With this week slow for news and other economic developments, some forex traders are taking a step back to look at the long-term picture. The US Dollar, in particular has come into focus, because of the uncertain consequences of its current economic policy and the related talk of central bank diversification away from the Dollar. “The United States’ expansionist fiscal and monetary policies, which are raising fears of inflation down the road that could erode the value of the dollar, is surely driving diversification out of dollar-denominated asset…The dollar has weakened whenever talk about an alternative reserve currency makes the headlines.”

This week brought a couple small developments on this front. First, China released its annual report on the economy, in which it renewed calls for a “supra-national” currency, to be administered by the IMF: “To avoid the inherent deficiencies of using sovereign currencies for reserves, there’s a need to create an international reserve currency that’s de-linked from sovereign nations.” Analysts caution however that the move is politically motivated, and it could be a while before it’s squared with economic reality: “There may be signs here of tensions mounting between the PBOC’s economic concerns over China’s holdings of dollars and the Chinese government’s diplomatic reasons for doing so.”

Still, China is walking the walk. Having already entered into swap agreements with Argentina and several other developing countries, it is moving to conduct as much of its trade in Chinese Yuan as possible. This week, it inked a deal with Brazil, “for the gradual elimination of the US dollar in bilateral trade operations which in 2009 are estimated to reach US$ 40 billion.” Previously, such trade had been settled primarily in Dollars, a bane for Brazilian companies, which collectively “have lost hundreds of millions over the last two years due to dollar weakness.”

There is also activity closer to home. “The government said on April 8 that it will allow Shanghai and four cities in the southern Guangdong province, including Shenzhen and Guangzhou, to settle international trade in yuan.” An agreement with Hong Kong, meanwhile, aims to settle at least half of bilateral trade in Yuan. “Hong Kong Financial Secretary John Tsang said the city will be a ‘testing ground’ for use of the yuan outside mainland China.” If successful, this program could quickly expand to encompass the rest of East Asia ex-Japan.

In the short-term, these baby steps won’t have much of an impact on the Dollar. Besides, most Central Banks remain committed to the Dollar, if only for lack of a viable alternative. “The Fed’s holdings of Treasuries on behalf of central banks and institutions from China to Norway rose by $257.2 billion this year, or 15 percent, according to data compiled by Bloomberg. That compares with an increase of $127.3 billion, or 10 percent, in the first half of 2008.”

Even China has stated that its reserve policy will not feature any sudden changes. In sum, “It seems safe to say that the Chinese are pursuing a rather logical path. They will continue to accumulate dollar reserves, as doing so fits their three-adjective criteria [liquidity, safety and returns], while also pushing for international acceptance of an alternative to the dollar in a new global currency.”

By coincidence, today’s release of final GDP data confirms - rather than negates - the economic picture that I painted yesterday. “The economy slumped a downwardly revised 2.4% in the first quarter, which was narrowly the largest decline since the second quarter of 1958. The annual decline in output was 4.9%, the largest since records began in 1948.” The news didn’t affect the Pound, given that it refers to a period that ended a few months ago. At the same time, it revealed the seriousness of UK economic troubles and the depth of the hole that it must climb out of in order to achieve recovery.

Of course, the Bank of England is doing its part to try to help the economy along: The minutes from its last meeting showed that the BOE “voted unanimously to keep interest rates at a record low of 0.5 percent and maintain its 125 billion pound quantitative easing programme, minutes showed on Wednesday.” Experts reckon that the BOE will probably continue to keep rates low. Unemployment remains high and output will likely remain well below its potential well into any economic recovery. One analyst argues, “Even if the recession is now over, inflation could keep falling until mid-2011. Which means that it should be below its 2 per cent target in late 2011 and early 2012. Because Bank rate is set with regard to where inflation will be in two years time - as it takes that long for monetary policy to significantly affect prices - this points to rates staying low for at least a few more months.”

But the Bank’s rate cuts are being offset by the Pound’s recent 15% rise- its strongest quarterly performance in over 20 years. Based on some models, such a dramatic rise is equivalent in force to a 4% hike in interest rates. The quantitative easing program is also beset with problems, namely that 50% of the newly printed money has been used to purchase assets/bonds from foreign investors, which are more likely to take the money out of the British economy.

