May the USD Rest in Peace?

Has the tipping point arrived when the U.S. dollar ceases to be the preeminent reserve currency in the global economy -- a status it has held for 60 years? Such conjecture has been triggered by the recent dip in the dollar against the euro, following on the Federal Reserve's three interest rate reductions -- the latest on Dec. 11 -- that reinforced a two-year slide in the dollar against the euro by 40%. This bit of financial esoterica is not only of interest to financial markets, foreign-exchange speculators and the beleaguered American tourist in the euro zone. Since World War II, the dollar has been held as reserves by other countries in their financial portfolios because of its universal acceptance in the world economy and its stable value. For the country whose currency achieves this status, there are considerable advantages. The United States can run large trade deficits, buying more than it sells in the world, because the selling countries are eager to acquire dollars as reserves. Such trade deficits are in reality debts whose reconciliation can be postponed as long as countries seek dollars as reserves. Political power also derives from this financial reality, as countries become willing to accommodate the reserve currency country in order to gain access to that currency. The euro's introduction was not unmindful of these political and financial power configurations. Today, Hugo Chavez of Venezuela and Mahmoud Ahmadinejad of Iran have joined a group of Europeans waiting and hoping for the dollar's demise. In the backrooms, where financial-political diplomacy is discussed, similar desiderata are expressed by some influential leaders in Russia, China and the oil-exporting countries of the Middle East. Countries make decisions to hold their trade surpluses in a reserve currency based on several considerations: the rate of return, degree of risk, relative strength of economies competing for reserve status, and a more subjective determination of the confidence in a country's decision-making. Risk pertains to exchange rate stability. Holding dollars has made a country's dollar reserves worth less by as much as 40% in the euro zone when the dollars are used to purchase services or commodities from euro zone countries. Over the last several years, and especially in the last six months, these factors have turned against the dollar. Exchange rate risk has risen rapidly. The euro zone economies have started to grow faster, restoring confidence in their near-term economic performance. The rate of return has gone against the dollar, with the three interest rate cuts in fall 2007. Finally, there is a general malaise about the solidity of U.S. policymaking. It started after the Iraq war in 2003 and has deepened with each revelation of new problems raised about American governing competence. Is it any wonder that there would be speculation about the future of the dollar as the dominant reserve currency? Seen from Asia, the Middle East or Russia, those in charge of reserve portfolios must be asking: Is it prudent to place new surpluses in dollars at the same rate as in the past, or should we diversify further into euros? The rate of return is down on dollar assets because of lower interest rates and instability in American financial markets. While future risk rises with a gloomy exchange rate outlook for the dollar, why not place more of our new surpluses into euros? Indeed, the question should be asked: Why haven't major dollar reserve countries diversified more into euros than they have? In 1999, when the euro was introduced, roughly 71% of all reserves were held in dollars; today, it is about 65% (and 25% in euros), a modest decline that largely reflects a natural increase in euros held as reserves in the expanding euro zone among new entrants into the European Union and wannabe members that have started to take reserve positions in euros. While there are no clear movements out of dollars, anecdotal musings have surfaced.For example, Cheng Siwei, vice chairman of the Standing Committee of the National People's Congress, caused financial markets to tremble when he said that China -- which holds $1.4 trillion in dollar reserves and is accumulating dollars at a rate that will add about $500 billion in 2007 -- would invest outside the dollar. Cheng's comments were "clarified" a few days later by Chinese financial officials.The explanation for apparent continuity in holding dollars as reserves can be found in the idea of sunk costs. It is costly to diversify out of the dollar. Any sharp movement would cause the dollar to fall even faster and further, hurting the dollar holders even more than the U.S. Cutting off one's nose to spite one's face is not a prudent financial policy. Some gradual portfolio adjustments at the margin, with more of new dollar surpluses placed in euros, will occur, but this will appear as a continuation of trends and foreshadow a soft landing for the dollar. It could be a hard landing if the Fed continues to cut interest rates. The U.S. cannot be complacent about the sources of the dollar's current weakness. Further interest rate reductions will only hasten the dollar's decline as a reserve currency; continuing trade deficits do the same. Restoring confidence in the United States as a 21st century nation is of the highest priority, and not just for global financial reasons. There is a point, we know not where, at which the cost of holding dollars exceeds the cost of jettisoning them.