Is the U.S. Dollar’s Reign Nearly Over?

On November 23rd, 2010 China and Russia announced their decision to stop using the U.S. Dollar to settle transactions between each other, opting to use either the Chinese Yuan or the Russian Ruble instead.

The bilateral trade agreement was signed in St. Petersburg by Russian President Vladimir Putin and Chinese Premier Wen Jiabao. This development signals further deterioration of the U.S. Dollar’s credibility as a reserve currency.

The last straw may well have been the enormous amounts of money that the Federal Reserve has already dispersed in attempts to stimulate the U.S. economy, in addition to its most recent and quite controversial $600 Billion QE II package that was announced in early November.

Dollar’s Weighting Decreased, Euro Higher in IMF SDRs

Another clear signal that the U.S. Dollar’s supremacy continues dwindling is the fact that the International Monetary Fund or IMF reduced the weighting of the Greenback in November in its basket accounting currency known as the Special Drawing Right or SDR.

SDRs consist of a form of international reserve asset used by the IMF largely to settle their financial obligations. Its value is based on a weighted basket of four currencies: the U.S. Dollar, the Euro, the Yen and the Pound Sterling.

Each currency is given a specific weighting or percentage in the basket that makes up the full value of the SDR, and these weights are adjusted every five years.

In the most recent SDR weight change, the U.S. Dollar’s weighting was just cut from 44 percent to 41.9 percent, while the Euro’s weighting increased from 32 percent to 37 percent, and the Pound Sterling from 11 percent to 11.3 percent. The Yen’s weighting was also reduced from 11 percent to 9.4 percent.

A year before the IMF reduced the Greenback’s weighting, the Governor of the People’s Bank of China Zhou Xiaochuan suggested replacing the U.S. Dollar as a global reserve currency with SDRs.

Central Banks Diversifying into Other Currencies

A great deal of controversy surrounds the “diversification” of central bank reserve assets out of the Greenback and into other currencies. Nevertheless, many central banks have been quietly selling dollars and buying other currencies to hold in reserve instead.

For example, the Russian central bank began reducing its U.S. Dollar reserves — which then made up almost 90 percent of their foreign currency holdings — in 2008. Although still substantial, its U.S. Dollar holdings now make up a more modest 80 percent of reserves.

After Russia, Indonesia admitted that it too was reducing its U.S. Dollar holdings, and it was followed by South Korea, which is the fourth largest holder of U.S. Dollars after Japan, China and Taiwan.

In addition, some oil rich Middle Eastern countries — like Iran in 2008 whose president called the Greenback “worthless piece of paper” — have announced that they will no longer use U.S. Dollars to trade oil, opting to use other currencies like the Euro and Yen instead.

How a Weak U.S. Dollar Affects the World Economy

As the status of the U.S. Dollar as a reserve currency continues to lose luster, its value will also very likely decline over time.

The global economic impact of a weaker U.S. Dollar makes imports to the United States more expensive and therefore affects the ability of world exporters to sell goods in the United States. This tends to have a domino effect as less and less gets sold in that huge marketplace; and more pressure is put on exporters in other countries.

Nevertheless, a softer Dollar tends to benefit industries in the United States as people need to buy domestic goods in the face of higher priced imports.

Overall, the diminished demand for goods in the United States and the lower value of its currency have negatively affected the world economy as a whole, contributing significantly to the global financial crisis.

It is therefore rather unsurprising that many forex traders have found that being short U.S. Dollars makes sense as a long term currency trading strategy in spite of its recent corrective late year rally.

J. Hawk