The government, meanwhile, is probably out of options, and may have to even unwind some of its fiscal stimulus due to lack of funds. In fact, the “deterioration in the U.K.’s public finances…prompted Standard & Poor’s to warn on May 21 that the country could lose its AAA debt rating. The firm estimated the cost of propping up Britain’s banks at 100 billion pounds ($166 billion) to 145 billion pounds and said government debts could double to almost 100 percent of gross domestic product by 2013.” The budget deficit in 2009 alone could surpass 15%.

In short, there is potentially more downside than upside to these efforts, especially as far as the Pound is concerned. The BOE’s easy money policy makes the Pound an unattractive buy in the short term, while its QE program could stoke inflation in the long-term, without much benefit to the economy. Furthermore, it will be difficult to rein in this program because of the perennial budget deficits of the government, which “must sell about 900 billion pounds of gilts over five years…The Bank of England will buy a third of these gilts.” The recent rise in government bond yields as well as the rising cost of bond insurance (i.e. credit default swap premiums) confirm that investors are growing increasingly nervous. According to a Harvard University historian, “The probability of a real sterling crisis is around one in three.”

Still, there are optimists. Says one analyst, “The U.K. economy’s heavy dependence on the finance sector, recently seen as a big flaw, has also turned into a benefit. ‘Sterling is basically a bet on global financial well-being.’ ” Also, “Foreign demand for gilts rose to an all-time high in the first quarter of this year as concern the world economy would stay mired in a recession drove investors to the relative safety of government securities.” But these notions are somewhat contradictory. When you map these ideas against the backdrop of the Pound, you can see that is benefited primarily from the perception of recovery- not from the safe-haven perception.

These optimists believe the Pound will rise as high as $1.80 against the USD and €1.40 against the Euro. Under the best-case scenario, quantitative easing and government spending will trickle down to the bedrock of the economy, and will be unwound immediately after the economy enters a recovery period so as not to spur inflation. Under the worst-case scenario, though, the government will continue to run large budget deficits and fail to find enough buyers for its debt. The resulting stagflation would cause investors to rush for the exits and for the currency to collapse. In all likelihood, the actual outcome will fall somewhere in between.

After a nearly 20% rise against the Dollar, the British Pound has been rangebound for nearly the entire month of June, with one columnist likening the situation to a “pause for breath.” For him, this amounts to a temporary cessation on the Pound’s inevitable upward path: “Compared to long term levels, the pound was still better value than its peers. He said: ‘It’s still cheap - about 10% below it’s trade-weighted average at present.’ ” For others analysts, however, the picture is not so cut-and-dried.

Forgetting about purchasing power parity for a minute, there are numerous factors which could halt the Pound’s rise. First and foremost is the British economy, which is still struggling to find its feet. “The U.K. economy will recover ‘mildly’ next year, according to the OECD, compared with a previous projection of a 0.2 percent contraction. Gross domestic product will drop 4.3 percent this year, versus a March forecast of 3.7 percent.”

Some economic indicators have begun to stabilize, but the two most important sectors, housing and finance, are still wobbly. Economists warn that “any recovery could be slow and uneven because banks are still unwilling to pump loans into the economy.” In the latest month for which data is available, mortgage lending slowed to a record low, with consumer lending not far behind. With regard to housing,”The annual fall in house prices in England and Wales slowed for a third consecutive month in June, according to property data company Hometrack, but prices were still 8.7 percent lower than a year ago.”

There is the possibility that the BOE’s quantitative easing plan and the government’s fiscal stimulus will provide the economy with the boost it needs. At the same time, both programs will have to be reined at some point, sooner rather than later in the case of government spending. With UK national debt predicted to reach 90% of GDP by 2010, “Most people - the prime minister excepted, apparently - believe that taxes will have to rise and/or public spending fall after the next election. This would at least threaten to hold back economic activity.” Not to mention that both QE and government spending could actually backfire and generate inflation without economic growth (i.e. stagflation). BOE Governor Mervyn King captured this overall sentiment, when he said, “I feel more uncertain now than ever. This is not the pattern of a recession coming into recovery that we’ve seen since the 1930s.”

In short, from a purely economic standpoint, it doesn’t look good for the Pound Sterling. But of course forex is about much more than GDP…stay tuned for Part 2, in which I’ll elaborate on this point, and bring interest rates and inflation into the discussion.