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Curious Case of the Dollar Game

As investments in the dollar keep going up, the author takes a look at what makes this currency so appealing to investors

In the last six to eight years, the only financial asset that investors seem to be comfortable holding all the time has been the US dollar. Data from the US treasury show that as on June 30, 2006, the total foreign holding of US financial securities (which include debt as well as equity investments) had stood at around $7.8 trillion.

This number has jumped big time since then and as on June 30, 2013 (the latest data available), stood at $14.4 trillion. The US treasury security, which is the financial security issued by the US government to finance its budget deficit, has been a favourite among foreign investors. Budget deficit is the difference between what a government earns and what it spends.

At the end of June 2006, the total foreign investment in US treasury securities had stood at around $2.1 trillion. This made up for around 26.9 per cent of the total foreign investment in US financial securities, which had stood at $7.8 trillion. At the end of June 2013, this number stood at $5.6 trillion or around 38.9 per cent of $14.4 trillion, the total foreign investment in US financial securities. What this tells us very clearly is that over the years the preference for treasury securities, which are deemed to be the safest financial investment going around, has gone up.

As of October 2014, the total foreign investment in US treasury securities stood at $6.06 trillion. Of course, we do not have the data for the total foreign investment in US financial securities to compare with. It would be interesting to see if the proportion had gone up since June 2013.

This global willingness to hold dollars creates other distortions in the system. As James K Galbraith writes in The End of Normal-The Great Crisis and the Future of Growth: "Foreigners earn dollars by exporting more to the United States than they import from the United States. They convert their dollars into Treasury bills [short-term financial securities issued by the US government] and bonds [long-term financial securities issued by the US government], because the latter pay interest and the former do not."

With dollars coming into the US, the value of the dollar against other currencies remains strong. "Their willingness to hold dollar assets, in turn, supports the value of the dollar, which raises imports and reduces exports, and so reduces tax revenue at the US Treasury, compared with what would otherwise be," writes Galbraith.

A stronger dollar essentially means that the US can import goods more cheaply. At the same time a stronger dollar makes things difficult for US exporters. Low exports mean that the exporters based in the US earn lower, and this, in turn, leads to lower taxes for the US government.

Data from www.tradingeconomics.com shows that the US trade deficit between January and October 2014 stood at $422.1 billion. Trade deficit is the difference between imports and exports.

And the major reason for this is the fact that the world is comfortable holding US dollars. As Galbraith writes: "So long as the world wishes to add to its reserves of Treasury bills and bonds, corresponding US budget deficits are inevitable...Any desire to eliminate the US budget deficit corresponds to a desire to eliminate the US position as the supplier of financial reserves to the world."

Since 2009, the US government has run a budget deficit of more than $6 trillion. What motivates the world at large to hold dollars? Why do they invest in US treasury securities? Because if they did not, it would drive down the value of the dollar against other currencies. This would lead to America importing less and exporting more, a situation which would help the US government earn more taxes and in the process control its budget deficit.

This would also mean that the interest rates in the United States will start to rise, as fewer dollars from all over the world chase US financial securities. Higher interest rates in the US would end the dollar carry trade, where institutional investors borrow in US dollars and invest in financial markets all over the world. This has led to bubbles all over the world.

But then we don't know why the world loves dollars. Galbraith summarises the situation best when he writes: "If we knew the answer, we could know the expected life span of the dollar-based international monetary system."

Vivek Kaul is the author of Easy Money. He can be reached at [email protected]