Analysis: Dollar’s reserve status eroding as America shuns austerity

Markets are increasingly rewarding countries embracing fiscal tightening with stronger currencies, slowly eroding the dollar’s long-held reserve status according to foreign exchange specialists.

Thanos Papasavvas, the head of Investec’s currency division, says this trend has been most evident in Britain, where the coalition government’s austerity budget saw sterling propelled to the second-best performer behind the Swiss franc in June.

“Even the euro seems to have found a temporary respite from selling pressure as most of the key players, including Germany, have put forward deficit reduction programmes,” he adds. 

“Unlike the eurozone and UK, the US is behind the curve of fiscal adjustments. With potential for the oversold euro to squeeze higher from cheap levels, the US dollar is beginning to look vulnerable to a bigger sell-off as political gridlock prevents action on the deficit.”

The dollar was rising against other major currencies at the height of eurozone sovereign concerns but recently fell to a 15-year low against the yen.

Stewart Cowley, the head of fixed interest at Old Mutual Asset Managers, highlighted recent attempts by California’s celebrity governor to tackle the state’s habitual $19 billion deficit as endemic of the country’s situation. (article continues below)

While market watchers have been worrying about Greek solvency in recent months, Cowley says California has a GDP comparable to Mexico, Spain or Italy, and twice that of countries such as Australia.

“With a deficit of just over 1% of GDP a year and a gross debt-to-GDP ratio of under 20%, this is hardly comparable to the sort of crisis seen in Europe,” adds Cowley.

“The complication for California is that, by law, they have to balance the budget or make cuts.”

“The US dollar holds a dominant position in the hearts and minds of investors but, over time, that credibility is being eroded”

Cowley says this tussle between borrowing and spending in America has echoes of the priority setting seen in Europe.

“In Europe, we have embraced deficit reduction with the enthusiasm of a zealot, while in the US there is much greater reluctance to balance the books, hence the stand-off in California. All of this makes you wonder which alternative investors will choose—profligate America or austere Europe.”

He notes recent figures from the IMF showing the US dollar’s share of global foreign exchange reserves fell from 62.2% to 61.5% in the first quarter, the lowest level in more than a decade.

“The US dollar holds a dominant position in the hearts and minds of investors but, over time, that credibility is being eroded,” adds Cowley.

Among the most important money holders is China, with $2.4 trillion of reserves, and the country has recently upped flows into the yen.

China bought a net 508 billion ¥($5.94 billion) in short-termJapanesebills in June, extending its buying spree of the country’s debt seen since the start of the year.

Looking forward, Cowley says central banks’ desire to diversify foreign exchange reserves and continual printing of unwanted dollars spells an uncertain future for the currency.