The future of the US dollar

The future of the US dollar

The future of the US dollar

Prospects for high fiscal deficits and inflation will likely continue to weigh on the US dollar. The euro stands to gain thanks to its more stable macroeconomic environment. Some emerging market currencies should also appreciate versus those of developed countries.

Powerful trends are eroding the US dollar’s strength

The US dollar has been battered in 2009, and it seems likely that the greenback will weaken on a structural basis. We expect that the USA’s high and increasing government debt levels and its large current account deficit will weigh on the US dollar for the foreseeable future. Additionally, we expect the US may experience higher inflation than other countries, further burdening the dollar. However, there is no ready substitute for the dollar in global trade and as the world’s reserve currency. Given that so many countries have their savings in the US currency, a dollar collapse would be universally resisted.

Central banks will seek to diversify their forex reserves

The reason for the dollar’s strong grip, despite its myriad problems, is straightforward: network effects – the cumulative benefits of having a single, dominant reserve currency– are of considerable value to the global economy. Given America’s profound economic problems and the general demand for a more diversified currency portfolio among official and private investors, we expect the share of dollars held in international portfolios to decline. In sum, we think the US dollar is likely to slowly lose its absolute dominance. Over the past 20 years, the US has been able to deploy vast amounts of dollar-denominated assets around the globe thanks to the dollar’s status as the world’s reserve currency. But over the next several years, the US will continue to rely on foreign investment flows to finance its huge trade and fiscal deficits. This means that any shifts in foreign exchange reserve holdings must occur gradually and deliberately in order to prevent any risk of a dollar collapse.

A multi-currency reserve framework may slowly emerge

While the euro may be the strongest contender for the US dollar’s status as the world’s reserve currency, the Eurozone’s heterogeneous political structure limits its chances, much as Japan’s towering debt-to-GDP ratio hinders the yen, while the limited convertibility of the Chinese yuan also creates obstacles for its adoption globally. Since there is no single currency waiting in the wings to take the dollar’s place, we think a multicurrency reserve framework, with the US dollar playing a central role, seems the most likely development.

The currencies of developed countries that export natural resources, such as Australia, Canada, New Zealand and Norway, tend to move with commodity prices. In our view, so-called commodity currencies are likely to prove a strong store of value and appreciate against a weakening US dollar.

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