Three Themes In May (Part I): How Threatened Is The Dollar?

In May, there are three themes which have persisted: the replacement of the greenback as the world's reserve currency, the threat of skyrocketing inflation, and the devaluing of U.S. creditworthiness. Curiously, while there's been no sign that any of these conditions are erupting into fully-fledged long-term trends, speculation that they will has only become more intense. This 3-part series examines these events:
While it's true that the dollar has receded from highs early in the year, that's only because it was so strong amid a flight of cash to Treasury bonds. It's not as if the dollar has fallen off the edge of the charts.

Yet reading all the commentary, it's difficult not to be convinced that some kind of intense devaluation hasn't already happened and that the world isn't now headed towards an international monetary system backed by either the Chinese yuan or by a hard asset such as gold.

"Are the Chinese finally getting serious about loosening their ties to the dollar-and even replacing the greenback with the yuan as the global economy's reserve currency? The evidence is mounting that they are," announced Business Week last week under the headline China's Yuan: The Next Reserve Currency?
Another frantic article titled End of the dollar era puts it more sensationally still:

I tend to agree with Professor Roubini, one of the very few American economists who saw through the bubbles and predicted the crisis long before the actual meltdown, when he says: "While the dollar's status as the major currency will not vanish overnight, we can no longer take it for granted. Sooner than we think, the dollar may be challenged by other currencies, most likely the Chinese renminbi."

The big problem with replacing the greenback in favor of the yuan as a reserve currency is that although it is growing at an astonishing pace, the Chinese economy is nowhere near mature enough to occupy such a role. For the moment, China's growth is almost entirely dependent on exports (around 67 percent), while it has numerous political and economic reforms ahead of itself in the next decade.

Indeed, one of the most overlooked qualities of the U.S. economy -- and by extension its currency -- is the country's political stability.

Other theorists speculate that with inflation on the rise, the only really secure reserve currency source is in gold bars. As I pointed out earlier this month, however, gold wouldn't work as a reserve currency simply because it's a finite resource that would end up causing more problems than it would benefits for rapidly growing emerging market economies.

Why then all the bearish speculation over the future value and role of the dollar? Part of the reason is that economists are terrified that with all the money that the Federal Reserve is printing, inflation will skyrocket, causing dollar-denominated assets to be worth much less. With the U.S. economy in a quagmire, argue others, while China's economy booms, the yuan is a more natural choice.

But for what it's worth, for the moment the talk is pure conjecture. Since March, the dollar has fallen 10 percent vs. the euro, around 8 percent vs. the Thai baht (a good emerging market currency indicator), and it's held pretty steadily vs. the yen. While that's not stellar performance, it is hardly diabolical given the greenback's previous strength.