Could the dollar lose its status?

May 13, 2011: 10:43 AM ET
dollar, currencies

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CNNMoney guest columnist Scott Boyd is a currency analyst with Toronto-based foreign exchange trading firm OANDA.

Despite the dollar's dominance over the past six decades, some feel it may be time to reconsider the dollar's historical position as the world's preferred currency.

OANDA, MarketPulse
Scott Boyd is a currency analyst with OANDA and contributes to the company's MarketPulse FX blog.

When the U.S. dollar experienced a pronounced devaluation during the last recession, the Organization of the Petroleum Exporting Countries (OPEC) argued against pricing oil in dollars.

OPEC members complained that a weaker dollar resulted in declining revenues after converting to other currencies and some OPEC countries even went so far as to demand to be paid in euros which was particularly strong at the time.

China also joined the chorus of dollar doomsayers warning that it was "reconsidering" including the dollar as part of its foreign currency reserves. China is by far the largest holder of foreign currency reserves with a reported $2.85 trillion as of the end of 2010.

About 65% of this ($1.85 trillion) is held in U.S. securities while 26% ($741 billion) is denominated in euros. Japan also maintains a significant U.S. dollar exposure with nearly $900 billion in its reserves.

As the fastest growing economy on the planet China certainly has the means to build up a considerable reserve fund, but it is America's dependency on deficit financing that makes so many U.S. dollars available for purchase in the first place.

Boehner offers 'red meat' on debt ceiling

The latest estimate is that the deficit for this year will require at least $1.5 trillion in financing to close the operational gap and will push the country's total debt very near -- if not beyond -- the current $14.3 trillion cap imposed by the government.

While the debate over America's debt policy is fodder for another day, the one undeniable fact is that this dependency on foreign creditors places the dollar in peril. A sudden sell-off by one of the larger debt holders would seriously devalue the dollar and set in motion a series of events that could trigger another recession.

If not the dollar, then who?

If the dollar is such a questionable investment, why do central banks continue to buy and hold U.S. dollars? The answer is simple; the U.S. dollar has traditionally been one of the most resilient of the major currencies and has long been considered a "safe harbor" during uncertain times.

Even though this reputation has been tarnished of late, a fundamental question remains; if not the dollar, what other option is there?

The euro? Let's be honest, with emergency bailouts for three Eurozone nations already and counting, the euro carries significant risk.

The British pound? While it can be argued the pound was the global currency before the dollar, the days of the pound serving in this capacity are long gone. Ultimately, anointing any single currency as the reserve currency leaves the investor vulnerable to exchange rate fluctuations.

As you can imagine, China has been less-than-thrilled with the Federal Reserve's ultra-low interest rate policy and the resulting low-dollar valuation over the past few years.

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One possible alternative is a "basket" comprising several currencies and even certain commodities. Using the concept of a basket in this manner minimizes the impact one single currency or commodity could have on a central bank's reserve assets.

Interestingly, such a basket already exists in the form of Special Drawing Rights (SDRs) available through the International Monetary Fund (IMF).

The IMF recently proposed the idea of using these synthetic assets to serve not only as reserve funds, but also as the means for pricing commodities to negate the impact of a weakening dollar.

So far, the idea of SDRs to replace the dollar has never really progressed beyond the discussion stage, but should countries like China abandon the dollar in favor of SDRs, the impact on the dollar's value could be significant.

For starters, the value of the dollar would plummet and consumers would face higher prices.

Assuming the government could even find buyers willing to purchase U.S. bonds, it would be necessary to dramatically increase yields in order to entice investors.

This would add greatly to overall borrowing costs and could compel the government of the day to implement drastic spending cuts to close the deficit gap.

Scott Boyd also contributes to OANDA's MarketPulse FX blog. To top of page

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