The Mighty Dollar

The US dollar is like stock in America and lately it's been taking a beating. Since the financial crisis eased at the end of first quarter of 2009, the dollar has slumped and as of early August, was trading at its lowest level against most of the major currencies since the failure of Lehman last September.

The dollar's woes are well known. As a unit of measure and a symbol of America, it is weak. Central banks are diversifying their massive reserve holdings away from the dollar. Numerous countries, including China, Russia, Brazil and India, want to have their imports and exports invoiced in something beside the dollar. Spearheaded by China, efforts to reform the international monetary order and diminish the role of the dollar have appeared to gain momentum in recent months.

Many market participants and the media are repeatedly telling this story. It is so ubiquitous that we take it for granted, almost intuitively. There is only one problem with it: the facts.

Begin with the dollar's decline. It is true that dollar has fallen a bit, but do not lose sight of the forest for the sake of the trees. The dollar's recent decline needs to be put in a larger context. As of August 3, the dollar was 7.4 percent stronger against the euro compared to a year ago and nearly double that against sterling. The Australian dollar, backed by higher interest rates, supported by higher commodity prices and the proximity of China, the fastest growing economy in the world, is off nearly 10 percent against the dollar over the past year.

When one buys a share of stock or a bond, one is acquiring an income stream (return) that can be modelled and valued. Over time, those returns must compete with other investment returns and because of this, become anchored into the business cycle.

Currencies in their pure form do not generate an income stream. Valuation is much more elusive. Currencies, including the dollar, do not have a predictable relation to the business cycle. Sometimes, high interest rates (referring here not only to policy rates, like the Fed funds rate) attract money and drive a currency up in value. Other times, it is the currencies with low interest rates that strengthen. In fact, of the major currencies, only the low-yielding yen appreciated against the dollar over the past year and did so by an impressive 13 percent.

This also means that sometimes a currency can appreciate despite a weak economy. After all, the dollar appreciated markedly during the steepest parts of the economic contraction. Now, as there are signs that the long-awaited recovery may be at hand and the S&P 500 has rallied more than 50 percent off its early March lows, the dollar's decline has gained pace.

What about the central banks? Surely, foreign central banks, which hold several trillion dollars in reserves, are diversifying away from the dollar. The IMF is the most authoritative source of reserve data. However, even there, the data is incomplete, because some countries, like China, do not report the allocation of their reserves.

With that caveat, the data is fairly clear. A number of factors, besides simple pro-active accumulation, influence reserves such as through intervention. These include the swing in value of the currencies and the investment portfolio (largely bonds) and the yield payments. The dollar's share of global reserves appears fairly stable around two-thirds. It remains by far the most important reserve asset.

The euro, Europe's single currency, is second. It accounts for about 25 percent of the world's reserves. In the years prior to the run-up to European Economic and Monetary Union that created the euro, the ECU, German mark and French franc accounted for roughly a quarter of the world's reserves. This means that ten years after the euro's birth it remains no larger than the sum of its parts. If there has been a shift in reserves, the IMF data suggests it has been away from the Japanese yen and toward the British pound.

The dollar is not only a reserve asset, but it is also the key metric in the world economy. The price of various commodities ó from energy and precious metals, to food, fibres and industrial commodities ó are priced and traded in US dollars. There may be countries like Iran, Venezuela, and Russia that may accept other currencies, but this is the exception that proves the rule.

The dollar remains the main invoicing currency. More than half of Italy's exports, for example, are invoiced in dollars, not the euro, even though the US absorbs less than a tenth of Italy's exports. When Australia sells China iron ore, or when most of East Asia sells an electronic component, the dollar is more often than not the benchmarking and invoicing currency.

The US dollar remains on one side of around 90 percent of the foreign exchange trades, which in 2007 averaged around $3.2 trillion a day, according to the Bank for International Settlements. When central banks intervene, they do so mostly against the dollar.

While there have been calls for international monetary reform, there is no clear alternative to the dollar on the investment horizon. European markets are still not fully integrated. The European bond market is more like the US municipal market, with many different issuers, generally small issues, with different issuing schedules, conventions and tax regime, than the US Treasury market.

Europe is preoccupied with some combination of broadening and deepening of its union. It is the great experiment of our time: Can there be monetary union without political union? It is interesting and important, but it is not the stuff that makes for a numeraire. China has not nearly developed its financial institutions enough to supplement, let alone supplant, the dollar. Its currency, after all, is not even fully convertible. China needs to deepen its capital markets and bolster transparency and the rule of law before it can truly offer much of an alternative.

Despite its blemishes, there is simply no realistic and compelling alternative to the dollar.