Is It the End of the US Dollar? - Outside View

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Is It the End of the US Dollar?
Aug 30, 2010

Now I'm not talking about the end of the dollar as a currency. Rather, I want to explore the idea that the US dollar is losing its status as a dominant reserve currency. If we take a look at the financial press, we could easily get the impression the dollar has nowhere to go but down.

What are the factors that contribute to the weakening of the dollar? First, the US Federal Reserve led by Ben Bernanke has been pursuing quantitative easing policies, and is likely to continue to do so in the future. In fact, I get the impression that the Fed is more than happy to let the dollar devalue if it means better economic growth.

Next, governments and central banks around the world are selling their dollar reserves, in an attempt to diversify. They are buying other hard currencies such as Euro and Yen, and are also investing in gold, which is arguably a currency too. The bottom line is that the US central bank wants a weaker dollar, and the rest of the world's central banks are worried about a weaker dollar.

Currencies are all relative. For the dollar to fall in value, another currency needs to rise (and presumably take its place as a dominant reserve currency). What are the options here? The four most actively traded currencies are dollars, euros, pounds, and yen. Britain is the smallest of these in terms of its economic size, so it is doubtful that it can become a reserve currency. Japan's currency already behaves like a reserve currency in many ways. It usually goes up on bad news. A lot of this has to do with Japan's ultra low interest rates that have funded carry trades for many years. How about the Eurozone? It certainly has its own problems. Most pressing is the huge divergence between countries like Germany and Greece that are forced to use the same currency with the same interest rate, despite their vastly different economies.

What else could replace the dollar? The Chinese renminbi could be a contender, but this could be a long while away. China's currency is tightly controlled and is difficult for investors to trade in an out of. The final option is gold. Gold is a not a currency, but is used as a reserve by central banks. Gold could certainly be used as a store of value, but is unlikely to ever be used extensively for transactions and international trade.

Although there are so many signs pointing towards a weakening dollar, we often forget to focus on the alternatives. The fact is that central banks around the developed world are also involved in quantitative easing. They want a weaker currency too (to help their export markets and get their economies moving). Most central banks want a weaker currency, but they can't all get it.

The US economy and the US dollar could certainly weaken over time. It doesn't however mean that its status as a reserve currency will be diminished. We still do most of our international transactions in dollars. Hence, there is always a demand for dollars for that purpose itself. For a country to pay for its imports such as crude oil, they need dollars. As of now there is no real alternative to the dollar as a reserve currency. Central banks can (and should) diversify their currency holdings, but it doesn't mean the dollar is no longer a reserve currency.

The financial markets and the financial press are both fickle. They always change their minds, and don't often behave in the way we expect them to. Just a few months ago, the markets and the press were talking about the end of the Eurozone. Predictions ranged from the euro reaching parity with the dollar, or the Eurozone breaking up entirely. None of this has materialized, but if you were to read the press three months ago, it seemed like this was almost a certainty. Today, we don't hear anything about this, but the PIIGS still have their debt problems, and could easily end up in recession.

In today's press, we are hearing about the end of the US dollar as a reserve currency. This is unlikely to occur anytime in the near future due to a lack of real alternatives. In the longer term, it could happen but it is definitely not certain, and it will depend a lot on the events of the coming years. Just because all the press likes to talk about the dollar's demise doesn't mean it will happen. In three months time, the market and the press could easily forget all this and focus on something completely different.This column, A Fresh Perspective, is authored by Asad Dossani. Asad is a financial analyst and columnist. He actively trades his own and others' funds, investing primarily in currency, commodity, and stock index derivative products. Prior to this, he worked at Deutsche Bank as an analyst in the FX derivatives team. He is a graduate of the London School of Economics. Asad is a keen observer of macroeconomic trends and their effects on global financial markets. He is deeply passionate about educating investors, and encouraging individuals to take part in and profit from financial markets. To put it colloquially, he wishes to take Wall Street products and turn them into Main Street profits!

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