Revaluation off the agenda, but how safe is the dollar?

The upturn in the fortunes of the United States dollar over the summer months has really put an end to talk about revaluation of the dirham which raged earlier this year until the government made a definitive statement saying it was not going to happen. But what is far more open to question this autumn is the fate of the greenback and, via the peg, the outlook for the UAE currency.

Will the dollar gain prove to be a short-term bear market rally, or turn out to be something more durable? It is certainly a major consideration in an export dependent economy like the UAE, and effects major sectors of the domestic economy as well, from tourism to real estate.

The precise reason for the recent dollar rally seems to come down mainly to massive market intervention, particularly during the Beijing Olympics. The Chinese have been buyers of dollars to keep their exports competitive at a time when the economy is slowing down, something reflected in the recent 50 per cent crash in their stock market.

The European Central Bank appears to have been a seller due to concerns about the impact of the overvalued euro, and there has been little support for sterling against the dollar. However, the problem with co-ordinated market interventions – for that is what this seems to be – is that they generally fail in the long term.

A market intervention is like feeding drugs to an addict. They need more and more until the drug has no effect or leaves them unconscious. Remember, for example, the many attempts to stop the devaluation of the sterling in the past century. All of them ultimately failed.

So how long can the dollar defy gravity? It might make it to the US presidential election. A stock market crash – as investors take onboard bank failures and a poor profit outlook – could actually rally the dollar a little longer, as liquidating portfolios would actually boost demand for cash, for a while. But the unbelievable size of US indebtedness, and the size of the bailouts likely to be required for the banking system, suggest that the dollar does indeed have substantially further to fall in the near term. As this column has argued in the past a two-dollar euro can be expected as the US printing presses roll to bail out the banks, and a hundred or more could fail compared to nine so far.

So should UAE residents and investors see any strength in the dollar as a chance to exit this autumn? The problem is that we seem to be moving into an era of competitive devaluations. For example, if you had bought sterling for its high interest rate two months ago then you would be sitting on a 7.5 per cent capital loss against a three per cent gain in annual interest compared with holding dirhams or dollars. Any sterling asset, such as a house, would also be showing the same loss in dollar terms.

My personal view is that in these circumstances gold, and also silver, should be regarded as currencies of choice. Most pertinently because of their relatively fixed supply, which becomes especially significant when the printing presses are rolling, albeit metaphorically as most of the new money will be issued in US treasury bonds.

Again life is never that easy as precious metals also took a hit over the summer when the massive currency interventions caught the market off guard in thin summer trading. But that does surely leave gold and particularly silver at exceptionally attractive levels.

On the other hand, the lesson of this summer for investors was surely that diversification remains the best way to stabilise returns. Gold investors with large US assets, for instance, could balance the gain in one class against losses in the other. Keeping a spread of assets – both correlated and non-correlated, does make considerable good sense in such a volatile environment.

That might also include the UAE dirham. At present it appears that nothing much is likely to happen before the GCC monetary union in 2010, and what happens then will fall short of a full union. But there is a lot of time before 2010, and one has to wonder how the UAE authorities would respond to another big devaluation in the dollar.

It could still be that the dirham proves a better place to hold cash, if a revaluation were to suddenly come back onto the agenda. There is, after all, no advantage to holding dollars in terms of the interest rate, and a possible revaluation comes at no additional charge to the account holder.

To conclude, I do not envy treasury managers this autumn as currencies could swing violently and be subject to unpredictable market interventions of a somewhat competitive nature. And in this environment an above average exposure to precious metals looks advisable, although the dollar may hold up for a while.