As countries diversify, US dollar vulnerable

Still, no other currency appears ready to take over the dollar’s dominant role in foreign exchange markets in the foreseeable future, which will likely prevent any precipitous fall in the greenback, the analysts and strategists said at the Reuters Investment Outlook Summit in New York.

Comments by Russian President Dmitry Medvedev suggesting a need for a global reserve currency other than the greenback highlighted the challenges facing the dollar — and sent it sliding across the board. Just a few months ago, China had suggested how the dollar could be replaced as the world’s main reserve currency.

The United States’ expansionist fiscal and monetary policies, which are raising fears of inflation down the road that could erode the value of the dollar, is surely driving diversification out of dollar-denominated assets, analysts said.

“What you are seeing is dissatisfaction with the dollar as the world’s reserve currency,” said Steven Englander, chief foreign exchange strategist for the Americas at Barclays Capital. Nouriel Roubini, the economist known for predicting the current financial crisis, said the main fear haunting investors is that the United States could allow inflation to return or the dollar to devalue as a way out of its debt problems.

“Over time, the willingness of the US creditors to finance (US spending) and buy dollar reserves is going to be reduced,” said Roubini, chairman of New York-based economics research firm RGE Monitor.

The dollar has weakened whenever talk about an alternative reserve currency makes the headlines. Calls for currency diversification have come mainly from emerging economies such as Brazil, Russia, India and China, or the BRIC nations.

In their first summit held in Russia, leaders of the BRIC countries called for “a stable, predictable and more diversified international monetary system.”

They did not make any direct reference to the dollar in their final statement. Although the dollar had strengthened considerably against the euro from March through the beginning of June, it has weakened in the last two weeks since talk of diversification away from the greenback reemerged.

Despite its growing weaknesses, the dollar will retain its reserve currency status for a considerable period of time for lack of better candidates.

“That diversification is happening very slowly, but it is important to recognise that the dollar has that position as a reserve currency because so much trade in the world takes place in the form of dollars,” Abby Joseph Cohen, senior investment strategist at Goldman Sachs, told the Reuters summit.

She expects most global trade will likely remain denominated in dollars for a long time, despite diversification efforts by some countries.

The United States also has a deeper and broader fixed-income market than any other nation, which is essential for a global reserve currency, Cohen added. Robert Prechter, founder and president of Elliott Wave International, said potential substitutes for the dollar would face problems similar to those haunting the greenback now.

“All the currencies, all the credit created in the various currencies is in trouble. That means dollar credit, euro credit, yen credit, all types,” he said.

Prechter is one of the few economists who is “extremely bullish” on the dollar. He believes the US currency, which has been a traditional safe-haven investment, is poised for a “major move up” as soon as financial markets crash again, after investors realise the global economy is not recovering as expected.

Others, such as Greg Peters, Morgan Stanley’s head of global fixed-income and economic research, say that lack of credibility in US policies will keep undermining the value of the dollar.

“Right now I’m not convinced that we have the proper credibility to say that we have a strong dollar policy. I think the markets are capitalising on that,” said Peters.