Deficits and the Dollar, Mutually Exclusive?

There has been a lot of chatter among policymakers about the future of the dollar. In particular, the BRIC countries have opined on the need for a new, global reserve currency to replace the greenback's predominance. (Last week, India chimed in).

At the same time, many emerging market countries, including the BRICs, continue to increase their dollar holdings. I recently posted on how foreign exchange reserves have been very useful in cushioning the adverse effects of the crisis. (Imagine how confidence in the Russian economy would differ if the central bank didn't hold over $400bn in reserves).

What do we make of all of this? How is it that the dollar's reserve status is being questioned, but simultaneously reinforced by the same countries who are doing the questioning? This paradoxical sentiment can probably be viewed as an expression of concern about the United States' deteriorating fiscal health.

Morgan Stanley has just released a report entitled America's Fiscal Train Wreck, outlining the deteriorating state of the US government's balance sheet, which will eventually lead to higher borrowing costs:

America's now chronically rising deficit will almost surely expand debt beyond the appetite of global investors to hold it without significant concessions in the form of higher interest rates or a big enough decline in the dollar to make it look cheap, or both... Standard estimates suggest that a 20-point sustained increase in debt/GDP - what we will experience between 2008 and 2010 - will boost real rates by 70-110bp.

If the cost of borrowing increases, it may be tempting for the US government to opt for a dollar devaluation. 

Meanwhile, David Woo, head of FX strategy at Barclays, argues in today's FT that talk of a dollar alternative is unrealistic, but that the United States' fiscal health will limit the government's ability to borrow in the future:

Notwithstanding the problems with the current global reserve system, there are at present no obvious alternatives to the dollar. That said, US fiscal profligacy will push the dollar risk premium higher over time. In other words, the US's ability to obtain cheap external funding for financing its twin deficits is likely to be curtailed.

Will the US be able to trim its fiscal deficits (unlikely) before an erosion of confidence leads to higher borrowing costs to the American government? If not, then we are likely to see dollar weakness. Yet, if there is no alternative to the dollar, will central banks simply allow the value of their reserves to plummet? Back to Mr Woo:

In the near term, the global economy remains too fragile to absorb the shock of a large and disorderly decline of the dollar. In that respect, the chances for a co-ordinated intervention among developed economies to support the dollar are higher now than any time in the past 10 years.

The behavior of central banks indicates that the advantages of holding dollars outweigh the risks. The costs of switching out of dollars would be high, particularly if they lead to a run on the dollar. At the same time, there is more and more concern that the status quo cannot last.

Fiscal profligacy and a strong reserve currency are becoming an unsustainable duo.