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March 3, 2006

The Golden Caliphate


by Ann Berg

As the Dubai Ports World plan continues to simmer, most congressional leaders twittering about security have ignored the potential monetary consequences of nixing the deal. By telling DP World, a United Arab Emirates corporation with willing investment dollars, to "go stuff it," we can stop worrying about the so-called threat to dollar hegemony posed by the creators of the Iranian oil bourse. An improbable senatorial alliance of Chuck Schumer, Norm Coleman, and Bill Frist is beating the Iranians to the punch.

How Twin Deficits Have Reinforced Dollar Hegemony

American consumers have run a trade deficit (importing more than they export) for 30 years. The trade deficit propels a constant dollar flow into the developing world's central banks. These dollars then recycle into purchases of U.S. securities such as promissory notes (bonds) created by the Treasury to finance the budget deficit.

Lagging financial markets in the developing world exacerbate this cycle. Capitalizing on cheap labor pools, most emerging countries are focused on expanding their manufacturing and export sectors. The emphasis on exports retards the creation of U.S.-style banking, capital formation, and risk-management institutions. This asymmetrical economic situation inhibits the access to credit and capital in the home economy.

The Modern American Financial Market

The collapse of the Bretton Woods agreement in 1971 ushered in a capital markets revolution, marked by the birth of financial futures trading.

This innovation sparked an explosion of new products. Parcels of debt (mortgages, credit cards, small business loans) were bundled into tradable instruments. Investments such as stocks, bonds, and real estate were packaged into securities or trusts, then peddled to an international customer base.

As a result, a smorgasbord of credit and investment options known by such acronyms as ARMs, S&Ps, ETFs, and REITs now beckons the American public. The system's wealth effect has been staggering. Economists estimate that the cash extracted through home equity loans (HELOCs) lined consumer pockets with $600 billion last year. By spending this money on imports, the American consumer sends dollars to foreigners, who in turn spin the dollars around to fund even more borrowing.

Given the foregoing, can the dollar's reserve currency status be vulnerable?

Scenarios

One possibility often mentioned is a slide in the multi-trillion dollar housing market, which would stanch equity extraction from homes. The chilling effect on the economy is hard to quantify. As sophisticated as the new marketplace is, it does not provide homeowners "price depreciation insurance" or "put options" on their homes. In other words, homeowners shoulder the entire downside risk of any decline in the value of their homes (in sharp contrast to financial intermediaries that can resell the mortgage loans).

A dip in home prices could therefore close the door on borrowing against home values and greatly curtail consumer spending. This would reduce foreign bank dollar deposits available to finance both public and private U.S. debt. Most economists posit that interest rates would have to rise sharply to continue attracting investment funds. Nonetheless, it is unclear whether such a scenario would end dollar hegemony.

Another possibility bandied about is the switch of petrodollars to petroeuros. This specter has been recently raised by the upcoming launch of the Iranian oil bourse. However, futures markets depend upon transparent legal systems (especially enforceable property rights), institutional trust, minimal state intervention, and a level playing field between long and short players and the IOB fails on all counts. Furthermore, exchanges do not dictate trading terms; a euro-based oil futures contract will only succeed when the underlying trade switches its pricing mechanism.

A third and radical possibility is the emergence of a unified Islamic financial movement that could possibly center on the gold dinar. When Jude Wanniski wrote about this potential in November 2004, he cited the dinar's flawed promotion and the IMF ban on gold-backed currencies in debtor countries as two impediments to success.

But several things have changed in the last year and a half.

First, the IMF is losing its relevancy as a U.S. policy tool. As the world gets richer, it is starting to reject dollar-based loans. Argentina, Brazil, and Russia have decided to pay off their IMF loans, and Turkey which suffered economic collapse in 2001 has asserted it will no longer need IMF assistance by 2008. Also, the dramatic oil price increase has made most Islamic countries much wealthier in a short time span. What's more, the global easing of interest rates has made access to capital in domestic currency far easier and, at the same time, fiat currencies are quickly depreciating against gold.

Most importantly, the U.S. is becoming increasingly protectionist. By saying "no" to foreign investment, especially on an idiosyncratic basis, it is throwing down the gauntlet to foreigners, daring them to jettison their dollar-based investments. Therefore, several conditions both financial and political are in place to cause a shift in global finance.

Significantly, the fastest growing global money field is Islamic financing. Islamic bonds, or sukuks unlike most U.S. bonds, which pay interest are securities that pay out revenue streams from rents and leases in accordance with Shariah law. In its infancy, the field claims about a half trillion dollars. If the Islamic nations were to adopt a gold standard as their underlying currency basis, it could have multinational appeal.

Moreover, since Islamic financing includes the mainstream retail products of mortgages, small business loans, and consumer credit, its potential consumer market is staggering. (A mortgage, for example, is structured as a "rent to buy" arrangement.) Because its guidelines are religious tenets, its scope would be transnational.

Imagine the power of an Islamic financial supermarket, rivaling the sophistication of the U.S. market (itself only 30 years old), to channel dollar holdings into dinars for a billion-plus people! The embrace of a pan-Islamic, gold-backed system would create an unquantifiable financial upheaval.

Ironically, this could be the financial free market flip-side to the totalitarian Spain to Indonesia "caliphate" so vilified by the administration.

As U.S. lawmakers blithely vote to raise the debt ceiling to $9 trillion while angling for political points over the DP World scuffle, Dubai, coincidently, is sponsoring a four-day International Islamic Finance Forum for the week of March 19. It promises to feature the basics of converting conventional debt into Islamic financing, the techniques of Islamic securitization, and the training of Shariah scholars. Chuck, Norm, and Bill would do well to attend.

 

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Ann Berg has spent a 30-year career in commodities and capital markets as a trader, consultant, and writer. While a commodity futures trader and Director of the Chicago Board of Trade, she advised foreign governments, NGOs (the United Nations, World Bank), think tanks (Catalyst Institute), and multinational and foreign corporations on a variety market-related issues. She was also a frequent conference speaker at international derivatives markets forums. In recent years, she has contributed articles to several commodities/capital markets publications, including Futures Magazine, Traders Source, Financial Exchange, and the Financial Times editorial page. Berg is also an artist. She is currently working on a body of work entitled The Unknown Unknowns – The Things You Don’t Know You Don’t Know, which explores U.S. national security policy.

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