment when inflation is rising dangerously. The grandaddy of them all is China, hence the riot at Tesco's. Chinese inflation was confirmed at 6.5 per cent last week. The yuan's dollar peg is being loosened, but at a snail's pace. China is terrified of a collapse in exports following currency appreciation, and, besides, is sitting on a cash pile of over a $1 trillion. Interest rates are kept artificially low, boosting the economy and sucking in foreign money. Three of the world's 10 largest companies are now Chinese, and at current growth rates China will overtake the US as the world's largest economy in just over 10 years. Could its currency likewise replace the dollar?

The answer lies in economic history. The dollar and sterling duelled for supremacy between 1918 and 1958. Before the First World War, 60 per cent of world trade was invoiced in sterling. At the start of the 20th century, some 64 per cent of currency reserves were held in sterling; by the end, it was around 4 per cent. Today the dollar commands around 70 per cent both of trade and world reserves.

In his book Whiskey and Gunpowder, Professor Avinash Persaud, an ex-currency trader, argues that there was a big delay between the US becoming the world's largest economy (around 1880) and the dollar replacing sterling. Other factors were important – for example, the growth of a liquid market in dollars after the establishment of the Fed in 1914. It also required investors to start believing in US financial security after years of the rollercoaster asset bubbles that typify emerging economies.

For these reasons, Persaud argues, we are decades, maybe 50 years, away from the yuan doing likewise. I agree with him, but there may be an intermittent period when the dollar shares its supremacy with several of the world currencies – not least the euro and maybe even sterling.

Again, economic history points to this. As investors became concerned by the loss of British economic supremacy up to 1914, they switched to a broader basket of currency reserves then gradually replaced them with the dollar. The basket approach is what the canny Kuwaitis did when they quietly ended their peg in March. It still means selling dollars, but not in a panic.

Perhaps this is the future for the dollar: a long, painful death.

Christopher.walker@tiscali.co.uk

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