Is the Dollar Up for the Fight?

The dollar has taken a beating lately as a result of massive U.S. government debt coupled with a comparatively slow recovery. Adding insult to injury, a number of leading countries have called for its demise as the global reserve currency. But don't count the dollar out yet.

"C'mon fellas, give me a break," was how comedienne Amy Poehler put it when she played the dollar in a Saturday Night Live skit during the pre-euro era. Foreign currencies had been outperforming the greenback and as U.S. importers and overseas travelers could testify, it was not a pretty picture. This year, that scenario has been recreated and updated for the current economic crisis. One powerhouse after another has lined up to declare the U.S. dollar has had its day as the dominant reserve currency. China, Russia, France, India and Brazil have all called for a replacement to the dollar in recent months. "What was true in 1945 can no longer be true today," French President Nicolas Sarkozy said in August. "The dollar cannot claim to be the only currency in the world."

Present and future concerns

These latest concerns about the dollar can be partly attributed to the current economic crisis, in which overwhelming reliance on the U.S. currency has roiled economies through-out the globe. There is also considerable worry about a weakening dollar acting as a roadblock to worldwide recovery, as well as the prospect of inflation decimating foreign reserves held in U.S. dollars.

Nobel Laureate Paul A. Samuelson has warned that a "truly global financial panic" is a likely prospect if countries decide to suddenly unload their huge dollar reserves. And Columbia University economist Joseph Stiglitz has called for "a new global reserve system" to put the world's economic house back in order. But is the dollar down for the ten-count? Will we be awash in has-been greenbacks? Not necessarily, according to a number of observers.

In the view of Wharton's Richard Marston, director of the Weiss Center for International Financial Research, the dollar will probably remain the reserve currency for now, reflecting the dominance of the U.S. economy. But he does see the potential for the dollar "to deteriorate quite substantially in the long run," if the United States is slow to reduce spending as its economy recovers.

"If we continue to borrow from foreign countries to sustain our spending, eventually there will come a time when asset holders around the world will begin to wonder whether the United States is creditworthy," Marston says.

Incumbent advantages

Morris Goldstein, a senior fellow at the Peter G. Peterson Institute for International Economics, shares the view that the dollar is still the strongest contender. He does not see a switch to an alternative as inevitable. "The incumbent reserve has a lot of network advantages, and the only case in which people would be moving away from it is if U.S. economic policy makes them very nervous," Goldstein says. "You'd have to have extremely poor economic performance in the United States - high inflation, runaway fiscal deficits with no prospects of correcting them, and very large trade deficits with no end in sight."

Among foreign exchange strategists, one of the biggest champions of the U.S. dollar is Marc Chandler, global head of currency strategy at Brown Brothers Harriman & Company. In his recently published book, Making Sense of the Dollar, he points out that the dollar's share of world reserves has grown in the last year, not fallen.

"There's no sign of a move away from U.S. dollars taking place," Chandler says. "Even the Chinese, who have been among the most critical of the dollar, have increased their dollar holdings. From June 2008 to June 2009, their store of U.S. Treasuries rose roughly 7 percent." Not all strategists see it that way. Mitul Kotecha, head of foreign exchange for Calyon Credit Agricole CIB, views the fading of the dollar as an ongoing phenomenon.

"The move away from the dollar as a reserve currency is already taking place as reserve holders become increasingly sensitive to their high exposure to dollar assets," Kotecha says. "Central banks have been diversifying their reserve holdings for several years and the share of the dollar in global foreign exchange reserves has been falling."

IMF data

As evidence, Kotecha points to International Monetary Fund (IMF) data that shows the percentage of dollars in foreign exchange reserves falling from more than 70 percent in 1999 to around 64 percent at the end of 2008. He also notes that the share of European currency has increased to 27 percent from 18 percent over the same period.

"Eventually, the dollar will likely find itself sharing the mantle of global reserve currency," he predicts. "But I don't believe the dollar's reserve role will diminish completely. The dollar remains the dominant currency in terms of trade and investment flows and any decline in its role in this respect will be gradual and take place over a number of years."

One of the biggest questions, of course, is what currency would nudge the dollar aside. The continued growth of other contenders, most prominently the euro, is by no means assured. Chandler notes that the dollar derives its strength from the massive U.S. Treasury market, and that the European bond market, by contrast, is fragmented.

"In Europe, there are a lot of different issuers, different conventions, different schedules and different tax rates," Chandler says. "It's like dealing with the U.S. municipals market."

SDR as a Contender

Another contender to replace the dollar, one suggested by China, is an IMF product known as special drawing rights (SDR).

The IMF created the SDR in 1969 to act as a shared currency for international reserves, but it has acted more as an accounting currency among member nations than a trading currency. Initially pegged to the dollar, it is now based on a composite of the dollar, the Japanese yen, the euro and the British pound. Under China's proposal, the IMF would expand the basket of currencies underpinning the SDR to all large economies. Most observers, however, give the SDR little prospect of supplanting the dollar.

"The IMF would have to decide the quantity of SDRs to create, something that could become highly politicized," Kotecha points out. "Moreover, the whole process of weaning investors and companies off the dollar could take years. Overall, the SDR is probably not the answer."

Roughed up though it may be, the dollar is still taking on all comers - and, for the time being, holding its own.

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