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Predicting the future value of currencies is a tricky business.

For instance, about one year ago, as the US economy started heading down the toilet and investors of all stripes began to panic, one would have thought that the impending collapse of the US economy would be bad for the dollar. But not so. In fact it was the opposite: as the crisis spread, US dollar assets became a safe haven from all the other collapsing world economies. Why? Because the US economy is still the biggest, most open, and most liquid in the world.

Nevertheless, without being too specific, I would argue that we are likely to see a long-run weakening of the US dollar. Here are at least two big reasons why:


Changes in the US Economy
It took having to be beaten over the head with a rather large recessionary stick, but US policy makers have realized that the economic conditions that prevailed in the last decade or so should not be repeated going forward. I'm talking in particular about 1) low domestic US savings, and 2) the US's reliance on everyone else to make stuff, sell that stuff to America on the cheap, and invest the money earned from selling that stuff in US assets with a low rate of return. American financial institutions would then take that money and invest it in riskier assets, earning greater return, and making everyone rich.

That's an oversimplification, but you get the idea. Recognizing that there's a big downside to this state of affairs, Obama's top policy advisors have been advocating a shift in the US economic strategy. Larry Summers has been the most explicit, according to two authors from the Peterson Institute:

"The US, [Summers] said, must become an export-oriented rather than a consumption-based economy and must rely on real engineering rather than financial wizardry. Tim Geithner, the US Treasury secretary, and other top officials have spoken similarly of rebalancing US growth.... Redirecting resources away from finance and consumption towards exports and investment will require relative price shifts, for which the dollar has to move down."

Now, you could argue that the extent to which Summers & friends will be able to achieve this goal is limited. The US competitive advantage is, after all, in financial wizardry and not exports. Nevertheless, that this is the long-run goal of Obama's policymakers is a statement of intent that deserves to be taken seriously. And I think that it is being taken seriously by a country whose policies will likely have an even greater impact on the future of the dollar: China.

China's Investment Strategy

"You should be screaming if your life savings are in dollars."
That's the assessment from FT Alphaville after further evidence that China is trying to quietly tip-toe away from the US dollar - something that is hard to do when you own about 1.5 trillion (!) of them. Nevertheless, China is attempting to escape its "dollar trap" by directing state-owned firms to start investing in dollar-alternatives like commodities and commodity-related companies. As China starts selling US dollar assets there will be more US dollars in the market, the value of any given dollar will go down and the currency will depreciate.

The long-term objective of this strategy is to eventually bring about the full convertibility of China's currency, the remnibi, and have it compete with (or replace) the US dollar as the world's reserve currency of choice. I say "long-term" because Beijing will need a long time to diversify away from the US dollar. But nevertheless, when you own 1,500 billion of another country's assets, your strategic decisions are going to be of some consequence.

Now, as I stated in the opening, currency predictions are fickle things. One could easily imagine a scenario where China's economy has an unexpected downturn and the safety of US assets will once again be appealing. Economic analysts are prone to overstating the long-run significance of current events. But caveats aside, the macro-level economic strategies of the two largest economies in the world suggest that the US dollar is going to weaken. Big time.