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The global economic crisis, which battered investor confidence across the board, seems to have led to overpricing of the dollar, when in reality it was not backed by sound economic fundamentals. In fact the US economy has been registering negative growth, with unemployment at its peak and no sight of economic recovery. Under such circumstances, the currency of such an economy should logically face weakness. But, we all know that the financial meltdown has spread far and wide and investors have been pulling out investments across Europe, Japan, and other emerging economies and investing it in the US dollar, which has the tacit status of being a world reserve currency. The Yen had also been playing this role till recently, until the heavy battering of the Japanese economy resulted in the Yen’s downfall. This put a majority of the onus of preserving value of investments on the US dollar and forced it up unreasonably.

While, the dollar’s inherent weakness was perceivable as indicated in my last article, ‘World Economy in Shrink Mode’, glaring statements to the effect by the Chinese premier made this more apparent. China has a huge exposure to US government treasuries. Years of its export generated trade surplus, has been invested back into US treasuries. This huge reinvestment also led to the US dollar remaining firm versus the Chinese currency. The artificially deflated value of the Chinese currency resulted in its exports remaining artificially cheap and pumping out more trade surplus, which went back to the US in the form of US treasury investments. Early this week, the Chinese premier, Wen asked the US to guarantee safety of China’s investments in the US treasuries, which have been estimated to be around $1.9 trillion. Such apprehension on part of the Chinese is expected as even a small depreciation in the US dollar will erode the value of Chinese investments. Even the markets seem to have factored in the increasing risk of investments in US government treasuries as the insurance premium on default by US government rose nearly 60% from a year ago.

Understandably, in order to maintain the credibility of the US dollar as a world reserve currency, the US needs to shore up its economy. In order to boost the economy the US needs to pump in more money into the system. We all know that pumping in liquidity is likely to lead to inflation and depreciation on the dollar.  This is exactly, what the US Fed seems to have done by Wednesday, when it announced that it would purchase up to US $ 600 billion worth of long term government treasuries. In effect, the US will be printing more currency to buy treasuries. With interest rates being an all time low, the Fed seems to have adopted the classic tool of quantitative easing to enhance liquidity. The dollar reacted immediately and fell sharply against major currencies. The future direction of the dollar will depend upon the steps taken by other nations as well to address their monetary issues. If Europe adopts quantitative easing, the Euro may also undergo a downward correction resulting in a relative upward movement of the US dollar. However, in the long term, the US needs to regain its economic prowess to give the dollar its intrinsic value and maintain its status as a reserve currency.