-Jane Foley is research director at Forex.com. The opinions expressed are her own.-
If there is one foreign exchange story that will run and run it is the one about the U.S. dollar (USD) and its future as the world’s dominant reserve currency. The discussions on this topic have at least brought some agreement, namely that there is no clear alternative and therefore there can be no quick fix change. That said, much uncertainty remains as to what can, if anything, eventually replace the dollar.
The basis for questioning the USD’s position as global reserve currency stems from its declining value and its "poor" fundamentals. The dollar index is currently trading close to where it was 14 mpnths ago, ahead of the financial crisis. At that point the USD had been on a downtrend for over two years. The widening in the U.S.’s budget deficit this year has worsened the fundamental backdrop and drawn attention to its "twin deficits". This has made creditor nations nervous.
So, how bad are these fundamentals?
The U.S. current account deficit this year has actually improved. However, once the U.S. recovery gets underway, many expect to see the current account widen again. Textbooks suggest that a current account deficit should lead to a downward adjustment in the currency which will help address the imbalance. This is not always the case. Australia presently has a current account deficit of around 4.5 percent of GDP and the effective Australian exchange rate has rallied by 27 percent since January 1, 2009.
Current account imbalances, while always a potential currency negative, only weigh if international savers become less keen to fund it. Investment decisions will be determined by other factors such as relative growth and interest rates, political stability and fiscal coherence. A huge USD negative this year has been the widening in the budget deficit to potentially 11 percent of GDP from 4.7 percent in 2008. This implies huge bond issuance.