Global Reserve Currency: Dollar Will Remain King

Includes: GOLD, UDN, UUP
by: Disruptive Investor
Consider the following facts –
  1. Ever since the Federal Reserve was formed in 1913, the dollar has lost 95% of its value.
  2. The United States lost its AAA rating for the first time since 1917.
  3. The U.S. economy is still struggling to get back to robust growth and there is a high probability of QE3 in the foreseeable future (which would further weaken the dollar).
Just with these factors in mind, things look hardly positive for the dollar. Further, one can say with conviction that the debt and economic woes will not be addressed overnight. On the contrary, there is a high probability that the dollar keeps losing its value and U.S. economic growth remains sluggish for years to come.
However, having said all this, I am convinced that the dollar will remain the global reserve currency and Treasuries will still be considered a safe haven in the foreseeable future.
Just as an immediate example, the yield on the 10-year Treasury bond was at 2.56% when the markets closed last week. After the downgrade from AAA status, the yields are currently at 2.37% with trading still on in the U.S. markets. Clearly, with economic and financial woes around, investors are still looking at Treasuries as a relatively safer investment.
In the past, and also after the rating downgrade for United States, China has talked about an option for having an alternative reserve currency. However, in my opinion, any currency, which has to replace the dollar as a global currency, has to do it in an organic manner. Just creating another reserve currency would simply not work.
Coming to the current scenario, I see no currency that is close to replacing the dollar as the global reserve currency.
The fate of the euro is uncertain with the debt crisis deepening in the eurozone. More bailouts, political disharmony among member nations and continued weak economic activity in the eurozone will keep the currency volatile and also prone to disintegration.
Besides the euro, there are no other currencies which would even come close to being credible enough to replace the dollar as the global reserve currency. The Chinese yuan is still miles away from being a potential global reserve currency.
I would like to add here that I personally do consider gold as a strong currency. Asian Central banks are increasing their exposure to gold in order to protect the value of their reserves. However, it is difficult to imagine global transactions taking place in gold. Therefore, the dollar remains as the global reserve currency by default.
It is also important to understand that the fiat currency system is largely based on trust, which other countries and traders have on a currency. As long as the confidence remains, the currency survives. With around 60% of global reserve assets still held in the dollar, there is hardly any indication of massive flight away from the currency.
I do admit that several Asian countries are looking to diversify their holdings. However, this process is a gradual one and any rush to diversify away from the dollar would be more harmful for the currency reserve holders than the United States.
Another critical factor supporting the dollar’s status as a reserve currency is the perception of Gulf countries and the stability of the dollar. There is no indication from Gulf countries that they intend to move away from the dollar for oil trade. Further, the United States shares a high degree of political and strategic relationship with some key Gulf member countries. This ensures that the dollar would not be done away with for oil trading in the foreseeable future.
In conclusion, the dollar might be a weak currency, but we have relatively weaker currencies. The United States might be having big economic woes, but we have Europe struggling even more. The debt ceiling might have been raised in the United States, but we have a series of bailouts in Europe. The U.S. rating might have been downgraded, but money is still flowing into Treasuries.
In other words, on a relative basis, the United States and its currency might still be better. There is no doubt that the world is witnessing a shift of power from the Western World to Asia. However, the dollar still has a long way to go before anyone can think of dethroning the king.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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