US Dollar losing strength but not its throne

The US Dollar has finally chosen the path of a relentless slide downwards that almost everyone has been anticipating. For over two years, most pundits are hoarse from calling the dollar short; few listened but most ignored till October this year when the market acquiesced and acted.

This dramatic turn of events however begs the question, has the mighty dollar that adds up to about 64 per cent of all global central bank's reserves, is about to relinquish its pre-eminent role as the premier reserve currency of choice? The jury on this is still out. Whilst Euro is the next rightful contender, it is still however a distant second, accounting for approximately 20 per cent of global reserves with central banks. But on the other hand for Central Banks around the world, not to partly diversify into Euro would tantamount to throwing money away.

To many economists around the world, if anything that looked certain for a long time, the demise of the dollar was the one. The imbalances created in US economy through over-spending and over-borrowing was simply unsustainable. The current account deficit is only a few basic points away from hitting a record 6 per cent of GDP, and the budget deficit depending how it is calculated is hovering around the 5 per cent range of the GDP. Excess by any measure, and its absolute size can make many countries in this world bankrupt.

These gaping holes have not suddenly appeared from nowhere, but has been growing for the last few years. The consequent foreboding was predictable, but everyone chose to ignore it, including the chief protagonist: the US administration. For the US to run with such an imbalance for so long, and the world to ignore, also needed help from the Asian surplus economies, namely Japan and China, to willingly fund the deficit through their purchase of US Government debts. Not entirely an altruistic act by the Asians, as the purchase helped to keep their own currency undervalued and sustain their export driven economies.

The US administration was hoping that this status quo could go on forever, as it would allow both the government and the consumers to continue with their profligacy, and keep spending like no tomorrow. The market indeed took its time to react; perhaps had waited to see some policy driven corrections to redress the imbalance, but nothing was forthcoming, which is why this time the sentiment had firmly turned against the dollar and the renewed accelerated slide against Euro commenced around October this year. In the last three years the US dollar has lost 35 per cent of its value against the Euro and 24 per cent approximately against the Yen; yet we have not even begun to redress the macro economic imbalances of the US economy.

Speculation abounds about how much further the dollar has to fall before the market regains faith in the currency. If the dollar has to take the brunt of the entire correction by itself then it is conceivable to see a more severely wounded dollar, perhaps another 30 to 40 per cent fall from its current value. On the other hand if the correction is aided by pro-active fiscal policy measures by the US government, and further supported through currency revaluation especially by the Japanese and the Chinese, the Europeans having already taken quite a hit, then we just might see a lesser fall in dollar value.

Whatever maybe the new value of dollar albeit lower than what it is today, it is unlikely that another currency will take up its central global role.

Curiously with the sharp rise of the Euro, there is not too much of an outcry from the Europeans. This is because some of the European economies like Germany have lived through a much higher exchange rates in the early 90's when the German Mark (as a proxy for Euro) was at $1.43. So a little more to go from its current exchange rate of one Euro = $1.34, before the exports to the US really begins to hurt.

The Euro Zone, with its own problem of subdued growth can ill afford a further revaluation, as it will begin to hurt its own exports. It comes as no surprise to learn that the European Central Bank is not too keen for the Euro to become a major contender to the US dollar as a reserve currency. However it has left this decision of an enhanced global role as reserve currency, to be determined by market forces.

Any concerted effort by the global Central Banks, especially those in Asia who are carrying large reserves, to diversify their US dollar holdings into Euro is bound to precipitate the dollar's fall. However, Asian economies with their currency pegged to the dollar, may at least for a short while, have best of both worlds. By diversifying into Euro they safeguard their depreciating dollar investment, but consequent devaluation of the dollar has no effect on their export, owing to the pre-existing peg. Notwithstanding, this is not likely to happen in a rash or haste; whilst indeed a creeping diversification may have already begun a long time ago. In 1999 when the Euro was born, it consisted approximately 13.5 per cent of global reserve, which by the end of 2003 had gone up to 19.7 per cent. Current financial conditions can only add fuel to this process.

Notwithstanding the market imperatives for a rise in Euro's prominence, US dollar as noted earlier is way ahead in the pecking order for reserve currencies. This is partly because of its dominant role as a trading currency of choice between third parties. Also in foreign exchange trading terms, which is driven by amount of real trade and partly speculation, Euro is around 20-25 per cent of global FX trades whilst US dollar has a solid 40 per cent base. So as long as the influential role of dollar in global trade remains, it is likely to remain rooted as the principal reserve currency for global central banks. The Euro will indeed make some headway in percentage terms but dethroning of the dollar is still far away.

Ghalib Chaudhuri, a former investment banker, is currently managing partner of an independent consulting practice based in Singapore.