Canadian investors feeling the effects of a sliding U.S. dollar in their global portfolios should hold tight, according to a new study from Standard & Poor’s. The U.S. dollar is still the world’s most important currency and will remain so for the foreseeable future.

Purging a portfolio of U.S. dollars is unwise. Although the U.S. dollar has been dropping in value, there is no currency even remotely close to its position as the world’s benchmark currency, according to the S&P study, entitled Despite Pressures, the U.S. Dollar Remains the Key International Currency.

A large percentage of global investment funds are still heavily weighted in U.S. equities, which are generally denominated in U.S. dollars. On top of that, the Bank for International Settlements, which tracks foreign market turnover, says the U.S. dollar is used in 86.3% of the world’s exchange transactions.

While the U.S. economy has been flagging, Nickola G. Swann, the study’s author, says its economy is still the world’s most important, accounting for more than 27% of the world’s GDP — more than the next three largest economies (Japan, Germany and China) combined. Virtually all of the exports to the U.S. are invoiced in U.S. dollars.

“Without the dollar’s status, the U.S. would not have such ready access to external financing; interest rates would have to rise to attract higher domestic savings; growth would slow well below potential,” says Swann, a credit analyst at S&P. “The U.S. dollar did not attain this position by accident, however, nor is it simply maintained by inertia.”

Foreign investors and central banks are increasing their holdings of other currencies, but that’s on additional assets they acquire. Their total assets are still heavily tilted in favour of the U.S. dollar. Through the second quarter of 2007, the share of U.S. dollar reserves as a percentage of identified reserve holdings was 65%, according to Swann.

Benjamin Reitzes, an economic analyst with BMO Capital Markets, agrees with Swann’s conclusions that there is no real alternative to the U.S. dollar as the world’s currency benchmark.

“The U.S. dollar has had its problems, no doubt about that, but the U.S. capital markets remain the deepest and most liquid in the world,” Reitzes says. “As foreign investors accumulate more assets, the share that they buy in U.S. dollars will not be as large. This increases the downward pressure only slightly and shouldn’t impact on the U.S. dollar too much. As the credit crisis slump ends, the dollar should recover.”

A reversal in the U.S. dollar’s fortunes could leave those hoarding Canadian-dollar-denominated assets out to dry.

Ian McPherson, president of Criterion Investments, says trying to avoid this back-and-forth between the loonie and greenback is a perfect example of why investors need to consider currency hedging.

“Currencies are an important risk factor when you invest abroad, we believe that investors should hedge exposure and not take any subjective view whether those currencies are going to strengthen or weaken,” McPherson says. “Ninety-nine per cent of the mutual funds which are a proxy for investing abroad have been hurt by the strength of the Canadian dollar. We haven’t.”

McPherson says since experts can’t agree on which currency is on the rise, the need to remove currency risk will only increase, especially as investment portfolios become ever more diversified and contain more currencies.

“We let the portfolio management strategy run independently so they can pick what they believe are the best stocks for the portfolio. What we then do is look at our currency risk and how much exposure we have to each currency. We sell that currency risk to a major Canadian bank,” he says. “Let’s just accept [currency risk] for what it is and eliminate the risk.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(10/16/07)