Whither US Dollar?

With the world’s largest economy in the doldrums, soaring unemployment and ballooning deficit, immense pressure has been put on the greenback. The world’s reserve currency is on trembling ground, as most central banks are looking for alternatives.

A flood of greenbacks from the Federal Reserve and the Obama government may be necessary to prop up the ailing economy. He suggests that the US government must control its unprecedented levels of debt in the future or risk the consequences.

Printing too much

Part of the dollar crisis can be attributed to the Fed’s new monetary policy, under which it lent money to the member banks in the US virtually at 0% interest. This in turn enabled these banks indulge in dollar carry trade to invest in high performing economies in Latin America and Asia. The rate of return is much higher in these nations than in the US. Besides, the sharp decline in dollar value has also been due to diversification on the part of central banks (which currently hold around 90% of their foreign reserves in the dollar) from dollar to gold, euro and yen.

As the US economy looks very weak at present, it makes sense for nations to diversify out of the greenback. For instance, the Reserve Bank of India recently used $6.7 bn from its reserves to buy gold. The feeble consumer spending, rising unemployment and enduring worries about the fragile banking system in the US, have also hit the greenback adversely. Peter Schiff, President and Chief Global Strategist of Euro Pacific Capital, reckons that the dollar is on a long-term downward trajectory and that it could collapse if the US government continues with its current policies.

Losing hegemony?

Experts say that a persistently weak currency is a sign of economic imbalance in terms of lack of competitiveness or overconsumption, arising usually from excessive supply of money and credit. Thus, since the dollar is the world’s reserve currency, its collapse will have massive ramifications around the world. Amid weaker US economic growth, relentless trade deficit, and surging commodity prices, the era of the strong and overvalued dollar is over. A weaker dollar makes it easier for foreign investors to acquire key assets in the US, which is only one side of the problem.

On the other hand, a dollar crash will have disastrous implications for the world economy and financial markets. The greenback has tremendous influence throughout the world because many central banks (e.g. China’s) have pegged their currency to the dollar. Addison Wiggin, Editorial Director, The Daily Reckoning, opines, “Many exporting countries are seeing their currencies going up in value, making it indefensible to continue exporting at the same rates as in the past. So we have, through trillions of dollars of debt accumulation, created a de facto dollar standard in much of the world economy.” Analysts suggest that in order to keep the global economy on the right track, the US policy makers must first fix the dollar, as it is the single most important price in the world for its value, influencing prices and investments on a global scale. Therefore, with a weak dollar, global economic recovery might not be as broad as publicized. Since it is the world’s major reserve currency and a major trade settlement currency, the stability of the greenback has a key influence on the stability of the global economic recovery. It has been at the heart of the global financial markets for well over half a century, and if its demise is not smooth, it could lead to an era of competitive devolutions and other trade policies.

Conclusion

In a very short span of time, the world’s biggest lender has become its biggest borrower, a situation that Uncle Sam has made no serious attempts to change. It is worth remembering Washington’s standard take on this shift: “The dollar is our currency, but it’s your problem.

Tags: Currency Markets, Yuan, Reserve Currency, Financial Markets.

N Janardhan Rao, Senior Economist.