Is the US dollar doomed?

The US dollar was once the currency the world turned to in times of crisis. But no longer. Despite the unrest in the Middle East, the dollar is sliding. John Stepek looks at why this is happening, what the future holds for the greenback, and what might replace it as the world's reserve currency.

Credit rating agency Moody's downgraded Greece's debt again yesterday. It means Greek debt is now even further into junk territory than before.

"The likelihood of a default or distressed exchange has risen since the last downgrade of the Greek government debt rating in June 2010", said the agency.

The country's "endemic tax evasion" is the problem. The government is having trouble collecting revenue. As a result, it might miss its deficit-cutting targets.

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Athens said the decision was "incomprehensible". I suspect most of the rest of us reckon the only incomprehensible thing about it is that it took Moody's so long.

Here's what's really interesting though. Even in the face of this latest downgrade, the euro still held up against the US dollar, which at one point hit a four-month low against the single currency. As Ian King in The Times notes, so much for the greenback's 'safe haven' status

The dollar has lost its 'safe haven' status for now

The dollar is despised right now.

For a while, it was seen as the first port of call in a storm. But even amid the chaos in the Middle East and the fear of further sovereign debt problems in Europe, the dollar has been resolutely left to drift lower.

So why is this happening? And will this continue?

There are a number of factors weighing on the dollar right now. The high oil price is one. Obviously, there's the fear that high prices will hurt the US economy, which makes it a less attractive proposition. But on a more technical note, high oil prices shift money from oil importers to oil exporters. The oil exporters already have plenty of dollars. So when they get them, they tend to diversify them into other currencies.

High food prices aren't helping either. Until recently, all the talk has been of 'currency wars'. Last year, Brazil effectively accused the Federal Reserve of trying to destroy the dollar through quantitative easing. The scene was set for a race to the bottom, with every country in the world trying to keep their own currencies weak against the dollar, in order to maintain their export sectors.

The currency war is over

However, many emerging economies have now dropped out of the race. With food prices surging, they are being forced to choose between social stability and competitiveness. And that's no competition. In fact, BNP Paribas has declared that the "currency war" is over. "If you have to choose between having an uprising in your country, or letting your currency go to avoid food price inflation, you will let your currency go", BNP's Sergio Trigo Paz tells the Financial Times. In other words, emerging markets are happy to let the dollar fall, if it takes the edge off rising import prices.

Rising global commodity prices are of course partly down to the Fed's money-printing ways. So you could argue that Ben Bernanke is achieving his apparent goal of destroying the US currency. But will it continue?

The idea of the reserve currency being toppled is an unnerving one. As University of California professor Barry Eichengreen pointed out in The Wall Street Journal recently, "85% of foreign exchange transactions across the world are trades of other currencies for dollars". In other words, the dollar "is not just America's currency. It's the world's".


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Eichengreen who has just written a book on the dollar notes that there are three reasons for this dominance. First, the dollar is the world's most liquid currency. Secondly, US Treasuries are seen as the safest of 'safe havens'. And thirdly, there aren't any real alternatives. Other 'safe haven' currencies such as the Swiss franc are simply too small "to account for more than a tiny fraction of international financial transactions".

What could replace the dollar as reserve currency?

However, nothing lasts forever. And beyond all the short-term reasons to fret about the dollar, there are some longer-term moves happening. Eichengreen reckons there are two potential rivals to the dollar. There's the euro, already the world's 'second' reserve currency. And there's China's currency, the renminbi, or yuan which some are starting to call the 'redback'.

Now there are plenty of problems with both, as Eichengreen acknowledges. The euro is "a currency without a state" while the renminbi is "a currency with too much state". But China is certainly trying to internationalise the yuan. Just last month the country announced that it "hopes to allow all exporters and importers to settle their cross-border trades in the yuan by this year". The central bank intends to "respond to overseas demand for the yuan to be used as a reserve currency".

Of course, people have been declaring the death of the dollar for years. And when any asset is as widely despised as the dollar is right now, it's usually a bad idea to bet against it. Data from the Commodity Futures Trading Commission (CFTC) last week suggested that short positions on the dollar are at their highest level since January 2008. As Camilla Sutton of Scotia Capital tells Dow Jones Newswires, any shift in attitude could lead to a rapid dollar rally. For now, traders "don't want to step in front of the trend," but "once the shift happens you need to be very quick footed".

And I suspect that the US won't give up the privileges it enjoys from having the reserve currency easily. However, in the long run, the idea of a world where there are three reserve currencies rather than just one is appealing. Why? Because if there's one financial arena that could do with being subject to the discipline of genuine competition, it's the global currency market. Right now, if the Fed wants to wipe out the value of the dollar to give the US an unfair advantage, then it can because there's no real alternative. But if you have a choice of the dollar, yuan, or the euro, then there's more reason for governments to try to preserve the value of their currencies. Until that day arrives, of course, there's always gold.

By the way, if you're interested in trading currencies, I suggest you sign up for our free MoneyWeek Trader email. Veteran trader John Burford specialises in trying to spot turning points and trade against the herd. Sign up here free to learn more tips and tactics for successful spread betting.

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John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.