October 28, 2008 / 5:35 PM / in 9 years

U.S. dollar to remain reserve currency of choice

By Nick Olivari - Analysis

NEW YORK (Reuters) - Naysayers who predicted the U.S. dollar’s demise as the world reserve currency of choice have been silent of late given the greenback’s meteoric recovery in recent months.

Slammed over the last several years as U.S. government budget and trade deficits mounted, the greenback was seen ceding its status as the predominant currency to the euro.

Talk of nations reducing their dollar reserves in favor of the euro prompted talk the dollar would also lose favor as the medium of exchange for commodities.

However, the global financial crisis that has rocked markets worldwide has seen investors voting with their cash and buying U.S. dollars, indicating that reports of the greenback’s death as a reserve currency have been greatly exaggerated.

“Talk of the euro replacing the dollar is off the table,” said Michael Woolfolk, senior currency strategist at Bank of New York Mellon. “The U.S. has the only economy in the world that supports a strong currency by policy and is an anchor for the global economy.”

The current credit freeze has its roots in the U.S. subprime mortgage market where overzealous lending in exotic debt products has led to a wave of homeowner loan defaults and problems with repackaged mortgage securities.

But the crisis went global when holders of those mortgage securities faced huge losses and became reluctant to take on additional risk through either lending themselves or buying more securities.

Investors then were quick to understand that the United States was the only nation with the political will to act quickly and the government and private sector infrastructure in place to implement policies. The pockets of the U.S. tax payer to fund a bailout added to the allure of the U.S. currency.

“The United States continues to be the only entity sufficiently large and coordinated enough to deal with the multiple issues surrounding the credit crisis,” said Andrew B. Busch, global FX strategist BMO Capital Markets in Chicago. “It clearly is not over.”

The dollar’s value against major currencies had changed little in the first half of 2008, after a six year slide, but since mid-July when the magnitude of the credit crisis became apparent, the dollar has rebounded significantly.

The Intercontinental Exchange’s U.S. dollar index <.DXY has climbed 21.3 percent since that time, roughly corresponding to a 21.8 percent drop by the euro against the greenback.

The British pound has dropped 23 percent while the Australian dollar plunged 37.5 percent against the U.S. dollar.

Emerging market currencies have been particularly hard-hit as investors fled risk and repatriated funds either home or to the safety of the U.S. dollar.

Latin American-focused funds suffered their 20th straight week of outflows, EPFR Global data showed on Friday, losing a net $134.8 million to redemptions. Europe, Middle East and Africa funds had outflows of $189.1 million.

The U.S. dollar has gained 27 percent against the South African rand since mid-July and 21 percent against the Turkish lira.

To be sure, International Monetary Fund data relating to the first quarter shows the U.S. dollar’s share of currency reserves of central banks around the world had declined to 63 percent from 65.1 percent a year earlier.

That though, was more a function of a decline in the dollar, analysts said, with little evidence of a large shift away from the greenback.

While countries hostile to U.S. foreign policy such as Iran had talked about pricing oil in euros and other nations such as Russia did increase euro reserves, action was always piece-meal.

“Those nations who threatened to move to the euro from the dollar or actually did move in terms of reserves or commodity prices are going to be punished and the ones who didn’t are thankful,” said Andrew Bekoff, chief investment strategist at Meyers Associates in New York.

And with crude oil prices down 56 percent from its peak in mid-July, there is even less incentive to move commodity pricing away from the dollar.

“A stronger dollar will buffer the Middle East (producers),” said Bekoff. “Even though crude is down it is not as bad as it could be if they were selling in euros.”

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