Forex Blog: Currency Trading News & Analysis.

December 24th 2007

Commentary: The Future of the Dollar

Despite its multi-year decline, the US Dollar remains the world’s undisputed reserve currency, claiming a 65% share of total Central Bank reserves. However, the chorus of soothsayers proclaiming the apocalypse for the Greenback is growing louder by the day. Every week seems to offer a new piece of news confirming that the Dollar’s reign is coming to an end. Analysts are drawing parallels between the British Pound of 50 years ago and the Dollar today. China is threatening to diversify its reserves into Euros. Iran and Venezuela are leading calls to price oil in terms of a basket of currencies, rather than in USD. The other members of OPEC are considering de-pegging their respective currencies from the Dollar. What does all of this mean? Is the Dollar truly in danger of being replaced as the world’s reserve currency?

The short answer is ‘no.’ The US twin deficits have expanded every year for the past decade and economic theory suggests that in order for a nation’s current account to rebalance itself, a decline in the value of its currency is required. At the same time, these deficits are sustainable for as long as foreign investors, sovereign and private, are willing to sustain them. And despite the looming threat of recession, economic data and anecdotal stories suggests that such investors remain willing to lend their financial support. For example, the announcement of record-breaking losses by American financial institutions has been met with solid commitments to invest by international investors.

In addition, while foreign exchange reserve diversification is certainly justifiable from a risk management standpoint, it hardly makes sense from a financial standpoint. The case could have been made for foreign Central Banks to exchange their Dollars for Euros and/or Pounds several years ago when both currencies were trading at relative bargains to the USD. Now that these currencies are more expensive, it seems harder for to justify buying assets and securities denominated in them. Furthermore, Central Banks must recognize that diversifying now would be counter-productive, by sending a wave of panic through the markets and undermining their efforts. As one analyst pointed out, Japan and China, the two largest holders of USD, both have a vested interest in an expensive Dollar.

However, the long answer to the question posed at the beginning of this article is closer to ‘maybe’ than ‘no.’  In the long-term, Central Banks will certainly move towards a more diversified portfolio of currencies.  For countries like China and Japan, this will help minimize risk.  For countries in the Middle East that peg their currencies to the Dollar, this will enable them to conduct monetary policy independent of the US.  Ultimately, US capital markets are the most stable and liquid in the world, and regardless of the value of the USD, it will serve the interests of Central Banks to denominate a large portion of their portfolios in Dollars.  Besides, analysts can be extremely fickle. It was only five years ago that the Euro was trading below parity with the USD and analysts were predicting its collapse.  The fundamentals underlying both currencies have not changed much since then, yet commentators have reversed their positions. Who knows what such analysts will be preaching five years from now…

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Posted by Adam Kritzer | in Commentary, US Dollar | No Comments »

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