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Why being the king of currencies has its pitfalls

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“…it’s been described by Europeans and others over the years as an “exorbitant privilege” that ensures the world lends to the U.S. Treasury in its own currency at low interest rates regardless of dollar strength.”

The world is getting an object lesson on the problems of having one dominant global currency and even the supposed prime beneficiary, the United States, can see the downside.

Alarming bouts of volatility in world financial markets over the past 12 months have been rooted in a fear of what happens when a world with its highest-ever peacetime debt pile faces even a hint of higher interest rates.

Despite a constant narrative about U.S. households and banks paying down debts ever since the global credit crash eight years ago, any ‘deleveraging’ that did happen was more than offset by higher government, corporate and personal debt around the globe in Europe, China and across emerging markets.

In fact, aggregate world debt is now far higher than it was before the 2007-08 crash.

“The saga of debt is far from over,” says a report from Morgan Stanley. It goes on to explain why Morgan Stanley expects demographic-led shifts in savings and investment to soon push interest rates higher and transform that debt mountain into additional deadweight on world growth over next five years.

But the role of the U.S. dollar as the world’s main reserve currency denominating large chunks of that debt pile is showing up as complicating factor that’s added to risk of instability.

The first U.S. interest rate increase in almost a decade in December – just a quarter of a percentage point – was enough to trigger a convulsion in world markets that led to the worst start to a year for global stocks since World War Two.

Underlining ’cause and effect’, the subsequent recovery only came about once the Federal Reserve hastily made clear it was pressing the pause button precisely because of seismic events in world finance.

Few doubt a growing U.S. economy that’s near full employment can absorb some normalization of interest rates from near zero, and a higher dollar goes hand in hand with that.

But the rest of the world clearly can’t.

The Bank for International Settlements estimates that while U.S. dollar dominance means it accounts for almost 90 percent of all foreign exchange transactions and some 60 percent of hard currency reserves. But crucially it also accounts for about 60 percent of all debts and assets outside the United States.

And if the rest of the world goes into shock because of the higher cost of servicing and paying back those dollar debts, the boomerang effect on U.S. exporters, commodity firms and the wider economy just ends up tying the Fed’s hands in ways made crystal clear this year already.

To read the full article, click the link below.

http://www.reuters.com/article/us-global-policy-reserve-analysis-idUSKCN0Y20FQ

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