The future of the dollar is cloudy at best. It has had a recent bounce, but I see this as temporary.  There are indications that foreign countries are moving away from the dollar. 

This Bloomberg article discusses the US dollar as reserve currency, and yes you should care.  

Dollar Reserve Status Is Tale of Fading Glory

 http://www.bloomberg.com/apps/news?p&refer=columnist_sesit&s

This site seems to edit bloomberg links.  Try copying and pasting this link without the spaces:

http://www.bloomberg.com/apps/news?pid=

20601039

&refer=columnist_sesit&sid=

asyzv2fq7NnA

Dollar Reserve Status Is Tale of Fading Glory: Michael R. Sesit

Commentary by Michael R. Sesit

May 2 (Bloomberg) -- Reserve currency status is like your health: Abuse it, and you risk losing it.

With the dollar's 45 percent decline against the euro during the past six years and its 37 percent drop on a trade-weighted basis, there is a growing concern that the greenback's six-decade reign as the world's most important currency may be ending.

It's not. The dollar is the world's reserve currency, and absent some unexpected exogenous shock, will probably remain so for some time.

Nonetheless, the dollar's premier status is under threat, especially as a store of wealth, by both foreign governments and private investors. Also, companies are using it less as a currency in which to invoice and settle international trade transactions.

Why care? Reserve currency status allows the U.S. government to borrow in its own currency, lets the U.S. run large trade deficits, and helps the government and American companies to fund themselves at low interest rates. It makes it easier for U.S. companies to do business and increases the international demand for U.S. assets.

Moreover, as the specie of choice, the dollar is blessed with seigniorage, the interest-free loan America receives from the hundreds of billions of dollars held overseas and hoarded as misfortune insurance.

Although the composition of official central-bank foreign- exchange holdings receives the lion's share of attention when people talk about reserves, it is the private sector's trade in goods and services that plays a dominant role in determining a currency's international status.

Cash Reserves

Official reserves equal 33 percent of global imports, according to UBS AG. If a company in country A trades with a company in country B and the transaction is invoiced and settled in the currency of country C, that third currency will have reserve status. That's because both companies are likely to keep cash balances in that currency.

``The dollar is the most important reserve currency in the world, but it is no longer the only reserve currency, nor even the overwhelmingly dominant choice as a reserve currency,'' says Paul Donovan, a London-based economist at UBS.

When the Bretton Woods system collapsed in 1971, almost all Japanese exports were priced in dollars. Now less than half are. About 40 percent of Japan's total exports are invoiced in yen, up from 34 percent in 2001.

Raw Materials

Seventy percent of Australia's exports are denominated in U.S. dollars, reflecting the dominance of raw materials in their makeup. Apart from commodities, the dollar plays a smaller role. For instance, 59 percent of beverage shipments to other countries are denominated in Australian dollars, 19 percent in pounds and 16 percent in U.S. currency.

Data on country invoicing patterns are hard to come by. Still, the decline in dollars held outside the U.S. from 1.83 percent of world trade in 2002 to 1.22 percent in 2006 reflects the U.S. currency's shrinking role as a medium of exchange.

Anecdotal evidence also suggests a trend. In November, India's Taj Mahal said it would no longer accept dollars and take only rupees. International drug dealers are said to prefer euros to dollars.

Ditto, Copenhagen-based A.P. Moeller-Maersk A/S, whose container-shipping line, the world's biggest, on April 1 began invoicing in euros for transporting containers from Europe and North Africa to Australia, New Zealand and the South Pacific. The shipping industry historically billed in dollars.

$4.9 Trillion

On the official side, developing countries have been steadily inching away from the dollar. Their foreign-exchange reserves surged to $4.9 trillion in 2007 from $1.2 trillion in 2000. Emerging-market countries accounted for 76 percent of total global reserves in 2007, up from 56 percent in 1997, according to the International Monetary Fund. Yet during that period, their dollar holdings shrank to 61 percent from 73 percent.

The euro has been the beneficiary, rising to 28 percent of developing-country reserves in the fourth quarter from 19 percent when the decade began.

Behind this dollar downgrade lies the U.S.'s rising debtor profile, an unpopular war in Iraq, the growing threat of trade protectionism, apprehension over the greenback's decline and the subprime crisis.

