The dollar’s future as a reserve currency

Forex players are well aware of the doom-and gloom scenarios that become fashionable from time to time regarding the U.S. dollar. Indeed, there have been periods in recent history when concerns about either the huge U.S. twin deficits or the precarious standing of the dollar as the de facto foreign central bank reserve currency have seized control of the forex market and dominated dollar movement. Examples include the late-2004 dollar sell-off and more recently the November 2006 bearish spiral in the greenback.

However, despite warnings from perennial dollar bears, the U.S. currency has not collapsed, and for now foreign central banks (largely Asian) continue to hold trillions of U.S. currency in reserve. In fact, official global central bank reserves are approximately $4.5 trillion as of the first half of 2006 — up from $2.7 trillion in 1999, according to Usha Haley, professor of international business at the University of New Haven. And it is estimated that roughly two-thirds of all global central bank holdings in the world are held in U.S. dollars.

In recent months, however, there has been (prompted by certain central bank announcements) a great deal of market chatter about reallocation of reserve assets away from the U.S. dollar, most notably toward the new kid on the global currency block — the euro.

“This has been an important issue in global markets,” says Michael Woolfolk, senior currency strategist at the Bank of New York. “People are concerned about whether the role of the dollar is under fire.”

Who are the largest holders of U.S. dollar reserves on the global scene? Are the twin deficits finally taking a toll on the credibility of the greenback? Is the U.S. dollar truly losing some of its allure as a reserve currency? What other global currencies are credible candidates for the job? Also, what’s behind the trend in growing U.S. reserve holdings in recent years?

Given the magnitude of this subject, it is also worthwhile to examine things from a historical perspective. When did the U.S. greenback take on the role of the world’s reserve currency? What was the evolution of that process and what lessons from that historical event can traders apply to their understanding of current conditions?