Why the world is backing away from the US dollar

Dollar

World central banks used to just talk about diversification – now they’re actually doing it

BY Edward Helmore LAST UPDATED AT 08:25 ON Tue 13 Oct 2009

Another day, another warning on the dollar. According to a Bloomberg report, central banks flush with record reserves are increasingly rejecting the greenback, further pressuring the world's reserve currency after its largest two-quarter drop in almost 20 years.

In a significant reversal, the euro accounted for half the accumulation of central bank surpluses over the spring and summer with the yen receiving 12 per cent. And it's a trend, reports Barclays Capital, that appears to be accelerating.

Central banks with cash surpluses are buying non-dollar assets with greater enthusiasm as it becomes clear emerging market economies will pull out of recession sooner than the US.

The bank says this movement is the culmination of what currency traders fears. "No one wants to be caught holding too many dollars," says Steven Englander, chief US currency strategist at Barclays in New York.

"Global central banks are getting more serious about diversification, whereas in the past they used to just talk about it. It looks like they are really backing away from the dollar."

At the root of concern is a self-evident conflict: the US economy is going to require more stimulus spending yet the deficit outlook threatens the willingness of foreign governments to continue buying US debt and, by extension, presents a significant long-term threat to the dollar.

This year the US Treasury is offering a record amount of debt to finance the 2009 $1.4tr budget deficit. The Obama administration, while publicly talking up the greenback, is quietly tolerating its slide in value - at least until it has to pay higher premiums to continue borrowing.

With the national savings rate at zero, US borrowings are supplied entirely by foreign parties who already hold half the national US debt, noted Roger Altman, former United States Deputy Treasury Secretary under Bill Clinton, in the Financial Times.

Altman says recent gloomy economic data places Washington in a "nearly impossible" fiscal situation. "It is just a matter of time before global financial markets reject this fiscal trajectory." He predicts a sharp and panicky decline in its currency if the market loses confidence in a nation's fiscal policy.

The counterveiling view is that currency diversification is hardly new and has already been discounted by the market. New flows may be going into other currencies, but no one is selling existing US holdings. And should fear come back - as many believe it will before any sustained recovery takes hold - money will flow back to the dollar.

Nor, reasons the New York Times Nobel Prize winning columnist Paul Krugman, is the falling dollar necessarily a bad thing. "The dollar rose at the height of the financial crisis as panicked investors sought safe haven in America, and it's falling again now that the fear is subsiding," he argues. "And a lower dollar is good for US exporters, helping us make the transition away from huge trade deficits to a more sustainable international position." · 

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