Dollar remains key global currency: S&P

ANALYST'S VIEW

The US dollar remains the world's most accepted currency despite the growing acceptance of the euro - since its inception in 1999 - and encroachment on the dollar's share in certain markets.

The AAA long-term issuer credit rating on the US rests on this position of the dollar as a key international currency.

Without this, the US would not have such ready access to external financing; interest rates would have to rise to attract higher domestic savings; and growth would slow well below potential.

The dollar did not attain this position by accident, nor does the US maintain it simply with inertia. This dominance is based on the US economy's fundamental strength - the casualty does not run in the other direction.

That strength comes from the economy's size, the flexibility of labour and product markets, and the prospect for higher productivity growth and favourable investment returns over the medium term.

As long as inflation is moderate and stable, financial markets sound and unfettered, and government spending efficient and sustainable, Standard & Poor's Ratings Services expects the US to continue enjoying the benefits a key currency brings and to maintain the AAA rating.

Dollar market share
One indication of the dollar's continued primacy is that it dominates foreign exchange trading, with most contracts quoting the dollar as one leg.

According to the survey of foreign exchange market turnover compiled triennially by the Bank for International Settlements (BIS), the dollar has a commanding position, peaking in 2001 at 90.3 per cent and retrenching only modestly to 86.3 per cent in 2007.

On the other hand, with the elimination of the predecessor currencies of the euro and thus their trading, the euro's trading volume fell to 37 per cent in 2007 versus nearly 60 per cent for the legacy European Monetary System currencies in 1995. Third place belongs to the Japanese yen, which has seen its share slip to 16.5 per cent in 2007 from its recorded peak of 24.1 per cent in 1995.

The British pound sterling, whose share declined slightly to 15 per cent in 2007 from 16.9 per cent in 2004, its recorded peak, is fourth. No other currency approaches a 10 per cent mark (again meaning that no other currency approaches a share of one-twentieth of foreign exchange transactions).

The dollar is also a key unit of account for cross-border finance although its importance has lessened.

According to BIS data, the euro has increased its share of international debt securities outstanding since its 1999 inception to 48 per cent in first-quarter of 2007 from 29 per cent in 1999, while the dollar's share fell to 36 per cent from 47 per cent in the same period.

The euro's market share appears to have stabilized since 2004. The euro also challenges the dollar in over-the-counter derivatives turnover, used significantly more in interest rate swaps, which are by far the most traded contracts.

On the other hand, the dollar is employed with greater frequency for interest-rate options, currency options, and currency swaps, and has also recently become used more often for forward rate agreements.

The dollar plays a preeminent role in trade, as well. Almost all imports and exports to the US are denominated in its own currency, a privilege no other country enjoys.

An additional indicator of the dollar's continued primacy is that the bulk of the foreign exchange component of international reserves remains invested in dollars.

Through second quarter 2007, the share of dollar reserves as a percentage of identified reserve holdings fell to 54 per cent in 1991 (during the recession coincident with the turmoil in the savings and loan industry) from 58 per cent in 1987, and then rose steadily to 71 per cent in 1999 (at the introduction of the euro) before sliding back gradually to 65 per cent in the second quarter of 2007.

As the euro's track record lengthens, as some central banks whose trade linkages are less tied to the US diversify their marginal foreign exchange holdings away from the US dollar, and as the dollar depreciates, its share of international reserves will fall further. The decline, however, will likely be steady and protracted, and recede only to levels maintained in the 1990s.