U.S. dollar faces threats to its reign

War spending, trade deficits, and devaluation against foreign currencies weigh on the greenback.

from the June 2, 2008 edition

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Today oil and most other commodities are priced in international trade in dollars. A few nations, including El Salvador, Panama, and Ecuador, have adopted the dollar as their national currency. They thereby lost the benefit of seigniorage, the free money governments receive when they issue new money. More than 100 nations do not allow foreign exchange markets to set the value of their currency, pegging its value to the dollar or euro by buying or selling that currency in those markets.

But with the jump in the price of oil and the tumble in the dollar, the psychology of world financial markets and perhaps central bankers is changing.

For one thing, the dollar has a serious competitor now – the euro, says Robert Hormats, vice chairman of Goldman Sachs (International). Euro member nations had a combined output of goods and services of about $12.7 trillion last year, not too far from that of the US. It also has a major financial market, even though it doesn't include that of London. Britain has stayed outside the euro area.

Already, central banks hold close to 30 percent of their international foreign exchange reserves in euros (about $1 trillion), a currency created in 1999, notes Mr. Hormats. Bankers are hedging against further drops in the dollar.

Another trend is for nations to peg their currency to the euro or a basket of currencies, which may include the dollar. In effect, both governments and private investors are seeking to diversify their international investment portfolios.

An IMF Working Paper (not official policy) released last week noted that "a sudden decrease in the willingness of nonresidents to continue funding ongoing trade deficits" [such as that of the US] could lead to a "currency crisis" with "a critical number" of nations switching their currency pegs or letting foreign exchange markets decide the value of their currencies.

Investors "are in the middle of hedging their bets," says Hormats, buying oil and other commodities on the futures markets. Such moves reflect concerns about US budget deficits, its dependence on imported oil, and a lack of consumer savings.

Some US hedge funds are now betting that certain Middle East nations will drop their dollar pegs and let their currencies soar. Last year Kuwait pegged its currency to a basket of currencies. Qatar has talked about doing the same. Ukraine last week altered its peg against the dollar to make its hryvnia more valuable.

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