In U.S. We Trust: Don't Ditch Dollar as Reserve Currency

Happy April Fools’ Day.

But, believe me, this isn't a joke!

This is about a serious warning that IMF Managing Director Dominique Strauss-Kahn gave to the European Union when speaking at the Romanian Parliament in Bucharest.

He said Europe is in danger of being relegated to the second division of world economic powers while the United States and Asia bounce out of the global downturn.

“The risk for European economies is to be in the second league and not in the first, with the United States and Asia,” Strauss-Kahn said.

“There is a probability that, if Europeans do not act swiftly, in 10 or 20 years' time the fight will be between the U.S. and Asia, while Europe will be left aside … Recovery is going fast in some parts of the world, such as Asia, not so bad in Latin America and probably going to accelerate in the United States.”

The IMF chief stressed “the risk of having Europe being marginalized” in 20 years. “To avoid this, the EU must be able to enhance the institutions ... go back to innovation, go back to competitiveness and go back, at the end of the day, to growth, which is not exactly what we see in the aftermath of this crisis,” he said.

“The crisis shows that we cannot have a single currency without having a more coordinated economic policy,” he said. “At a European level, you need more than regulation and supervision, you need a European resolution authority.”

Besides that, the IMF released its quarterly Currency Composition of Official Foreign Exchange Reserves, or COFER, report, which said the U.S. dollar’s share of global currency reserves rose to 62.1% in the fourth quarter of 2009. The euro’s share dropped to 27.4%, the Japanese yen’s share dropped to 3.0% from 3.2% and the British pound was unchanged at 4.3% during the fourth quarter.

Total worldwide foreign-exchange holdings rose to $8.08 trillion in the quarter, up from $7.86 trillion in the third quarter of 2009.

In the fourth quarter of 2008, total foreign-exchange holdings stood at $7.32 trillion.

The share of currencies outside the most-traded ones (which are the dollar, euro, yen, sterling and Swiss franc) in allocated reserves rose slightly to 3.1% in the fourth quarter, up from 3.03% in the previous quarter.

The data don't include China's $2.4 trillion reserves. There are 140 reporting countries in the COFER data, but the IMF doesn't disclose the reporting countries.

So, overall, dollar reserves rose to $8.08 trillion dollars, of which only 56.5% of the reserves are known by currency allocation. Unallocated reserves rose by about $77 billion in the fourth quarter.

China accounts for the bulk of the unreported, but don't forget Taiwan, which isn’t a member of the IMF because only countries are and therefore its reserves aren’t allocated either.

Taking into account all of the above, it’s difficult to see which currency could seriously challenge the U.S. dollar as the world’s prime reserve currency.

It certainly won’t be the euro if they don’t change course soon, which I think will be extremely hard to do.

Besides that, we still shouldn’t overlook the fact that the Chinese currency, known as the renminbi or yuan, isn’t a freely convertible currency, yet.

It’s good to remember that a reserve currency, or anchor currency, is a currency which is held in significant quantities by many governments and institutions as part of their foreign exchange reserves.

It also tends to be the international pricing currency for products traded on a global market, such as oil, gold, etc.

This permits the issuing country to purchase the commodities at a marginally lower rate than other nations, which must exchange their currency with each purchase and pay a transaction cost.

For major currencies, this transaction cost is negligible with respect to the price of the commodity.

It also permits the government issuing the currency to borrow money at a better rate, as there will always be a larger market for that currency than others.

In other words; only the U.S. dollar (and to a much lesser extend the euro, the Japanese yen, the British pound and the Swiss franc) fulfill these criteria.

Investors shouldn’t write off the dollar too soon.

Believe me, this is not an April Fools’ joke.