As if high unemployment, huge government deficits and a shaky economic recovery weren't enough, the credit crunch may soon inflict another indignity upon the U.S.
We all may soon bear the enormous costs that would come about if the world stops using the dollar as a reserve currency -- something akin to using U.S. chips in the global casino.
It's a worst-case scenario, and, of course, it might not play out. But it's worth a look to see how investors could protect themselves -- and profit -- from not just this scenario but the continued slide that could cost the dollar its favored position. The dollar has taken a beating, and it is going to keep falling.
Since January, the dollar has dropped about 9% against the euro, from $1.36 per euro at the start of January to $1.48 recently. Compared with a basket of foreign currencies weighted by trade, it's fallen 11%. (Click here to see how the dollar is faring today.)
I'll have some strategies and picks later in this column, but first let's look at what all this reserve-currency talk really means.
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A status symbol
Since World War II, the U.S. dollar has held special status for a simple reason: The biggest players in the global financial markets prefer to park their wealth in the currency of the country that looks the most stable.These players, including China, European governments and those of the oil-rich nations, have gone with the U.S. because of its military might, conservative budget policies, stable political system and rule of law. They also use the dollar when they trade with each other.
Now, though, as concerns grow about the fallout from the enormous borrowing in the U.S. to fight the credit mess, this status may be slipping away. The potential impact is so high it could permanently impair growth prospects in the U.S. Here's why:
The dollar in demand
Currently, global demand for dollar-based assets pushes up the prices of U.S. Treasurys and other bonds. This reduces yields, the interest paid to people who agree to buy that debt."We can issue debt without having to attract foreign buyers with higher interest rates," says Andrew Busch, a foreign-currency expert with BMO Capital Markets in Chicago.
The savings these low rates generate are so big that if they went away it would slow U.S. growth to the point where everyone's standard of living would take a hit, says Mark Zandi, a co-founder and the chief economist of Moody's Economy.com. Signs that demand for the dollar is waning keep popping up:
- Big players around the world seem to be backing away. "The gap between the growth of global foreign-currency reserves and foreign official buying of U.S. assets is near a record high," says a recent report from currency experts at JPMorgan Chase. It looks like some may be avoiding dollar-denominated government debt to reduce exposure to budget problems in the U.S., Busch says.
- Last week, a British newspaper, The Independent, said oil countries in the Middle East along with China, Russia, Japan and France are plotting to substitute a basket of currencies for the dollar in oil trading. Many of the identified countries denied the report, but the buzz created by the article "just shows the vulnerability of the dollar," says Axel Merk, the manager of the Merk Hard Currency Fund (MERKX).
- In March, China caused a stir in the currency markets when it called for the dollar to be replaced as the world's reserve currency. Russia has said it wants a new "global supercurrency" to replace the dollar. And last week the United Nations called for a new global reserve currency to substitute for the dollar.
Despite these rumblings, the dollar's status could be safe for a while longer for a simple reason:
"The U.S. markets are the deepest and most liquid in the world," Merk says. No other currency market can handle the amount of cash that flows around the world on a daily basis.
Video: Fallout from the falling dollar
"It is really the only 'bank' that is big enough to hold the transaction volume where people have instant liquidity and political safety on a 24-7 basis," agrees Fred Dickson, the chief market strategist for D.A. Davidson.
But longer term, "everything is up for grabs," Busch says. Much depends on how well lawmakers and the Federal Reserve can balance the risk of inflation with the huge debts run up trying to stimulate the economy.
Continued: Why the dollar will go down
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