I've been meaning to post this story for a while now. To that extent, it's a wee bit dated. But it's a compelling argument that Niranjan Rajadhyaksha, Deputy editor at Businessworld made a few weeks ago. His mind is razor sharp and his columns are worth keeping track of. One of the reasons why it occured to me today is because I read another very interesting piece earlier today on how pressures on European economies are mounting as the dollar falls. But before that, read Niranjan's piece.

The Falklands thing was about two bald men fighting over a comb.
Jorge Luis Borges

What is the Iraq thing about? Democracy? Oil? Or dollar supremacy? There is now a theory doing the rounds that America has invaded Iraq not to keep oil prices down but to keep the value of the dollar up. Much of what is said by the proponents of this theory is crackpot stuff. But there is also a bit of intriguing economics involved. The argument goes something like this. The most serious threat to the America economy does not come from oil prices. It comes from the huge current account deficit, which is currently in the region of 5% of GDP.

It means that America spends about $500 billion more than it earns from the rest of the world. Most other countries have seen their economies wrecked by such huge current account gaps. Think Thailand in 1997, Argentina in 2002 or India in 1991. Foreign investors rushed for the exits, taking their dollars with them. America is immune from this threat because the dollar is the most popular currency for global trade transactions. So while other countries have to give up their foreign exchange and gold reserves in order to buy from other countries, America merely has to print more dollars. It's a unique advantage that was slammed way back in the 1960s by French President Charles de Gaulle, who said that the reserve currency role of the dollar is an "exhorbitant privilege" for the American economy.

America's current account deficit keeps getting funded by the rest of the world. Most countries are quite happy parking most of their foreign exchange reserves in US bonds. The two biggest holders of dollar assets are Asian central banks and the Arab economies. Their desire to endlessly hoard dollars is partly linked to the politics of oil. Investment bank Morgan Stanley estimates that Asian central banks hold $1.4 trillion in liquid forex reserves. Take Japan out, and the total drops to $953 billion. About 70-80% of this is held in dollars. (Most central banks do not reveal the composition of their reserves.) One reason Asian central banks hold such dollar huge reserves is to build a cushion againt sudden spikes in global oil prices. The other major group of dollar-friends is the Arabs. Their receivables are in dollars and so it is their most preferred investment currency.

The Arab Monetary Authority estimates that Arab investments in America between 1975 and 2000 total $300 billion. (These include private sector investments as well.) Unofficial estimates go up to twice that number. But what if the Asian central banks and the Arabs stop hoarding dollars? America will find it tough to fund its current account gap. The economic pain could be immense. In the 1960s, de Gaulle tried to abandon the dollar and use gold. The tactic failed because the yellow metal was soon to be out of favour in the international financial system. Since then, there has been no viable alternative to the US dollar as the currency for trade and accumulation. This could change, with the euro now coming into its own. At the end of 2000, Saddam Hussain took the plunge. He announced that Iraq's oil trade would now be done in euros. He also converted his country's $10 billion reserve fund with the IMF into euros. Saddam was
pillored for what then seemed like a silly move --- he was letting politics get the better of economics. But the euro has appreciated by 17% against the dollar since then, and the dictator has, unknowingly, saved a part of Iraq's forex assets from falling in value.

Since then, there have been stray reports about other countries considering using the euro as the "transaction currency" for oil. Iran is one example. And if a large part of the buying and selling of oil can be done in euros, is there any reason why Asian central banks should hold upto 80% of their reserves in dollars? Meanwhile, there are also reports --- including one in the venerable Financial Times --- that Arab companies and banks are withdrawing money from the US because of what they see as discrimination after 9/11 as well as the war in Iraq.

The dollar has continued to wobble in recent months. It is no longer playing its role as the geopolitical safe haven. The euro seems to become more popular by the day. Nervous Asians and angry Arabs can change the balance of power in the financial system. The euro could seriously threaten the dollar as the world's preferred currency. That's as far as the economics goes. Now, just for the fun of it, a thought for the conspiracy theorists. Is it any wonder that the countries of the euro bloc are opposing the war? And that America's only ally is Britain, the one major country in Europe that has not embraced the euro?