Why There Can Be No Alternative To The US Dollar

Will the dollar maintain its key currency status? Or will the euro or the yen take over until some later date when China has become a formidable economic and financial colossus?

Doubts about the supremacy of the US dollar have arisen periodically since the second world war. There was more than just a glimmer of doubt in the early 1960s when the US started to have a noticeable payments deficit. The Federal Reserve tried to allay this problem by holding up short-term interest rates. In the 1970s, questions were raised about the sustainability of the US dollar as the key reserve currency when the US abandoned the gold standard, inflation rose sharply and huge transfers of wealth took place due to the explosion in oil prices. In the 1980s, market gyrations induced the countries of the leading currencies to cobble together the Louvre and Plaza accords.

Those attacks on the dollar were of greater magnitude than the latest setbacks and the economic and financial backdrop then was more perilous. Yet the US dollar remained the world's dominant currency then and it will continue to be the dominant currency now, for the following reasons.

First, the US is, and will remain for some time to come, the world's only superpower. This status is usually accompanied by currency supremacy.

Second, US economic growth next year will probably be significantly stronger than in the eurozone and Japan. In the US, real gross domestic product will probably increase by 3 to 3 1/2 per cent, compared with 2 to 2 1/2 per cent for Europe and Japan.

Third, a dramatic 1970s-style outburst in the US inflation rate is unlikely. The increasing globalisation of economic activity will not allow it.

Fourth, a key reserve currency needs the backing of large, open credit markets, strong, diversified financial institutions and a central bank cognisant of its global responsibility. European and Japanese financial frameworks lack the depth and breadth of their US equivalents. Some of their institutions are still trying to shore up weak balance sheets or rehabilitate themselves after scandals. Their central banks are not free enough from political influence to have a global vision.

Fifth, the incentives to invest in the US remain quite strong. The yield on two-year government bonds is now about 3 per cent in the US, compared with 2.37 per cent in Germany and 1.15 per cent in Japan. Higher US interest rates are also likely. With the likely prospect of some additional firming of US monetary policy, two-year US Treasuries will probably trade above 4 per cent in 2005.

Sixth, the US has a cohesive political system and tends to be ruled from the centre. Europe does not have a centralised government with fiscal and monetary powers over the entire region and lacks a leader who would speed up centralisation.

In such circumstances, to take pressure off the US dollar and realign economic and financial relationships in a smooth and orderly fashion is beyond the co-operative capacity of the major international participants. China would have to revalue its currency upwards by 50 to 70 per cent. Japan, with a high savings culture, would have to encourage its population, which is ageing rapidly, to become bigger spenders. Europe would have to allow enlarged deficit spending and an easing in monetary policy. The US would need to pull back on the throttle and raise interest rates faster than the current policy of a "measured pace".

The most likely outcome is that both China and Japan will yield very grudgingly. Both will continue to acquire a large volume of US Treasuries. For the time being, this serves a useful purpose for both. Japan, with its own large budget deficit, pays to its creditors somewhere between 1 and 1 1/2 per cent and receives around 3 per cent from its holdings of US Treasuries. In the jargon of Wall Street, this is a pretty fair "carry-trade", especially when the risk-taker is the government and not the private sector. For China, US Treasuries are very attractive assets with which to back up the country's weak banking system. Europe has its own somewhat mercantilist attitude, inadequate governmental capacity and many structural rigidities. As a result, the euro will be caught in a squeeze. In the near term, its value will rise against the dollar, perhaps by more than the Chinese and Japanese currencies. Europe will be disadvantaged globally. For the foreseeable future, even though the US has a very large budget and current account deficit, there really is no alternative to the dollar as the key reserve currency.

The writer is president of Henry Kaufman & Co and author of On Money and Markets: A Wall Street Memoir (McGraw-Hill Trade)