Third US default is imminent!
By: Tarique Khan Javed
President, Overseas Pakistani Investors Forum.
                           Dated: 6 May 2009

First default-End of Gold standard in 1971:

Up to 1971 US Dollar was a receipt for certain amount of Gold. In theory one could go to the Bank a get Gold instead of paper money. That was the strength of US Dollar and on this basis every one in the World started to use USD as reserve and trade currency. However as the supply of USD rose as a result of rising demand the paper currency far exceeded the underlying gold. By 1971 the position became untenable as it was clear that US could not come up with enough gold if every one demanded it. Thus US declared that it would not give gold against the paper Dollar. That was the end of so called Gold standard. This economist considers the first default of US.

Second default- The Plaza Accord in 1985:
The second default came in 1985 in the form of managed devaluation of USD against Yen and DM under Plaza accord. When the US dictated that its parity against Yen be reduced from One USD = 240 Yen to 140 Yen and against DM from One USD = 4 DM to 2 DM. The almost 50 depreciation in value meant that all US dominated debt was reduced to half while all USD dominated investment lost 50% value. It was a huge set back to Arabs, Japanese and other investors who had bought US Treasury Bond and made other investments in US.

US had no choice but to devalue its currency in the light of trade deficit since 1954. To regain competitive edge against the Japanese and others it was a necessary move. They had no choice. They knew that the investors will protest at the halving of their investment and it would make attracting future investment almost impossible.

As expected the real US economy got a boost as US goods and services suddenly appeared to be cheaper than Japanese, German and other country’s product.

However the most amazing thing was that world kept on investing in US Dollars and it remained the main reserve currency as well as trade currency. This  kept the value of dollar stable up to now.

But in the process USA has accumulated total debt of USD 12 trillion against total GDP of 14 trillion and its banking system is collapsing due to USD 4 trillion bad debt in the housing sector, USA is passing through its worst crisis.

Is Third default imminent in 2009-10 ?
It is almost impossible to pay back USD 12 trillion debt when US trade deficit is USD 2 billion per day. To save its Banks, Car industry and other unviable sectors, US need to borrow more or print more currency. It is doing both with impunity as Obama administration does not understand or care about the negative implications of their action. They are only interested in the short term objective of saving their government. However this attitude is swelling US debt and making the crisis graver by the day. USA has no choice but to devalue its currency by 50% to reduce the external debt to half and regain competitive advantage.  

World as a whole is passing through an unprecedented and un-chartered territory in terms of scale and scope of current financial crisis. Never before such large scale credit losses were recorded and never before a sole  Super Power was so indebted to the world. The implication of credit losses and potential default by USA is far reaching and effects almost all people in the world. USD 4 trillion credit losses can wipe out a large number of Banks all over the world who had investments in US housing finance market. Most Arab, Japanese, European and Chinese Banks used to investment their surplus funds in the large USD 11 trillion housing debt markets with excellent secondary market. One the other hand spectacle of US’s devaluation of its currency up to 50% is making investors very nervous. Among them China has openly raised concern on the potential erosion of value of its USD one trillion investment in USA Treasury Bond and USD One trillion investment in other instruments. Arabs are very anxious about the second devaluation of their reserves in USA. Arabs due to political compulsion are bond to keep all investment in US Dollars and also sell oil only in US dollars. In case of devaluation there are set to loose most.

The rising price of Gold is an indication that quietly Countries are shifting their reserve in Gold. No one wants to create a panic which will lead to massive sell out of USD leading to its depreciation to unacceptable levels. But the question is up to when this un-natural position can be maintained. In their self interest, countries will opt out of US investment tying not to alarm others.  This game of cat and mouse can not go on for long and must end within few months. I feel that USA will devalue its currency by 50% within a year. If this is done under an arrangement like the Plaza Accord in 1985, when the currency to devalued by 50%, it would be orderly, otherwise a chaos will set in and lead to great hard ship.

