Are investors in the US and abroad losing faith in the dollar?

Stan Honda/AFP
Flags flutter on Wall St. in this file photo. The dollar has reached new lows against the euro for 2009, and it has also fallen sharply against some other major currencies.

A down trend in the US dollar is putting new focus on a longstanding concern -- that the world’s greatest borrowing nation may be growing less creditworthy.

This week, the dollar has reached new lows against the euro for 2009, and it has also fallen sharply against some other major currencies.

It’s a puzzle. Suddenly, investors have less faith in the greenback, even as the outlook for the American economy appears to be brightening.

Many forces drive currencies up and down, but one factor that could be weighing on the dollar is the risk that decades of debt -- by both households, businesses, and the government -- are causing foreign investors to look on the dollar as a more risky asset to hold.

Debt increases perception of risk

All that borrowing, including the cost of President Obama’s fiscal stimulus spending to boost the economy, increases the perception of risk. Are US debtors, from the federal government to the cash-strapped state of California, going to default? Will the Federal Reserve resort to inflation -- debasing the value of dollar assets -- in its efforts to lift a debt-bound economy back to growth?

Such concerns appear to be weighing on the dollar this week, says Jay Bryson, a global economist at Wachovia Corp. in Charlotte, N.C.

Britain in trouble too

One reminder of the risk came from across the Atlantic Ocean, as the rating firm Standard & Poor’s downgraded outlook for Britain’s government debt from “stable” to “negative.” That means Britain could lose its top-tier credit rating of AAA.

“If they can downgrade the United Kingdom, they can certainly do the same thing for the United States,” Mr. Bryson says.

The dollar took a dive on Thursday, and in Friday trading the greenback reached as high as $1.40 per euro, higher than where it stood on Jan. 1. The US currency is also down in recent weeks against the British pound and Canadian dollar.

A bad month or two doesn’t necessarily mean that the dollar will keep falling. Bryson, for example, says he expects the dollar will strengthen this year, as investors focus on the prospects for a quicker economic recovery in the US than in Europe.

Tension in global markets

But the recent dollar downdraft points to a difficult tension in global markets over whether the dollar is a safe or risky asset. It has long been a haven for investors in times of trouble, as the current financial crisis has confirmed. The dollar moved up sharply late last year as global investors fled from private-market chaos to the safety of US Treasury bonds.

But this spring, investors have shown the other side of the coin. With panic receding, some have been focusing more on the long-term risks to the dollar posed by all that debt, and by questions about whether the Federal Reserve is committed to holding inflation at bay.

Bill Gross, who manages giant mutual funds at bond investment firm PIMCO, warned this week that the United States will lose its triple-A credit rating in “at least three to four years, if that.” He told Reuters news service that “the market will recognize the problems before the rating services.”

Britain, which got the warning shot from S&P this week, has government debts edging toward the amount of one year’s gross domestic product. The US government’s public debt isn’t as large, but it’s moving in that direction as the Treasury spends mightily to rescue banks and stimulate economic activity. Meanwhile, the Federal Reserve has been taking extraordinary measures to ease monetary policy, in a parallel bid to end the recession.

Debt at all levels

America’s debt burdens are widespread:

• The federal government is posting record $1 trillion budget deficits.

• Many states are struggling. In the biggest, California, voters rejected ballot measures proposed by Gov. Arnold Schwarzenegger that would have bridged a current imbalance by borrowing and raising taxes.

• Household debt surged over the past decade to about 140 percent of a year’s income, double where it stood in the 1970s and early 1980s.

• Prior to the recession, the financial industry facilitated a credit boom by boosting its own leverage, or borrowing. That business plan worked until the prices of assets like stocks and houses faltered, eventually causing a full-blown financial crisis.

These debt burdens can all weigh on the dollar if they leave investors with the impression of rising risk and diminishing potential returns.

Threat of a credit downgrade

For the federal government in particular, the threat of a credit downgrade has grown in the past year. Federal support has helped to calm financial-market panic, but the result has been new obligations for already stretched taxpayers. Banks, mortgage giants, insurance firms, and automakers have all gotten bailouts. Now some lawmakers are considering whether Congress should step in to help California out of its budget mess.

With big costs for healthcare programs also looming, some financial forecasters see the threat of big declines for the dollar.

“It's not only the foreigners buying US assets one has to be concerned about,” mutual fund manager Axel Merk wrote in a commentary Thursday. “If the trust of Americans erodes in the US dollar, that flight could have rather severe implications.”

Don't "print money"

Mr. Merk, who manages the Merk Hard Currency Fund, says that central banks should pull back “from trying to boost economies by printing money to finance government spending.”

For ordinary investors, funds such as Merk’s are one way to diversify into non-dollar investments. (Exchange-traded funds also offer a stake in single currencies such as the euro.)

Some financial experts say the simplest approach for global diversification is for people to own world stock mutual funds as well as US ones. Foreign stocks may do well, moreover, even if Armageddon scenarios for the dollar don’t come to pass.

For now, many forces in the economy are deflationary, not inflationary. Longer term, strong US economic growth could support the dollar, as long as fiscal and monetary policies are also sound.

Material from wire services was used in this story.

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