``These factors have all conspired to weaken investor confidence in the buck and undermine the dollar's position as the world's top currency,'' says Joseph Quinlan, New York-based chief market strategist at Bank of America Capital Management.

Asian and oil-exporting central banks also hold more dollars than they prudently need and are seeking to diversify their portfolios away from their traditional preference for highly liquid, relatively low-yielding Treasuries.

No Allegiance Owed

Many countries -- including China, Russia, Kuwait, Singapore and Norway -- are transferring tens of billions of dollars to sovereign wealth funds. Long-term investors with mandates to maximize returns, these entities owe no allegiance to the U.S. currency and over time their investments will probably result in their governments' holding fewer dollars.

The durability of the dollar's reserve-currency status owes more to the absence of a challenger than sound U.S. policies. The euro is hobbled by the lack of a single, pan-European capital market and its being a hybrid currency used by a mix of countries yet owned by none.

China's yuan is a potential contender, but not until that currency becomes fully convertible, the nation's financial markets more developed and internationally recognized laws more established -- which is years away. Japan, meanwhile, has always resisted the yen being a reserve currency.

It isn't ordained that the dollar surrender its position as the world's go-to currency. Yet if Americans insist on living beyond their means, eschew sound fiscal policies, ignore the greenback's weakness and remain tempted by protectionism, the dollar will in small bites begin to mimic the British pound -- the currency of a once proud but spent imperial power.

basically, after reading this I'm thinking foreign investments that are not dollar based will continue to out grow the US market for the next few yrs.  The flight from the dollar will continue for yrs. There is no quick fix that will make the dollar the safe haven for foreign investments.

As the dollar stabalizes, ie, ceases to fall, I would expect more foreign companies buying US companies. Because of the exchange rate, US companies will appear as cheap investments.  true, this will help the US economy, but the profits will be going overseas.

My strategy would be to continue to hold more foreign investments until the US companies are on the buying spree for companies in the global market place.  Right now it would be expensive for US companies to shift into owning Euro based companies or emerging market companies.

It appears like China is taking the long term view of buying into markets that have natural resources.  This will continue the boom in emerging markets.  They have been making trade deals that the developed world has not been agressively creating.  The view of protectionism is a defensive posture, reactive and not proactive.  The flight from the dollar will continue until it is viewed as a leader, setting the stage for others to follow.

interesting investment paradyme shift.

I don't see China's yuan being a contender for a very, very long time; and I agree that the primary reason the dollar has not suffered more is because there just isn't another contender at this time.

When they start comparing the US dollar to the old Italian lire, then I'll really start worrying. The lire traces its' existence all the way back to Charlemagne and represented one pound of silver then. Over time and wars and economic 'adjustments', the lire acted very much like the dollar has been over the past several years. It was absorbed/replaced by the Euro. At that time, 100,000 lire were worth about 51.65 Euros. Imagine buying a $200,000 home for a little more than 100 Euros.

And as they say, the rest of the story......

Report to The Secretary of the
Treasury from The Treasury Borrowing Advisory Committee
of the
Securities Industry And Financial Markets Association

April 29, 2008

The Federal government's budget balance is deteriorating in fiscal year 2008. Weaker economic activity has dampened the pace of revenue collection and lifted growth in economically sensitive spending. A recent survey of primary dealers estimates that the deficit for the 2008 fiscal year ending in September will exceed $400 billion with some economists expecting a deficit of more than $500 billion--a significant deterioration from fiscal 2007's deficit of $163 billion. Economic stimulus measures will complement the forces widening the budget deficit. This year's shortfall may surpass fiscal year 2004 as the largest on record in nominal dollars.

So we have the large balance of payments thing going and a growing budget deficit.  Both of which aren't good for the value of the US dollar.  Currently the Chinese and the Saudi's are keeping the US dollar afloat.  Wonder how this is in their best interests.  It has been said that they accumulate US dollars as payment for their manufactured goods, so they can keep their economy growing.  But accepting a depreciating asset (US dollars) for payment seems to be a funny plan especially long term.   Foreigners holding the trillions of US dollars will start buying more US assets/stocks/real estate etc and hence the sovereign wealth funds.  As Buffett has said we will be share croppers some day, working for foreigners and  not owning much.  But in the mean time the FED and Federal government is doing everything they can to keep the borrowing/consuming party going as long as possible.

http://www.treas.gov/press/releases/hp945.htm 

The Counter Argument: THE DOLLAR LOOKS READY TO RALLY (Barrons)

Don't believe the obituaries:  The dollar isn't dead.

