Financial Environment This Year the

Financial Environment This year the U.S. budget deficit is expected to total a record $1.84 trillion -- fueled by the banking bailout to stabilize the financial system and the fiscal stimulus package to jump-start the country's economy (Lazarro, 2009). According to this same source, the administration forecasts a $1.26 trillion for fiscal year 2010, nearly triple fiscal year 2008 when the United States government posted a then-record $454.8 billion deficit. Partly as a result of this deficit, the dollar has declined 40% between the years 2002 and 2008 (Amadeo).

The dollar temporarily strengthened during the recession in early 2009, as investors sought a relatively safe haven for their money, but the dollar's decline resumed in March 2009 and has been under downward pressure ever since this time (Amadeo). The decline of the dollar is not only decreasing the demand for dollar assets, as creditor nations fear that they money they are owed will be worth less as the deficit fuels inflation and as the dollar grows even weaker, but it's also causing many nations to view the U.S.

dollar as too financially unstable to continue to serve as the de factor world currency. This paper explains the current situation and how it will impact the future role of the U.S. dollar on world financial markets. In particular, China is displeased, for many good reasons, by the current and future prospects of the U.S. dollar. At the end of January, 2009, China held $739.6 billion of U.S. Treasury securities, more than any other creditor country in the world (Davidson, 2009).

If this situation continues, China will have to revise its exchange rate policy and let its yuan currency rise in value relative to the dollar, some say by as much as 30% which would, in turn, mean that China's investments in U.S. dollars, via its Treasury holdings, would lose as much as a third of their value (Davidson, 2009). With its strong trade balance, China has been under considerable pressure from both the U.S. And the European Union to allow its currency to increase in value (Daniels, Radebaugh, and Sullivan, 2007).

At the least, China is concerned that its reserve funds are mainly driven by factors China has little control over, such as fluctuations in the value of the dollar, the U.S. economic situation, and changes in U.S. economic policies (Batson, 2009). The governor of the People's Bank of China, Zhou Xiaochuan, has proposed the expanding the International Monetary Fund's (IMF) Special Drawing Right (SDR) to become the world's reserve currency instead of the dollar (Davidson, 2009).

The IMF is an organization that was created in 1945 to promote international cooperation, international trade, exchange-rate stability, a multilateral system of payments and resource availability to members with balance-of-payments difficulties (Daniels, Radebaugh, and Sullivan, 2007). The SDR is a special asset the IMF created in 1969 to increase international reserves and its value is determined by a basket of the five most important currencies used in international trade and payments (Daniels, Radebaugh, and Sullivan, 2007).

Although the weights of the currencies comprising the value of the SDR are reevaluated every five years, at the end of 2004, the U.S. dollar was 39%, the euro was 36%, the Japanese yen was 13% and the British pound was 12% (Daniels, Radebaugh, and Sullivan, 2007). China's proposed SDR plan for a new world currency is backed by other emerging countries such as Russia for a number of reasons. They believe that concentrating their assets in a few individual currencies exaggerates the size of flows and makes the financial system more volatile (Batson, 2009).

Further, reserve-currency nations would have more freedom to shift monetary policy and exchange rates which would make it easier for all nations to manage their economies (Batson, 2009). While the U.S. might not like the loss of control to the IMF, it could help the country avoid future economic catastophies because it would know longer be able to pursue irresponsible monetary policies, such as keeping interest rates too low for too long, which were facilitated by nations putting too much money in U.S. dollars (Batson, 2009).

The United Nations states that a new monetary unit based on an assortment of national currencies would give developing countries greater access to money that is now being spent of U.S. Treasuries (Gjelten, 2009). What hasn't happened "officially," i.e. The establishment of a formal IMF SDR world currency system or some other form of a supranational currency, seems to be occurring in the market anyway, but just in a more informal fashion.

For instance, already central banks throughout the world are favoring euros and the yen over the dollar as illustrated by the following numbers (Euro, yen to replace dollar as world reserve currency, 2009). During July through September 2009, banks put 63% their new cash into euros and the yen. As a result, the dollar's share of new cash in the central banks was down to 37 compared with approximately 67% a decade ago.

Currently, according to the IMF, dollars account for about 62% of the currency reserve at central banks -- the lowest on record (Euro, yen to replace dollar as world reserve currency, 2009). Further, if China itself were to tie its currency to a basket of currencies and manage the value of the currency it could be better off. For example, the country could free the yuan's value from reliance on the value of the U.S.

dollar and this could result in less far volatility due to the use of a more diversified basket of currencies (Daniels, Radebaugh, and Sullivan, 2007). With the creation of the stimulus package that relies heavily on debt creation, the U.S. has simply created another problem, the devaluation and instability of its currency. In effect, this country has decided to borrow from the future for better current prosperity.

The only question that remains is how the debt scenario will play out in five years time and what the implications will be for the U.S. currency in relation to others. Going forward, there are two main possibilities that could occur in the future. First, keeping interest rates at zero, printing even more money and selling more debt, could lead to hyperinflation and economic collapse (Euro, yen to replace dollar as world reserve currency, 2009).

Certainly, in this scenario, foreign governments will either be successful at creating some of a new world currency such as IMF SDR or will take their own measures to diversify their foreign-exchange reserves out of U.S. dollars. If this happens, the dollar is likely to fall even more and bond yields are likely to rise as investors demand higher compensation for their risk. The U.S. would also import less.