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By Jane Foley
The discussion on the USD and its future as dominant reserve currency will run and run If there is one story that will run and run in the FX market it is the one about the dollar and its future as the worlds dominant reserve currency. The discussions on this topic over the past few months have at least brought some agreement, namely that there is no clear alternative and therefore there can be no quick fix solution. That said, much uncertainty remains as to what can, if anything, eventually replace the dollar, and more pertinently what does this whole discussion mean for the value and the volatility of the USD going forward. The basis for questioning its position as global reserve currency stems from its declining value and poor fundamentals. The dollar index is presently trading close to where it was 14 mths ago, ahead of the financial crisis. At that point the USD had been on a downtrend for over two years. The widening in the US budget deficit this year has worsened the fundamental backdrop and drawn attention to its twin deficits. This has made creditor nations nervous. So how bad are these fundamentals? The US current account deficit this year has actually improved. However, many economists see this as temporary. Once the US recovery gets underway, many expect to see the current account widen again. Textbooks suggest that a current account deficit should lead to a downward adjustment in the currency which will help address the imbalance. This is not always the case. Australia presently has a current account deficit of around 4.5% of GDP and the effective AUD has rallied by 27% since January 1, 2009. Current account imbalances, while always a potential currency negative, only ever weigh on a currency if international savers become less keen to fund it. These investment decisions will be determined by other factors such as relative growth and interest rates, political stability and fiscal coherence. A huge negative for the USD this year has been the widening in the budget deficit to potentially 11% of GDP this year from 4.7% of GDP in 2008. This implies a huge addition of bond issuance. While poor take up in these offerings would be a negative signal for the USD, to date Treasury auctions have been well subscribed. While supply to date has not caused the USD any clear problems, budget deficits of this size inevitably imply fiscal spending cuts which could weigh on growth potential for a number of years. This suggests limited growth and inflation potential in addition to low short-term interest rates which is a poor dynamic for a currency. While a strong budget position is a highly desirable factor for a reserve currency it is not the only factor. Clearly a reserve currency needs to be fully convertible. This requirement counts the CNY out as a contender for dominant reserve currency for the foreseeable future. The ability to cope with huge liquidity demands from time to time counts out less liquid currencies such as the AUD, NZD and NOK. The EUR fails to fulfil the criteria insofar as there is no single sovereignty. It is still argued in some quarters that differing fiscal policies in the EMU has the potential to lead to friction, while others stress the geopolitical line that the absence of a single policy on defence would for some countries mean that the EUR would be an inadequate USD replacement. This does not mean that the EUR will not take a greater role in the coming years. There are signs that central banks have slightly increased their holdings of EUR along with the JPY this year and this trend may continue. Looking forward the USD is not likely to lose its position as global reserve currency any time soon. It is feasible that talk of a basket of reserve currencies will become more relevant with the EUR and the JPY potentially playing a greater role and perhaps the CNY playing a part in the next decade or so. However, any adjustment in central bank currency reserves will be slow and is unlikely to lead to any additional downward pressure on the USD particularly since creditor nations have an interest in protecting the value of their holdings. This factor suggests there is likely to be a great deal of political interest in smoothing volatility and slowing any additional USD declines. Assuming risk appetite hold ups in the coming weeks, EUR/USD could soon be trading above EUR/USD1.500. However, until the market perceives either an improvement in US fundamentals or experiences another retrenchment in risk appetite, further falls in the USD are likely to remain orderly. For Today's Market Update from the FOREX.com Global Research Team, click here
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