Prospects of alternative International currency:
Will USA be able to attract funds after the third default and maintain its status as world super power is point to ponder? Its seems that like the first two defaults world will have no choice but to keep USD as the world reserve currency and trade currency as no other alternative is available up to now. Japanese and Europeans are very smart in this matter and will never allow their currency be used extensively as a reserve and trade currency as this will raise the value of their currency artificially and make them uncompetitive in trade.

After the 2nd default in 1985 there was lot of talk about creating an international currency to replace USD. SDRs were proposed but never took off. The world leaders showed great apathy in not tackling the most important problem of the world and let the status quo continue. Every one knew that by not facing the huge international question the issue will not go away. It was bond to re-emerge as it has done now; but is much bigger scale.

China is leading the call for an international currency however the Arabs and Japanese are unable to lend support to the idea due to US pressure. Given the huge task its seems this will not be accomplished this time also and USA will be able to get away with stealing huge resources of the world without any punishment. What ever USA gives in the form of trade surplus to the world it takes back in the form of devaluation of its currency. Japan, China and Arabs became rich by selling their goods to USA which was the most liberal import economy of the world. If USA had adopted protectionist policies, China and Japan would not have found such large export markets that gave them their huge surpluses.

Conclusion and recommendation:

1. The need for a multinational currency to replace USD, as world’s reserve and trade currency, has been felt for long. Any country which allows its currency as a reserve and trade enjoys the benefit of being able to borrow as much as it wants from the world, as world accepts it paper receipt against goods and services. However, the additional demand for the currency makes it exchange rate become much higher than its actual value. This hurts its export severely and encourages import. This is what happened to USA.

2. In 1979, I wrote an article on “International Monetary System” which was published in Business Recorder, in which I predicted that the value of USD will be reduced to half. It was crystal clear in my mind that this will happen based on trading data. In 1985 when the process of devaluation started,  I advised my Bank to sell a much USD it can against Yen and DM and the Bank did that, in the process making lot of money. I also personally sold USD and made money. I also tried to prevent my employers Banks in Bahrain and Saudi Arabia,  from investing large sums in US housing market; however I was mostly overruled and now those Banks are technically bankrupt.

3. I see similar opportunity now and recommend that Government of Pakistan and individuals should try to take loans in USD but not keep reserve and savings in USD. Yen, Euro and Chinese Yaun are the best alternative currencies for keeping your savings. USD dominated 50 billion debt of Pakistan will effectively reduced to 25 billion when the devaluation comes but our FX reserves, if not diversified will effectively reduce from 11 billion to 5.5 billion.

4. With devaluation of USD all Gulf currencies SA Riyal, UAE Dirham, Bahraini Dinar, Qatari Riyal, Omani Riyal and Kuwaiti Dinar will see their values reduced to half. As they are not independent currencies but USD in the form of local currencies defined at certain rate and fixed for ever.

5. In 1984 at the request of my Bank, I wrote a paper on the “Long-term Economic prospects of UAE”. The paper was greatly appreciated by the Ruling Council, in writing, however, I was verbally told that they did not like my recommendation to delink the currency from USD or pricing Oil in Yen and DM. I was told to refrain from this issue in future. This gave me an idea of how dependent Gulf Regimes are on USA and what USA demands of them in return of giving protection. Now they will pay a price for this lack of independence as they see their savings disappear before their eyes and they can not do any thing about.

6. I guess we are more independent and should be able to safe guard our interest in this major change in world’s economic order. Any way or share is small and no one would notice.

7. If world musters courage to stand up against USA and come up with an alternative reserve and trade currency. The fate of USA as Super Economic and Military power will be sealed and it will become another Great Britain or France-ex great power. It will rapidly close all military bases and withdraw to its soil to save money.  

8. After the devaluation the country’s relative share in World economy will change drastically. Currently USA is number one economy with GDP of USD 14 trillion, Japan is second with GDP of USD 4 trillion, China third with GDP of USD 3.5 trillion while UK and Germany are 4th and 5th with GDP of around USD 3 trillion. Depending on the link with USD the shares will change. In the case of Japan and China in USD terms their GDP will double to USD 8 and 7 trillion while UK and Germany will be around USD 5 trillion.