Monday, March 31, 2008

Dollar vs. Euro

Following my post: "Why is the Euro doing so well...", a reader asks:

What about the other currencies, it's not just the dollar. Banks have started switch more and more of there reserve currency from the dollar over to the euro.

Good question, so instead of answering in the comments section, I thought I'd do a post. So here's my reading on the situation:

First off, it is not that the USD is just doing poorly against the Euro, it is also faring badly against other currencies as well. I hail from Canada so US$/C$ exchange rates are always of interest. I can tell you that going back up to Toronto to visit friends and family isn't as cheap as it used to be. Friends and family now view us as the poor American relations coming North to mooch off of them.

US$/C$ parity was such a momentous occasion, I actually remember where I was when I first learned of it back in September.

In regards to the question of banks switching over reserve currencies to the Euro, I think the reader is referring to a number of countries, namely China, using a basket of currencies (rather than just the USD) either as a reserve or as a peg.

The reason here is diversification. The dollar is tanking so if you're holding a large amount of dollars (as China is), then your holdings are rapidly declining. If you want to stabilize your holdings and diversify away some of your risk, then you’d want to start holding other currencies.

Essentially all of your value/risk is tied up with one currency and in the current environment, if that currency is the USD then you’re not feeling as rich as you once did.

If you’re pegged to the USD (meaning your local currency has a fixed exchange rate to the USD), then the value of your currency is also declining. For countries that import a lot, a declining currency is putting yet more very unwanted upward pressure on prices. This is particularly worrisome in the Gulf countries where the influx of oil money and their declining dollar-pegged currencies are contributing to huge increases in inflation.

The next question usually is, will the world move off the USD as a reserve entirely? Not likely, IMHO. Too many things are still priced in dollars and the dollar-as-global-reserve is too ingrained in the current system. It would take a huge calamity, greater than the credit crunch we are currently facing, to move the world off the dollar-reserve.