A convergence of global events spells trouble for the US dollar. But income investors can make the best of a bad situation by looking overseas. This fund provides exposure to non-dollar denominated debt that should perform well relative to the greenback.–The Editors

Green Isn’t the Color of Envy

Ever since the 1944 Bretton Woods Conference, the US dollar has been the world’s de facto reserve currency. That unparalleled status gave our nation a leading role in global economic affairs after World War II. It also marginally reduced costs for the commodities we consumed, giving us an economic edge over the rest of the world in terms of input prices. That era is coming to an end.

As you can see in “A Decade of Decline,” the dollar’s dominance has slowly eroded over the past decade. As loose fiscal policy and a fondness for deficit spending have chipped away at the world’s confidence in the dollar, global central banks have diversified their reserve holdings to include greater portions of other global currencies such as the euro and precious metals such as gold.

As a result, data from the International Monetary Fund (IMF) indicates that the greenback accounts for 62.2 percent of global foreign reserves today compared to more than 70 percent in 2000.

Faltering confidence in the stability of the dollar has led to calls to scrap the greenback as the global reserve currency. China has advocated greater use of international reserve assets such as the IMF’s special drawing rights, the value of which is derived from a basket of currencies. Other nations have said they will sidestep the dollar in favor of using their own currencies in international trade.

If the dollar were to shed its reserve currency status, the cost of financing large external debts would necessarily rise. Essentially, a more rational fiscal policy would be foisted upon the US.

Although global governments may be paring back their exposure to the US dollar, a sudden shift would cause the value of global reserves to plummet. Countries such as China may be saber rattling for a new currency of commerce, but drastic change is unlikely for now.

The greenback’s value has rebounded during the global financial crisis, but this second round of quantitative easing will surely help sustain a high deficit. Combined with a general decline in confidence in the dollar, the currency’s value will continue to fall.

The gradual shift away from the dollar will likely continue for several reasons. The world has begun to question America’s stewardship of the global economy. Global interest rates are rising, but the US federal funds rate essentially still sits at zero percent. Meanwhile economies outside the US, notably in emerging markets, are growing faster than the US economy.

Market Vectors Emerging Markets Local Currency Bond (NYSE: EMLC) is an attractive way to take advantage of these global trends. Purchasing only non-dollar denominated foreign government bonds, it provides attractive currency exposure and a means of benefiting from improving growth in countries outside the US.

In the wake of the string of financial crises that marked much of the 1990s, many emerging-market governments have reined in spending, allowed their currencies to float freely and strengthened ownership rights for their citizens.

Most of these governments have also built strong balance sheets that have helped insulate them from the worst of the recent financial crisis. That’s created a strong market for debt denominated in local currencies.

Non-dollar denominated bonds offer another added benefit for US investors. With the currencies of these nations expected to perform strongly relative to the dollar, emerging-market bonds will provide a nice currency bounce that will help pad returns.–Benjamin Shepherd