When the Federal Reserve cuts interest rates for t a seventh consecutive time this Wednesday, it will begin to wind down a pernicious campaign that has flooded the market with cheap dollars since last summer.   At the same time, the whoosh of air from Europe's deflating credit bubble puts new pressure on the European Central Bank to begin cutting borrowing costs in order to goose growth. 

It should have been obvious that a dollar bottom is in sight when Brazilian supermodel Gisele Bundchen began demanding to be paid in euros instead of dollars.  In an April survey conducted by Merrill Lynch 50% of global money managers said the greenback is undervalued, up from 30% three months ago, while a whopping 71% found the euro overvalued. 

The basic message of the article is that large exporting US companies like 

Mosaic, Apache, Halliburton, Bunge, Exxon, Newmont Mining Coca-Cola etc will be hurt by a rising greenback. 

So  is a lower dollar driving oil prices up, or are higher oil prices driving the dollar down.  This article argues the later.  If that is the case a rising dollar will not materially reduce the price of oil, hence Bernanke's bind.   

Bernanke's Bind:

The Fed, the dollar and commodities

THE spirit of St Augustine hovered over the Federal Reserve this week. “Oh Lord, let us stop cutting interest rates, but not yet,” is pretty much what America’s central bankers decided on Wednesday April 30th.

There are plenty of reasons to stop cutting. Real interest rates are now firmly negative. Although the housing market continues to contract, the economy is limping rather than slumping. According to initial GDP estimates released on Wednesday, output grew at an annualised rate of 0.6% in the first three months of the year—the same pace as in the previous quarter and faster than most people expected. The mix of growth was not good. Final sales fell while firms built up their stocks, which bodes ill for future output. But with tax-rebate cheques arriving in the mail, a dose of fiscal stimulus is imminent.

So is the weaker dollar driving oil prices up or are high oil prices driving the dollar down? The Goldman analysts argue the latter because oil exporters import more from Europe than America and hold less of their oil revenues in dollars. A second factor lies with central banks. Because the Fed focuses on “core” inflation (which excludes food and fuel), whereas the ECB targets overall inflation, America’s central bank runs a looser policy in response to higher oil prices, thus pushing the dollar down.

http://www.economist.com/daily/news/displaystory.cfm?story_ 

I remain convinced that the long-term equilibrium point in currency markets is "trade balance parity" - the exchange rate where trade flows balance and investment flows are unnecessary (or also balance).  

A strong currency in the sense of a high TBP forex rate is a virtue - it reflects domestic efficiency, export competitiveness, etc.  However, it is equally true that a forex rate which is undervalued relative to its TBP rate is also a virtue - leading to trade surpluses, investment outflows, increasing wealth vis-a-vis the rest of the world, etc.  Conversely, a currency overvalued relative to its TBP rate is a curse - declining domestic production, trade deficits, transfer of wealth to foreigners, etc.  Sound familiar?

The USD has fallen a lot against the Euro, etc, perhaps too much.  Nevertheless, the USD continues to be overvalued relative to its TBP as a result of (a) pegged currencies such as the yuan which are artificially held below their TBP, and (b) increasing wealth flowing to oil-exporting nations. 

Sooner or later, these imbalances in the forex market will unwind.  At this point, a dozen or so foreign institutions (central banks and such) not only finance the entire US trade deficit (growing again, by the way, due to higher oil prices), but also a growing "capital flight" of 3% or so of GDP.  

The specific developments for the USD depend primarily on what these dozen or so institutions do.  My guess is that they will gradually abandon the USD, in favor of "anything else", putting upward pressure on yen, pound, euro, etc.  Central banks are not known for their rapid decision-making or acute profit-maximization behavior.  For that reason I don't expect a sudden mass exodus from the USD but rather a sequence of abandonments.  As a result, the current mess is gonna take a while to unwind, but will be less damaging than a sudden USD plunge.

In the meantime, however, my portfolios are heavily tilted away from USD assets - in both stocks and bonds.

