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Will the Dollar Remain Dominant?

By Jane Hughes

The dollar has followed a rocky road in recent months, tumbling to nearly $1.18 against the resurgent euro and to an anemic 119 yen, as foreign investment in both bricks-and-mortar and portfolio investment in the States has ebbed. If the foreign exchange rate is essentially the bottom line of the country, then investor sentiment toward the once-mighty U.S. dollar – and the economy that underpins it – is definitely cooling.

But while day-to-day currency movements remain well-nigh unfathomable, there has been surprisingly little structural change in the FX markets, even over the past decade. The dollar may be slipping in value, but it continues to dominate the markets in other, perhaps even more important, ways. The arrival of the euro in 1999 was supposed to herald a new era in which dollar dominance of the FX arena gradually gave way to a more equitable distribution of power among a tri-zone currency world (dollar, euro, and yen). This has not happened. According to the most recent report by the Bank for International Settlements (BIS) on FX market activity, published in 2001, within the tri-zone world the dollar still reigns supreme. A whopping 90% of all currency trades still include the dollar on one side of the deal; by contrast, the euro figures in just 38% of all FX transactions.

The potential for internationalization of the euro – its use in transactions not involving the 12 component countries, and therefore its ability to challenge the dollar’s dominance of global FX markets – remains murky. As a general rule, this potential may be assessed in three ways: the euro’s use as a medium of exchange for Europe’s trade with non-European countries; its role as a store of value for stocks and bonds on world capital markets; and its use in official FX reserves held by the world’s central banks.
By these yardsticks, the picture is mixed.

  • Role in world trade: The U.S. accounts for only 14% of world trade, but the dollar is used to invoice close to 50% of the world’s exports. Clearly, there is room for the euro to play a much bigger role in world trade. Countries with close political, economic and financial links to the eurozone, like those in central and eastern Europe as well as some former colonies in Africa, may move toward the euro as an anchor currency. This would result in the emergence of a broader, informal “eurozone” encompassing countries well beyond its official limits.

  • Role on international capital markets: The introduction of the euro, clearly, is playing a big role in broadening the depth, liquidity, and appeal of European capital markets. In 1999, euro-dominated bonds accounted for 45% of all bonds issued on international markets, slightly outstripping the 42% of bonds issued in dollars. This could presage the evolution of the euro into a safe-haven currency over time, as investors assess the strength and stability of the euro as well as the credibility of the European Central Bank.

  • Role in official reserves: The dollar accounts for 57% of global FX reserves, and central banks have been loath to trade in their dollars for euros thus far. Political issues may eventually hasten this movement, but the huge bulk of FX reserves held in Asian central banks (China alone is holding around $200 billion) are conservatively managed. Given the initial weakness of the euro, and lingering doubts about the long-term viability of European monetary integration, it seems unlikely that the euro will challenge the dollar as a reserve currency for the foreseeable future.

So FX markets are still largely dominated by dollars. What else has not changed on FX markets? The birth of the euro led some observers (mostly French and German) to predict that London would experience a gradual decline in its importance as an international financial center, to be replaced by Frankfurt and Paris. This, too, has not happened. London continues to handle close to 1/3 of FX trading activities, far more than any of its competitors, and the institutional skills and infrastructure in the City of London command a hefty competitive advantage in the FX business.

Trading in “exotic” currencies, too, was supposed to take off. Faced with liberalization and deregulation in emerging currency markets around the world – and faced simultaneously with the need to replace lost opportunities in intra-European currency trading – many traders looked to exotic currencies as the next frontier. A decline in trading activity and increased efficiency in markets for the mature currencies of western Europe and North America (the euro, after all, is entirely about removing market inefficiencies) threatened FX trading profitability. Fortunately, at the same time governments in Asia, central and eastern Europe, Latin America, and even Africa were enthusiastically opening their markets to foreign capital. The result seemed inevitable.

Or was it? In fact, the data on exotics market activity has failed thus far to support the overheated rhetoric. According to the BIS, trading in emerging market currencies comprised just 4.5% of total FX market turnover in 2001, compared to 3.1 percent in 1998. So while trading in exotics is certainly edging up, and is expected to play a greater role in FX trading as the mainstream currencies get even older and stodgier, the markets are still heavily dominated by trading in dollars, euros, yen, and British pounds. (Indeed, trading in the three main currency pairs – dollar/euro, dollar/yen, and dollar/pound – accounts for close to 2/3 of total market activity.)

A few possible trends to watch for, then:

  • First, the possibility of a serious decline in market liquidity is worrisome. FX market participants have complained in the past couple of years that liquidity has become erratic. The rise of electronic brokers, consolidation within the banking industry, and the higher level of risk aversion among global hedge funds all contribute to this trend, and make it increasingly difficult to predict when these pockets of illiquidity will occur.

  • Second, the FX markets may prove more herd-like than ever, as trading business is more and more concentrated among a few large players and the big macro hedge funds play a cautious role. This may, in turn, presage more sudden and dramatic currency swings.∑ Next, the markets may prove more inexplicable than ever, stemming from the growing influence of equities, and merger and acquisition activity, in currency trading. Traditional reliance on fundamental macroeconomic factors to predict FX movements is increasingly discredited in this environment, but it is far from clear what can replace this methodology.

  • Finally, trading volumes will probably rebound after the period of consolidation at the end of the 1990s. Once the fallout from the emerging markets crises of 1997-87 is fully absorbed and the euro finds its rightful place in the markets, the inexorable march of globalization and resulting rise in cross-border capital flows will be reflected in higher turnover on FX markets. But buyer beware: The larger and more unwieldy the market becomes, the less responsive it will be to government intervention – and the easier it will become for traders to destabilize currencies of smaller and vulnerable emerging market countries.

Editor: Dr. Scott B. MacDonald, Sr. Consultant

Deputy Editors: Dr. Jonathan Lemco, Director and Sr. Consultant and Robert Windorf, Senior Consultant

Associate Editor: Darin Feldman

Publisher: Keith W. Rabin, President

Web Design: Michael Feldman, Sr. Consultant

Contributing Writers to this Edition: Scott B. MacDonald, Jane Hughes, Marc Faber, Jonathan Lemco, Russell Smith, Andrew Thorson and Robert Windorf

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