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Friday, June 8, 2012

Why the U.S. dollar remains a safe haven



I am retired and I invest my money in food, housing, transportation etc. and have nothing left for the stock market. Nevertheless I enjoy watching the market and reading business news. No doubt with many others I have always been a bit puzzled by the fact that when the economic seas get choppy and investors opt for risk off they often cling to the U.S. dollar and treasuries as life raft and safe haven.

Everyone knows that the U.S. itself has trillions in debt and is busy talking about jobs and elections and ignoring the financial cliff when tax cuts expire and huge automatic cuts start at the beginning of next year. So what planet are investors on? As the dollar goes up gold usually goes down. According to the market the U.S. dollar must be better than gold! Why is the U.S. dollar seen as a save haven every time an economic storm blows up? Well here is one answer by Michael Casey who is managing editor for the Americas at the DJ FX Trader a foreign exchange news service ,

Casey notes that as talk of the euro-zone ramps up nervous investors flee ""into the "safety" and "liquidity" of the world's dominant reserve and commercial currency."" Casey then asks why the U.S. dollar plays this role.

Casey also remarks that the question rather remarkably is seldom asked. If it is asked the answer is often completely unhelpful. The puzzled respondent may reply:: "It always has" and go back to business.

Casey responds that it should be obvious that the global financial system is broken and that the dollar is sitting on a questionable foundation. As long as the U.S. dollar as the world's prime reserve currency continues so will its role as a safe haven. Fortunately for the U.S. as of now the currency dominance remains and the alternatives such as the Euro or the Chinese Yuan are not attractive.

Casey notes that change will not happen overnight. For now the dollar remains a safe haven. Economic historian Barry Eichengreen a global expert on international monetary matters predicts that within ten years the U.S. dollar will no longer be dominant. However as of now the U.S. represents 80 per cent of all foreign exchange transactions as well as half of international trade invoices. Two thirds of central bank reserves are in U.S. dollars.

U.S. capital markets are deep and liquid so it is a convenient place to park funds while waiting for better investment conditions. Of course your return is not much better than if you put your money under your mattress over the short term at least.

Casey points out that in spite of its safe haven role that the U.S. is not really a bastion of financial stability. The U.S. is almost 16 trillion dollars in the red. The U.S consistently runs trade and fiscal deficits. The U.S. has barely enough foreign currency reserves to cover two weeks worth of imports.

Defenders note the reliability of the U.S. legal system and respect for property rights but investors remember the U.S. financial crisis and blame it on a dysfunctional Washington and Wall Street. The main appeal of the dollar claims Casey is the fact that there are no very attractive alternatives. Casey recommends that U.S. policy makers should now be considering a multi lateral alternative to the dollar.

Casey points out that many countries are already diversifying away from using the dollar. Some countries do this of necessity as Iran to get around sanctions but others do it for convenience. For example many countries such as China and Russia now accept payments in each others currencies.

Because of dollar dominance the U.S. has become addicted to cheap dollars. When Spanish debt is a problem borrowing costs are high but when U.S. debt is a problem borrowing is still cheap. As Casey puts it: "..whenever the Federal Reserve turns to the printing presses--as it will likely do again in another futile bid to fight America's economic malaise--those freshly minted dollars flow into commodity markets and the currencies of emerging markets. That complicates policy-making in those countries, the same ones that happen to be the biggest holders of dollar reserves and thus the ones with the power to demand change "" This explains why China complains about U.S. quantitative easing. Former French President Valerie D-Estaing put the matter eloquently as American "exorbitant privilege." Holders of huge amounts of U.S. debt such as China and Japan may decide that enough is enough. Rather than get a good return on their investments they are getting diluted dollars. Over time new safe havens will be found and the U.S. will face declining dollar influence and increased borrowing costs. For more see the full article

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