Today, Brazilian reais [one real, two reais] are equal to $0.604141 each, and the Canadian dollar is worth $0.990011, which is virtual parity. 

But what I find even more significant is that the Swiss franc recently reached parity with the U.S. dollar and is still worth $0.951826. [Data from xe.com]

The first time I went to Europe I bought Swissies for around a quarter each.  So if the Swissie can go from a quarter to a dollar, what's stopping the real from going from 60 cents to a buck?

Jagor 

OBrian0, well said and you reflect my feelings but my explanation suffers from a lack of your experience and/or skills.  I too have invested heavily in foreign stocks and bonds, but also I have invested in energy/oil/NG both domestic and foreign.   I think I understand most of what you had written but maybe you could help me understand your point.

The USD has fallen a lot against the Euro, etc, perhaps too much.  Nevertheless, the USD continues to be overvalued relative to its TBP as a result of (a) pegged currencies such as the yuan which are artificially held below their TBP, and (b) increasing wealth flowing to oil-exporting nations. 

Sooner or later, these imbalances in the forex market will unwind.  At this point, a dozen or so foreign institutions (central banks and such) not only finance the entire US trade deficit (growing again, by the way, due to higher oil prices), but also a growing "capital flight" of 3% or so of GDP. 

Are you saying that there will be a decrease in exporting wealth from the US to the oil exporting countries?   I can think of only four events that will stop the oil importation into the US on a major scale.  Without some major technological break through (or major oil find in the US which has a slim probability also) we will be forever (or close enough to forever that it won't matter to me) be dependent on the oil exporting countries for oil.  I guess the other way this dependence on foreign oil stops is if the US economy tanks completely.  The fourth and last option is if the foreign oil (along with China) exporters decide the US is no longer a good place to invest, then the music stops also.  All four of these are low probability events IMHO, and certainly there is lots of pain associated with a couple of the options that would stop the import of oil.  I agree a growing balance of trade deficit won't go on forever but it will be close enough to forever that it won't impact me personally. 

The more I think about it I agree with your statement,  

 Sooner or later, these imbalances in the forex market will unwind.  At this point, a dozen or so foreign institutions (central banks and such) not only finance the entire US trade deficit (growing again, by the way, due to higher oil prices), but also a growing "capital flight" of 3% or so of GDP.

I'd just like to know how and when, but by staying heavily into foreign markets and commodities is probably still the best investment option for the near term (1 year or so)

IMHO.

Thanks

John - Your question, if I understand it, is HOW can these imbalances unwind.  Not sure I can answer it, but I'll try.

The imbalance due to pegging can unwind by some combination of (a) loud protests by the targeted countries (US, increasingly Europe), (b) growing internal inflationary pressures in pegging countries, and (c) growing distaste for accumulating more USD assets.

The oil trade imbalance is probably more permanent, but can be mitigated by (d) long-term oil demand elasticity in the US, (e) increased spending by oil nations, and again (c) growing distaste for accumulating more USD assets.  Also, it could be offset by (f) a US trade surplus to other countries if USD falls enough.

Not a compelling list, I admit.  I used to think that the only solution was a political one - beefing up the IMF, etc.  Now it seems like a growing distaste for acquiring more USD assets might be more likely.  Particularly now that Wall Street has laid an egg.

But I'm not sure.  Maybe the US is just doomed to get eviscerated. But there are other solutions.   A modest wealth tax on non-US holders of US assets would solve the problem quickly.

Interesting (and frightening stuff).  The economist Rudi Dornbusch said that financial crises take much longer than expected to arrive, then happen much quicker than expected.  I remember being in Russia in 97 and 98 before the currency collapse.  The situation became absurd.  Then more absurd.  Then even more absurd.  Then suddenly and dramatically popped.

Off-topic, but I remember being in the bar with my buddies in Russia at the time, who were pissed because their investments in Russian mutual funds had dropped 95%.  I laughed at them and pointed out that their investment would now have to increase 20-fold for them just to get back to break-even.  They were not amused; but I invested within the week.  Now, almost ten years later, I read that the Russian market has in fact increased 20-fold since then.  I wish I had stayed fully invested the whole time.  Oh well.

