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The Mother of All Currency Crises

http://www.fool.com/investing/international/2009/03/27/the-mother-of-all-currency-crises.aspx

Christopher Barker
March 27, 2009

This is it, Fools!

For everyone who has wondered when the consequences of uncontrolled deficit spending and monetary interventions approaching $14 trillion would finally catch up to the U.S. dollar ... that time is now.

The world has seen enough.

On top of an $11 trillion national debt -- actually, it's above $56 trillion including entitlements like Medicare and Social Security -- the specter of $1 trillion deficits for years to come leaves little luster in the wilting greenback. Although the world gazed with detached fascination at Zimbabwe's plight, the role of the U.S. dollar as the planet's primary reserve currency makes this the mother of all currency crises.

History will reveal to our indebted descendants that the Federal Reserve's foray into quantitative easing with a $300 billion purchase of Treasury bonds -- essentially funding debt with more debt -- provided the final straw.

I have harbored concerns for some time that China and Russia would stop playing along with our fiscal madness and begin diversifying away from dollar holdings. In the run-up to a key summit of the G20 leaders in London next week, both nations have become vocal dissenters regarding the dollar-dominated currency regime.

The BRIC builds a wall of opposition
China and Russia are promoting a "super-reserve currency" using a modified instrument of the International Monetary Fund (IMF) called Special Drawing Rights (SDRs). The SDR is a basket of four currencies (the dollar, pound, euro, and yen), but China proposes including a broader set of currencies and using the SDR for international trade and to price commodities. Russia has indicated that the remaining BRIC countries -- Brazil and India -- also support this approach, and together these nations will comprise a formidable force at the upcoming G20 summit.

The United States also wants to deploy SDRs, but for precisely the opposite purpose. Incredibly, senior Treasury officials have called for the IMF to issue huge quantities of SDRs as a kind of global stimulus package. By suggesting that the IMF member nations engage in globalized quantitative easing, the administration provides further evidence of its unfettered resolve to stay the course with this dubious strategy of spending our way out of the crisis.

A former chief economist from the IMF, Simon Johnson, offered this eerie characterization of the proposal: "The principle behind it is that everyone would get bonus dollars and instead of the Federal Reserve having to print them, everyone gets them." Wow, did I miss something? Did he just reveal the existence of a magic money tree? Of course not, but to understand why that is, we have to know about more about SDRs.

Anatomy and history of the SDR
Back in 1969, when dollars remained convertible to gold, the SDR was created to permit the expansion of world trade beyond the confines of available reserves. For a few brief years, SDRs performed the function of a reserve currency. In 1973, when the world abandoned Bretton Woods for a floating fiat model, SDRs became little more than a means of capitalizing the IMF.

According to the IMF: "The SDR is neither a currency, nor a claim on the IMF. Rather, it is a potential claim on the freely usable currencies of IMF members." Therefore, a global market for SDRs is only achievable through securities (i.e., OTC derivatives). Yes, the very instrument which China and Russia are advocating as the next reserve currency of the world would require the creation of unfathomable values in those same derivatives which Warren Buffett called "financial weapons of mass destruction." Derivatives, dear Fools, are the missing link between Mr. Johnson's above explanation of Treasury's SDR plan and any semblance of actual logic.

The anti-dollar trade is on
Regardless of how the growing global aversion to the U.S. dollar plays out, the critical takeaway for investors is that the dollar is headed into weaker territory as ramped-up spending runs smack into a world with no appetite for the growing risk. Quantitative easing is a very slippery slope, and I am willing to bet that we have not seen the last of the Fed's purchases of Treasury bonds ... not by a long shot.

With that in mind, some of the very same investment opportunities that fell apart last year will come back into vogue. Commodity-related equities within BRIC countries look attractive to me, including Petrobras (NYSE: