One of the biggest surprises of the ongoing financial crisis has been the resilience of the US dollar and dollar denominated assets, especially in the face of a sharply deteriorating US economy. The "flight to safety" from the emerging markets in the form of unwinding of positions there by US financial institutions so as to shore up the credit strapped balance sheets of their parents back home, has had the effect of driving down both the domestic currencies and equity markets in these economies. This capital flight and attendant market declines have had a domino effect, hastening the scramble to the exit doors from the emerging markets.
The US enjoyed a capital inflow bonanza that funded its yawning current account deficits, and asset prices spiralled upward only to crash. As Carmen and Vince Reinhart explains, while the crash has constricted credit and is redrawing the financial landscape, the US has not been punished by investors pulling out the same way as the emerging markets. Instead of facing steep premiums on its debt, the US Treasury Bills have seen yields fall in absolute terms and markedly in relative terms to the yields on private instruments. What explains this "rush into a burning building at the first sign of smoke"?
Chastened by the 1997 East Asian economic crisis and in order to maintain their export competitiveness, these economies have been accumulating massive foreign exchange surpluses, which were invested mainly in dollar denominated assets. The twin booms in consumption in the US and global commodity and energy prices, swelled the forex surpluses. The IMF estimates that the international reserves of emerging market economies increased by $3.25 trillion in the last three years, with the bulk of the holdings in dollars. In fact, foreign governments, either directly or through entities like the Sovereign Wealth Funds (SWFs), now own almost a quarter of outstanding US government securities, and form about 10% of non-US nominal GDP. In the absence of adequate depth and breadth in their domestic financial markets, these forex surpluses were invested mainly in the US government securities, which despite their low returns offered the attraction of safety and liquidity.
With their forex investments intimately tied to the fortunes of the US economy, the emerging economy Central Banks are naturally wary of triggering off any alarms that would hurt them as much as anyone else. Many of these economies can only stay invested and watch in the hope that their investments survive the ongoing crisis without too much damage.
For an outsider, the unique position of the dollar confers on the US economy, in the words of Valerie Giscard d'Estaing, an "exorbitant privilege", whose costs are unfortunately borne by foreigners. This situation can be best summed up in the words of the former US Treasury Secretary, John Connolly, who once quipped, "the dollar is our currency, but your problem"!
This "privilege" partly explains why all previous and future US administrations have and will oppose any efforts that could lead to the emergence of Euro and the IMF's SDRs as alternatives to the dollar. However, in the aftermath of the bitter experiences of the sub-prime mortgage crisis, we could see a definitive shift in the investment strategies of investors, both private and government, away from dollar (and dollar denominated) into a more diversified basket in the coming months and years. To that extent, is the sub-prime crisis the beginning of the end for dollar?