Brad Setser talks about the trade imbalances, the build up of US dollars as a result and all the implications of these items in his blog.  I believe Setzer is a professor and I personally find his discussions interesting.  One of the main points he has made is that the US dollars held overseas are increasingly being held by foreign central banks, versus the previous situation where US dollars were being held by private individuals and companies along with foreign central banks.  I'm not sure Setzer ever said this shift is bad (or good for that matter), but he has provided data to support the shift in who holds the US dollars over seas.  It would seem to me that as the dollars concentrate the risk of something going wrong also concentrates and by using the worlds central banks as a loan source to support our consumption based on borrowing, eventually you (the US) will give up control IMHO.  It would now just take a few central banks to upset everything, where up until a year ago it would have taken many organizations.

Here is an article by Setser where he discusses both the "good" parts of the current situation and the potentially  "bad" parts. 

http://www.rgemonitor.com/blog/setser/252597/#readcomments 

 Ken Rogoff argues that it doesn’t make sense for poor countries to provide the US with a form of foreign aid by holding more low-yielding US assets that they need: “central banks know that holding these low-yielding Treasury bills is just an aid program to the United States.” Some analysts – a group that clearly includes me as well as Jim Fallows -- question whether it makes sense for China to be financing, indirectly, real estate speculation in the US rather than schools in Shanghai.

“Investing money in the United States requires spending that much less on enormous problems at home, like pollution and a shortage of health care. By indirectly making mortgages cheap in the United States, China has helped foster the boom that saturated Miami with glittering condos even as tens of millions of Chinese live in dilapidated concrete block apartments.

Mike Dooley, on the other hand, argues that emerging market financing of the US is the best development program the world has yet devised. Emerging markets get a market for their exports; the US – uniquely – can run up big external debts without taking on a lot of currency risk because of the dollar’s global role.

There is a comparable debate over whether enormous central bank financing of the US is a “good” or a “bad” thing for the US. The growth of central bank dollar reserves has unquestionably provided the US with cheap credit. And many Americans are worried about the diminution of the dollar’s global status – in part because the shrinking international purchasing power of the dollar is a powerful symbol of America’s own shrinking global standing. It is hard to argue that it is “Morning again” in America when a dollar only buys 65 euro cents and, for that matter, when one dollar buys less than 1/100^th of a barrel of oil.

On the other hand, there is – I suspect – concern about the extent the US has come to rely on other governments rather than private markets for financing. A country that relies on other governments for financing – and to recapitalize its banks – potentially puts own policy autonomy at risk. And the US has traditionally valued its policy autonomy.

In other words we may all become share croppers, working for organizations out side the US that own the assets and we all are hired help. 

Speaking of future of the US Dollar, what are your thoughts on this information?

 http://www.lifeaftertheoilcrash.net/

"Peak Oil" who knows, but at current prices of $125/barrel or so the trade balance deficit for the US will increase significantly. The increase in the trade deficit will put more downward pressure on the US dollar.  The average 2007 price for oil was around $70 a barrel.  If oil stays at $125/barrel for the remainder of this year, the average for 2008 will be around $115/barrel.  Since we import about 60% of our oil, the increase in price will have a dramatic negative impact on our trade balance.  I've seen predictions that the increased price of oil to $125 would add $100 billion to our trade deficit in 2008.  Some of this might be offset by a slowing US economy that needs less oil.

If world "peak oil" has been reached (world oil production hasn't increased materially since 2005) then the trade balance problems in 2008 are  just a taste or things to come.  I personally suspect that world oil production will increase in the short term of a few years.  After that who knows.

The missing piece of this discussion is the fact that world demand for oil has risen significantly.  With the BRIC countries coming out of the EM arena, their demand for oil will continue to ramp significantly.

The rising cost of oil is only partly due to being tied to the dollar.  As the dollar gains strength, the oil cost will not drop significantly due to increased demand.

The recent oil finds off brazil, the opening up of russia oil is due to a longer term view of the cost of oil.  If they felt oil would return to the 70-80 per barrel and remain there for 5+ yrs then the market would not have gained based on the new finds or russia opening up more..

The US needs to reduce its consumption, period.  I still can explain how I can spend a week in France driving around in a rental car and only use 1/3 tank.  I think the europe cars are more fuel efficient,  why?  Does the US require standards that europe doesn't?  The cars seem as safe, is it clean air standards?