Is the US Dollar in Jeopardy of Losing its Status as the World Reserve Currency?

February 10, 2012

BY: Robert Hallberg, Topics: US Dollar

A weak economy, skyrocketing debts, and endless money printing has been an ongoing story in the US for the last couple of years. Given these set of circumstances one may wonder why the dollar hasnt lost more of its value. Perhaps its because all those other currencies arent much better or maybe its because the US dollar is still the reserve currency of the world used to settle international trade.

The US dollar became the world reserve currency during the middle of the last century at a time when the pound sterling was losing its reserve status, as more and more people were gravitating towards the US dollar. Then during the early 1970s the US asked Saudi Arabia to only accept US dollars as payment for oil and to invest their surpluses in US Treasuries. In exchange, the US pledged to protect Saudi Arabian oil fields from the Soviet Union and other possible threats, such as Iran and Iraq. By the middle of the 1970s all members of OPEC was using dollars as payment for oil and from this monopoly the dollar slowly became a global reserve currency for most commodities and goods. The result was a huge increase in demand for US dollars, propping up its value.

This privilege has given the United States the ability to print huge amounts of money to fund domestic programs at home and military spending overseas. The inflation has been largely absorbed by foreigners trading and saving dollars overseas.

Nevertheless, the ongoing money printing and abuse of the dollar have gradually eroded its value. Many foreigners have become reluctant to store their reserves in a depreciating currency, and here are now clear signs that the dollar might be on its last leg.

The cracks in the foundation of the dollar system have become more and more evident. First, the US lost its triple A credit ratings and more downgrades are expected to follow. Secondly, the Fed has embarked on open monetization through quantitative easing and the Fed is now the largest holder of US treasury bills. Third, we have negative real interest rates even by using government numbers, with inflation running at 3.2% and bond yields around 1.9%. Furthermore, foreigners are already dumping the dollar and setting up alternative payment mechanisms for conducting trade.

Whether the US dollar falls out the sky or loses its reserves currency status over a longer time period, remains to be seen but the process is already in motion. The amount of dollars held by central banks around the world has already been decreasing over the past decade. The chart shows the US dollars and pound sterling held as reserves by central banks.

The pound sterling was the reserve currency used to settle international trade before the US dollar took its place. As the world slowly turned away from the pound sterling it gradually lost its value and influence. During a 50-year time period the pound lost 80% of its value against the dollar and 99% of its value against gold. The chart below shows the USD/GBP exchange rate since 1935.

Perhaps this is what awaits the US dollar. The trend away from the dollar is already in motion but its still unclear what will take its place. Perhaps it will be the Chinese renminbi, SDRs, or may be gold. Regardless, I urge any prudent investor to buy gold as protection against the decline of the dollar.

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