The decline of the US dollar

Posted 30 September, 2009

The sun is setting on the US dollar (USD) and a new global currency order is emerging, driven by a chasm-sized US fiscal deficit, historically low US interest rates, rapid recovery of Asia and the rise of the euro.

But first, a little historical background…

The USD became the world’s reserve currency in 1944 as part of the Bretton Woods Agreement. Most international transactions have been in USD ever since, giving it great political and economic power and today, some two thirds of all foreign reserves are held in USD. But in recent years the value of the USD has declined by more than one third and central banks across the world are beginning to pull out. The United Arab Emirates reduced its holding by 50 per cent and China and Russia have also reduced theirs. And now there’s speculation that America’s AAA debt rating could be lowered.

I see four main factors driving the decline of the USD and the rise of a new world currency order.

The first is the health of US finances. Other countries’ keenness to hold USD as reserves is based on the financial soundness of the US economy. But this is being shaken by America’s massive current account and budget deficit. For me, an interesting statistic that sums it up is the fact that there are only some 10 million factory workers actually producing anything in the US. In other words, to stop this massive imbalance between exports and imports the US must produce more and consume less, because currently its main export is bits of green paper. Then there are its debts which have grown by five times since 1980 from $8 trillion to 44 trillion. Every day the US borrows $3 billion just to keep going, and in 2009-10 its budget deficit will exceed $1.5 trillion. This is unsustainable.

Second, many economists worry that over the past decade the US Federal Reserve has put too much money into the economy to keep interest rates low. This weakens the value of the currency and thus decreases the value of other central bank reserves.

Third is the growth of Asia. As Ambrose Evans Pritchard writes in the UK’s Daily Telegraph: “China and rising Asia have reached the point where they can no longer keep holding down their currencies to boost exports because this is causing mayhem to their own economies, stoking asset bubbles. Asia’s ‘mercantilist mindset’ of recent decades is about to be broken by the spectre of an inflation spiral. The policy headache was already becoming clear in the final phase of the global credit boom but the financial crisis temporarily masked the effect. The pressures will return with a vengeance as these countries roar back to life, leaving the US and other laggards of the old world far behind.’

The final factor is the rise of the euro as a better bet. Today around 25 per cent of global reserves are held in euros, and this is growing. OPEC nations along with Russia and China are pushing to redenominate oil payment into euros and Iran now trades more than 60 per cent of all oil trades in other currencies. This means the euro is now big enough to become the new global reserve currency if things go that way. Alan Greenspan said a little while back: “It is absolutely conceivable that the euro will replace the dollar as reserve currency”.

But this could take years. While you can bet your bottom dollar that the USD is stretched to its limit, it remains the currency of the world’s largest economy, and it has no immediate rival as the global reserve currency…for now at least.