Bloated deficits endanger dollar’s global status

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Worries about burgeoning U.S. budget deficits are weighing on the dollar and undermining its status as the world’s pre-eminent reserve currency.

Russia and China have been calling for an alternative to the dollar, citing profligate U.S. deficits and finances, but moves by Japan and other developed nations to defend it in recent days staved off the possibility the Group of Eight would have to address the issue at its meeting in Italy this week.

Still, President Obama is likely to get an earful of concerns voiced by other world leaders about the dwindling value of the dollar, which has fallen 12 percent against other major currencies since March.

The dollar’s decline stokes inflation in the United States while causing economic problems for countries such as Russia and Brazil that export oil and other commodities that are priced in dollars. In a perverse chain reaction that took hold in financial markets last year and has re-emerged recently, the dollar’s decline put pressure on commodity prices, leading to a spiral in the price of oil and basic foodstuffs, and driving up inflation worldwide.

While no official action is likely for now, the debate about the dollar’s future has been intensifying as the Obama administration and Congress move to pass a $1 trillion health care bill, consider a second economic stimulus bill and craft other costly legislation that would increase already bloated budget deficits. The precarious effect this has had on the dollar prompted World Bank President Robert B. Zoellick to warn this week that the U.S. must pay attention to the problem.

“The U.S. should take all these [remarks by] commentators as serious statements about the need to preserve the unique status of the dollar as a reserve currency,” Mr. Zoellick, a former Bush administration trade representative, told Reuters news agency, although like many world leaders he stressed that budget cuts should be timed to occur after the world economy emerges from recession. “That means making sure that, after the stimulus plans, to restore fiscal discipline and have a sound monetary policy.”

China, Russia and Brazil threatened early last month to use this week’s summit to push their view that the world needs to start seeking an alternative reserve currency. But Chinese officials more recently backed off and even sought to reassure U.S. leaders in advance of the G-8 meeting, saying they don’t think the dollar will be replaced any time soon.

“The U.S. dollar is still the most important and major reserve currency of the day, and we believe that that situation will continue for many years to come,” Chinese Vice Foreign Minister He Yafei told reporters in Rome.

“You may have heard comments, opinions from academic circles about the idea of establishing a super-sovereign currency. This is all, I believe, now a discussion among academics. It is not the position of the Chinese government.”

Financial markets are particularly sensitive to China’s comments on the matter, because it is thought to hold about 70 percent of its nearly $2 trillion in reserves in dollar-denominated bonds and the value of those investments erodes as the dollar falls. The foreign minister’s statement helped to relieve pressure on the dollar, at least temporarily.

Even Russia, which has become the most vocal critic of the U.S. currency’s role in world commerce, backed off its strident calls for action as the summit neared.

“The dollar system or the system based on the dollar and euro have shown that they are flawed,” Russian President Dmitry Medvedev told the Italian media. “But I am a realist, and I understand that today there is no alternative to the dollar or the European currency.”

While China would like the International Monetary Fund to develop a new sovereign currency to replace the dollar, Russia has been pushing the idea of “regional reserve currencies,” an approach that likely would heighten the role of the Russian ruble in Eastern European and Asian commerce.

Some European leaders have called on the United States to defend the dollar in light of the verbal trouncing it is getting around the world.

“I have just one message,” said European Central Bank President Jean-Claude Trichet. “It is extremely important that the United States of America [say] that a strong dollar is in the interests of the United States of America.” So far, no Obama administration official has complied, although Treasury Secretary Timothy F. Geithner went to China in May to make a case quietly for the trustworthiness of U.S. investments.

“The extraordinary loosening of fiscal and monetary policy in the United States is the main reason the dollar’s dominant reserve status is being questioned,” said David Woo, foreign-exchange strategist at Barclays Capital. Many foreign investors fear that the Federal Reserve has been feeding Congress’ appetite for spending and literally printing money to help finance the U.S. deficits.

But while Europeans and the Chinese may eventually want their currencies to enjoy the “exorbitant privileges” afforded by reserve status - including interest-free loans from countries around the world that hold dollars in reserve - no other country is prepared to make the sacrifices needed to displace the dollar at this time, he said.

China, in particular, would have to allow its currency, the yuan, to float freely in global markets - something it has been unwilling to do because of the advantage in trade it gains from pegging its currency to the dollar.

“There are at present no obvious alternatives to the dollar,” Mr. Woo said, but as a result, “U.S. fiscal profligacy” will continue to push the dollar lower and force up interest rates on U.S. Treasury bonds and other securities.

“The U.S.’s ability to obtain cheap external funding for financing its twin deficits is likely to be curtailed,” he said.

Jamie Heighway, market analyst at Custom House, a Canadian investment firm, noted that the dollar ironically has benefited from news that the U.S. and world economies may be further away from a recovery than previously thought. Throughout the economic crisis, the dollar has intermittently reprised its role as a safe-haven currency for investors fleeing riskier markets around the world.

But those gains are threatened by the renewed talk of diversification away from the dollar at the G-8 meeting, Mr. Heighway said.

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