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Friday, March 12, 2010

U.S. Dollar Still World's Most Trusted Currency

USA Today

The U.S. will spend about $1.8 trillion more than it gets in revenue this year. Next year, it will add an estimated $1.2 trillion to the debt.

Expenses in the billions may not attract much attention these days, but when it gets to the trillions, people sit up and take notice. In a CNN/Opinion Research poll conducted in January, 83% of those polled thought the federal budget deficit was extremely important or very important. The debt and the deficit are enormous political issues and will likely play a big role in the 2012 elections.

But there's one big group that's singularly unimpressed by the size of the deficit: the world financial markets.

As big as the U.S. debt is, it's not as bad as many other countries' debt, relative to gross domestic product. No other country has a currency as strong or as well-regarded as the U.S. has, even with its current fiscal woes.

Could the debt eventually push the U.S. away from its status as a reserve currency and into second-tier status?

"It's very difficult for a reserve currency to lose that status," says Kristin Lindow, vice president at Moody's Investors Service. "It takes another nation to take its place, and right now, there isn't one."

As long as the U.S. looks better fiscally than other nations, it will be able to finance its deficit. But that doesn't mean it can continue to bleed red ink forever. In the short term, interest rates are likely to remain low as the Federal Reserve tries to nurse the economy out of recession. In the long term, however, unchecked borrowing could lead to higher interest rates and slower economic growth. As such, the debt has serious implications for savers and investors.

Fears of dire economic consequences have mounted as the U.S. annual budget deficit has soared — and the warnings aren't just coming from Republicans. President Obama last month created a bipartisan panel to rein in the nation's deficits. In November, Treasury Secretary Timothy Geithner called the deficit too high. And Federal Reserve Chairman Ben Bernanke is worried about the deficit, too.

"We have a debt that will continue to grow," Bernanke told Congress in February. "It's important to look at the deficit as it goes forward."

But even though the nation's debt, relative to gross national product, is the highest since World War II, the financial markets seem unconcerned. Investors eagerly buy our debt and use the dollar as the premier trading currency worldwide.

Auctions tell a tale

To get some idea of the demand for Treasuries, just look at the most recent auction. On March 8, the government sold $136 billion in Treasury bills — short-term, government-backed IOUs. Of that, about $29 billion was new debt. The rest was rolled over from maturing debt.

You'd think that a borrower that added billions more to its debt each week would be getting the stink eye from lenders. But not when the borrower is the U.S. government. Monday's Treasury auction was an astonishing success: Investors bid $4.27 for every $1 of debt the government had to sell. The yield: a rock-bottom 0.15%. That same day, the dollar was in the middle of a two-month rally. A stronger dollar means a buck buys more of a given currency. A euro cost $1.37 on March 8, down from $1.51 on Dec. 3.

And the dollar remains the premier currency of world trade. Oil is bought and sold in dollars, for example, and more than a dozen countries, including China, peg their currencies to the greenback. About 61% of bank foreign reserves are denominated in dollars, according to the International Monetary Fund.

So far, there's no other currency that has the liquidity and acceptance of the U.S. dollar.

"From the market's standpoint, other currencies and other economies have more serious and immediate fiscal concerns than we have here," says Brad Tank, chief investment officer for asset management firm Neuberger Berman.

Even though China may grouse about U.S. deficits, it doesn't have many other places to put its reserve currencies. And if China suddenly sold its $1 trillion in dollar holdings, its currency would soar, making its goods too expensive for the U.S., its largest trading partner.

Last year, the dollar got hammered vs. the euro. But the recent debt crisis in Greece is driving home the message that the euro has considerable drawbacks. Greece rattled the European Union by revealing that it had far more debt than previously thought and may need a $35 billion bailout to pay its debts. At the moment, there's no clear system for bailing out EU countries, and traders fear that the Greek problem will spread.

Problems all over

"The Greek problem is only part of the problem," says G. Kenneth Heebner, manager of CGM Mutual, one of the nation's top-performing mutual funds. "Other countries — Spain, Italy, Ireland — have similar problems, and it will take some time to get those problems fixed."

Alternatives to the dollar have myriad drawbacks. The Chinese yuan, which most people feel is an eventual successor to the dollar as a reserve currency, is still pegged to the dollar, and it is not fully convertible to foreign currencies. The British pound, the world's reserve currency until the dollar took over, has its own problems: Britain has an even higher debt-to-GDP ratio than the U.S. does. Japan's debt-to-GDP ratio is nearly 100%, the worst among developed nations, and there simply aren't enough yen in the world to carry the burden of global trade.

What about gold? Although most banks have gold reserves — China and India have added to theirs recently — there just isn't enough of it to handle the world's $60.6 trillion GDP. Mankind has mined about 161,000 tons of gold, most of which is still in use. Those 161,000 tons are worth about $5.7 trillion at today's prices, less than half U.S. GDP.

But not forever

No country or currency stays on top forever, and some see signs that the dollar is already starting to slide.

"The entire sovereign sector is being challenged from the standpoint of deficits and supply going forward," says Pimco bond wizard Bill Gross. "The U.S. is at the top of the heap, but investors are beginning to worry whether the checks are unlimited."

One sign that caution is beginning to creep in: Insurance against U.S. Treasury default cost about a quarter of a percentage point before the 2008 credit crisis. It's now about half a percentage point, Gross says. Pimco writes some of that insurance, he says, because it thinks a U.S. default isn't going to happen. But the premiums are going up because more participants are growing wary.

If the dollar does fall out of favor, it will do so gradually: It took the British pound more than 60 years to lose its reserve currency status, says Moody's Lindow. For example, China remains one of the largest buyers — and holders — of Treasury securities. One reason it buys is to keep its own currency cheap vs. the dollar. But the Chinese have been net sellers of Treasuries in recent months, Gross says.

It's unlikely that the Treasury won't attract enough buyers at an auction, or that the dollar will collapse on the global currency markets, or that the Fed will flood the market with debased dollars to pay the debt. The Fed seems to have stopped pumping money into the system, says Richard Asplund, research director at Barchart.com, and it has stopped buying Treasury securities in the secondary market. Sooner or later, it will reverse course and start taking money out of the system, Asplund said. As a final step, the Fed will start to raise short-term interest rates to ward off inflation.

Even though politicians — and much of the public — are worried about the dollar, few on Wall Street or the world financial markets seem to be.

"You can say whatever you want, but the dollar is the currency of last resort," says Asplund. "It's the currency people want in a crisis."

The financial world is supporting the U.S. debt and the dollar because there's no reasonable alternative at the moment, but it may not be able to overlook the nation's fiscal condition forever.

"When debt to GDP reaches 90%, as it looks like it will, interest rates rise, growth slows and bad things happen," Gross says. "That's the potential going forward — not a default."