Will the Saudis Start a Stampede Away from the Dollar?

PHILADELPHIA TRUMPET

9/26/07

Will the Saudis Start a Stampede Away From the Dollar?

The Fed is risking everything: its unique relationship with oil major Saudi Arabia, inflation, and the dollar's status as the world's reserve currency. All to save speculators and the economy from the housing bubble.

This year marks the 62nd anniversary of President Franklin D. Roosevelt's meeting with Saudi King Abdulaziz ibn Saud on board the uss Quincy in the Red Sea. That meeting marked the day the dollar became the petro-dollar, and the greenback began its role as a reserve currency. The two nations had struck a mutually beneficial agreement: America would protect the Arab kingdom, and Saudi Arabia would only sell its oil for dollars.

The accord worked great for many years, significantly benefiting both nations. Saudi Arabia, tucked away in the volatile Middle East, had the backing of a superpower, and America received all the economic benefits that came from the world having to buy dollars to purchase oil.

The dollar-oil link, coupled with America's status as the most powerful and economically prosperous nation after World War ii, led the world to adopt the dollar as a reserve currency. Global trade and finance came to be largely conducted in dollars.

Americans reaped huge benefits. Growing trade and global demand for oil, and consequently the dollar, led to a strong and stable U.S. currency. Demand for U.S. dollar investments like Treasuries kept interest rates low in America and allowed Americans to easily borrow in order to invest and spend.

It also allowed America to tax the world. Here's how.

As the global economy grew, foreign nations stockpiled U.S. dollars. Since the dollar was considered a safe store of wealth, foreigners were content to invest and hold trillions of in U.S. government Treasuries and other dollar-denominated assets. But over time, something happened. Eventually, America transformed itself from the world's most prosperous nation to the world's most debt-ridden. Simultaneously, America's changed from being the world's largest producer nation to the world's largest consumer nation.

America at all levels of society became addicted to debt, borrowing ever larger sums of money to finance current expenditures. The catch for foreign dollar holders was that each time more money was borrowed into existence, the dollar supply expanded, and all existing dollars become worth less. Similarly, each time the Federal Reserve injected new money into America's banking system (whether to stabilize markets or stimulate the economy) it also expanded the money supply, also devaluing the dollar. In other words, because the world is forced to hold dollars to buy oil (and conduct other trade), America is able to essentially tax the rest of the world by paying back its debt with devaluing dollars.

But America's huge global tax windfall is about to backfire.

Former Federal Reserve Chairman Alan Greenspan warned last week that the chances of a U.S. economic recession were over one in three. At the same time, in a last-ditch effort to encourage people to borrow money and get the economy back on its feet, the Fed lowered its benchmark interest rate a half point from 5.25 to 4.75 percent.

Although a lower interest rate may stimulate the economy, it also increases the threat of price inflation and often leads to a devaluing currency. The dollar has already fallen approximately 20 percent since the beginning of 2006. Now it is falling further.

The weak dollar is having a huge impact in Saudi Arabia—to the point where Riyadh may be forced to defect from the dollar.

Since 1986, the Saudi Arabian riyal has been pegged to the U.S. dollar, meaning that the Saudis actively manage their currency to maintain a set exchange rate between the two currencies. One way Saudi Arabia does this is by matching interest rate levels set by the U.S Fed. Another is by recycling its massive oil-dollar profits into U.S. Treasuries. As dollars are soaked up from circulation and tucked away into Treasuries, the greenback is supported and the riyal maintains its peg to the dollar.

Without Saudi and other Middle Eastern oil-dollars being recycled into U.S. Treasuries, the dollar probably would have fallen much faster over the past few years.

As a close ally of Washington, Saudi Arabia has tried to stick with the peg. Now, however, the weakening dollar is dragging the Saudi economy down with it. Because Saudi Arabia relies so heavily on imports, a weak riyal (due to a weak dollar) means the effects of inflation are multiplied in that nation.

"They face an inflationary threat and do not want to import an interest rate policy set for the recessionary conditions in the United States," Hans Redeker, a bnp Paribas officer, said. Inflation in Saudi Arabia is now at 4 percent. In other nations that peg their currencies to the dollar, the United Arab Emirates and Qatar, inflation has risen to 9.3 percent and 13 percent respectively.

Last week, something unprecedented happened—something that could lead to a Middle Eastern stampede away from the dollar.

The Saudis refused to cut their interest rates to match that of the Fed.

This refusal has led to speculation that Riyadh is preparing to break its currency's peg to the dollar.

The very speculation of such a scenario has already contributed to the dollar's downward spiral against most of the world's major currencies. The euro broke the $1.40 mark this past Thursday—the highest it has been in its five-year history—and the Canadian dollar is almost on parity with the U.S. dollar, with a value of 99.99 U.S. cents. Gold, considered by many to be the anti-dollar, is soaring, and commodities like oil and wheat have recently set price records in dollar terms too.

"There is now a growing danger that global investors will start to shun the U.S. bond market," reports the Ambrose Evan-Pritchard, the international business editor of the Telegraph. Foreign purchases of U.S. bonds decreased from $97 billion to $19 billion in July alone. Rumors of Saudi unpegging are weakening the dollar even further.

The rumors could be well founded.

Earlier this year, the Gulf Cooperation Council, which includes Saudi Arabia, Kuwait, Qatar, Oman, United Arab Emirates and Bahrain, met to decide whether or not to unpeg from the dollar. At the time, Bloomberg announced that the cooperation was unified in its decision to refrain from such action (March 15).

But then on March 20, in an unforeseen turn of events, Kuwait announced that it was tossing the dollar peg out the window and replacing it with a basket of currencies.

"This will almost certainly lead to a domino effect in the Middle East," wrote CaseyResearch.com. "[A] move that would likely be warmly welcomed by the local citizenry there, and not so warmly welcomed by those in the U.S. …."

At that time, CaseyResearch.com noted that America had trapped itself between a rock and a hard place with only two choices. "Raise interest rates to head off a devastating mass exodus from the dollar and sink the economy … or lower interest rates to keep the economy afloat and doom the dollar."

America has now showed its hand. The Fed has chosen the economy over the dollar. But if the dollar is not a store of wealth, what good is it? Unfortunately, this means that the dollar's day as the world's reserve currency may be about to end.

Nobody wants to lose money. Foreign nations hold trillions of U.S. dollars as reserves and to conduct global trade—trillions that are becoming worth less by the day.

The Fed has shown, by cutting interest rates, that it is not interested in protecting the dollar's value. Thus the incentive for foreign nations to diversify their currency reserves away from the dollar will only intensify—putting more downward pressure on the dollar.

If Gulf Cooperation members really do want to divorce from the dollar, then selling oil for euros or another currency would be the next logical step. If that were to occur, America would be in big trouble.

First Kuwait, now Saudi Arabia, who will be next? A dollar divorce precedent has been set.

The Trumpet has been warning about a coming dollar crisis for years and pointing to a new economically dominant Europe to be the eventual result.

Herbert W. Armstrong predicted that a severe crisis would shock Europe into finally uniting. He believed that this crisis would be the collapse of the Western world's monetary system—the dollar, the pound, and the shekel.

Right now your dollar still has value. It can be used to get your financial house in order. Watch for the U.S. dollar to continue to lose value. For more information on this trend, please read "New Global Trend: Dump a Dollar, Buy a Euro."