Little is asked of a reserve currency other than that it hold its value and remain widely accepted for the purchase of internationally traded goods such as oil, ore, and food. Despite these minimum standards, there are only four currencies in the world today that meet the criteria: the U.S. dollar, the euro, the British pound, and the Japanese yen.
Of that select group, the dollar is by far the most preferred denomination. According to IMF data, more than 60% of the world's foreign exchange reserves are based in dollars. The next most popular reserve currency is the euro, with a little less than 30% of reserves, though it's been gaining on the dollar in recent years as skeptics around the world begin to fear the U.S. government's accumulating debt and growing deficits. Far behind that are the yen and the pound, with less than 5% of reserves.
But that's it. That's the menu if you're looking for a low-risk vehicle for your savings, and frighteningly -- I'm bearish on all four of them.
Let's start with the dollar
I've been predicting the demise of the dollar for more than a year now. The evidence for this is that the Congressional Budget Office expects our federal budget deficit to exceed $1.3 trillion this year, or more than 9% of GDP. While not yet more than the 12% of GDP that has some predicting the demise of Greece, the size of our current deficit is troubling for a country that would like to continue to benefit from being the world's reserve currency. The CBO also projects our national debt at $8.8 trillion, or 62% of GDP by the end of the year. While not yet in outright crisis territory, it's going to take some hard decisions by the government to rein in that number -- decisions I'm not confident our elected officials will make.
What that means is that we're likely to turn on our printing press to meet our obligations, thereby devaluing the dollar. This will annoy the 62% of the world that's holding their currency reserves in dollars and prompt them to find alternative means to hold their savings, leading to further weakness in the dollar. Thus, one doesn't want to be caught holding nothing but dollars as these events take place.
Of course, I'm being proved wrong
Yet while the dollar did weaken 10% against the euro for most of 2009, making good money for holders of CurrencyShares Euro Trust
Take, for example, the continent's recent experience with Greece, which has $25 billion in debt due by the end of May and another $152 billion due between 2011 and 2014, with a very questionable ability to make those payments on its own. Similar problems lie in wait for other European economies such as Portugal and Spain. While it had previously not been clear what, if anything, the European Union would do to support these member states, the recent EU/IMF framework agreed to by the continent's presidents shows that the EU will step in and assist member states in financial need. Thus, Greece's balance sheet is also the euro's balance sheet -- an unsettling prospect for risk-averse investors.
This has explained the recent flight from the euro, and because currency values are relative, another currency has to strengthen in order for the euro to weaken. Since there are only two major reserve currencies (really, Britain and Japan have bigger problems and less liquidity than the U.S. and Europe), the U.S. has benefited from Europe's troubles even though we've done nothing to solve our own underlying financial problems.
This cannot last
Being less bad than very bad, however, is not a sustainable solution, and the dollar remains a ticking time bomb within investments such as Treasuries and high-grade bonds that many investors consider lower risk. But if investors shouldn't be in the dollar, the euro, the pound, or the yen, then where the heck should they be?
This is a tricky question. One answer, of course, is gold, and that's why gold prices, vehicles such as SPDR Gold Shares
This doesn't mean gold should be expunged from a diversified portfolio, but only that it should remain just a part of a diversified portfolio.
The prospects for other currencies
Longer term it's inevitable that the world's large emerging economies will see their currencies strengthen against the dollar as they develop and investors reassess their risk profiles. Ultimately, currencies such as the Brazilian real, Chinese yuan, and Indian rupee may become credible reserve currencies.
In the here and now, however, these countries remain too volatile both politically and economically for their currencies to reliably hold their value (the most important characteristic of a reserve currency). Further, in the case of China, we're looking at years before that country allows its currency to strengthen due to its reliance on export manufacturing -- as I wrote in last week's column.
In other words, while investors are smart to have some exposure to each of these countries, one would not want a portfolio devoted 100% to any of them. There's just too much uncertainty.
All told, there is no one safe haven in which to denominate your investments today -- not the dollar, not the euro, not gold, and certainly not Ukrainian hryvnia. The solution, then, is diversification, and you want a smattering of currency and commodity exposure in your savings in order to protect yourself from looming volatility.
Philip Morris International
The takeaway, though, is that these are volatile times the world over, and you won't find shelter for your portfolio in any one company, currency, country, or asset class. Tread carefully.
Tim Hanson is co-advisor of Motley Fool Global Gains. He owns shares of Philip Morris International, which is a Global Gains recommendation. Coca-Cola is both an Inside Value and an Income Investor recommendation. Motley Fool Options has recommended a bull call spread position on Yum! Brands. The Fool's disclosure policy notes that the title of this article is not grammatically incorrect, but rather pays homage to a song by Rage Against the Machine.