Is the Dollar’s Status as Main Reserve Currency in Question?

05/19/2009 12:01 am EST

Focus: FOREX

Last week, USD was dragged down by an article from David Walker, the former US comptroller general, saying that the US government bond AAA credit rating is at risk as the effectiveness of the “current financial condition, structural fiscal imbalances, and political stalemate” are questionable.

The dollar's status as a global reserve currency has been under great challenge as the nation is running a high budget and trade deficit. The current situation is similar to the UK after WWII, when sterling lost its status as the world's main reserve currency.

Since the collapse of Lehman Brothers in September 2008, the US government has employed tremendous expansionary monetary and fiscal policies so as to revive the economy. It's estimated that the Obama administration will have sold a record $3.25 trillion in securities in the fiscal year ending September 30. The huge figure scared bond investors as the record pace of borrowing will expand budget deficit and send yields lower.

As over 60% of the US Treasury securities are being held overseas, concerns about the dollar from foreign central banks have increased. Last month, China explicitly called for a new international reserve currency and asked the IMF to explore the use of the special drawing right as an alternative to the dollar. Although the dollar's dominant status will be threatened when worldwide central banks diversify their reserve holdings to other investments from USD, we do not think its reserve currency role will be replaced in the near- or medium-term future.

According to IMF, USD contributed 64% of total foreign exchange reserve as of 4Q08. Although it represented a 0.4% decline from the previous quarter, it's still leading euro (26.5%) by a huge margin.

After WWII, the Bretton Woods System was developed in 1944 as governance of the international financial system. The dollar has been acting as the world's main reserve currency as the US government guaranteed other central banks that they could sell their US dollar reserves as a fixed rate for gold if they wanted.

For other currencies to overtake the throne, it will take a long time, while the suggestion of SDR may not be feasible for the time being. The currency value of the SDR is determined (on daily basis) by adding the values in US dollars, based on market-exchanged rate of a basket of currencies. The currency amount of each currency is fixed and reviewed every five years, while the weight of each currency changes as exchange rates fluctuate.

The SDR value below is calculated using data on May 14, 2009:

*The exchange rate for the Japanese yen is expressed in terms of currency units per US dollar; other rates are expressed as US dollars per currency unit.

Source: IMF: http://www.imf.org/external/np/fin/data/rms_sdrv.aspx

The SDR value is 1.5172.

If euro rises 5% to 1.4242 while other currencies remain unchanged tomorrow, SDR value will become:

The SDR value is 1.545.

Now assume the dollar's dominant status as the main reserve currency has been replaced by SDR. That means the current 64% reserve holdings in USD will be reduced to around 40%, and around 24% of the dollars will need to be dumped by world’s central banks. Practically, more than 24% will need to be sold as such a massive selloff in USD will cause the huge depreciation, which in turn reduces USD's weights in the SDR basket.

In fact, in the current financial crisis we are facing, the dollar has demonstrated its safe-haven characteristic. We have seen the dollar rise against major currencies (except for yen) as investors became risk averse and we’ve seen the dollar decline as there were signs of economic recovery. Although the value of the dollar will fall, the notion that other currencies will replace its status soon is unlikely.

Currency Composition of Official Foreign Exchange Reserves:

By the ActionForex.com Staff

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