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The resilient dollar

America depends on foreign savings to finance its current-account deficit, about 5% of GDP in the 2nd quarter 2008. Despite the recent crisis happening in the US, the dollar has uphold itself surprisingly well.

Kristin Forbes, of the Massachusetts Institute of Technology, recent conducted a study to discover what lies behind the hearty appetite for dollar assets. She looked as several factors that might affect the cost and benefits of buying American assets, including each country's capital controls, its financial development, its investment returns at home, and how useful dollar assets were in diversifying risk. Two striking results emerged:

  1. There was little evidence that foreigners buy American as a hedge against risks at home. If a country's investment returns moved in tandem with America's, this did not reduce their thirst for dollar assets. This is the opposite of what financial theory predicts - that investors would be keener on foreign assets the less they were correlated with their domestic ones.

  2. A lack of financial development at home makes foreigners keener to invest in America. What attracts them is the size, liquidity, efficiency and transparency of its financial markets compared with what is on offer in their domestics markets. This findings adds weight to theories which explain global imbalances as a consequence of slow financial progress. In this view, poor countries save hard and buy foreign securities because of a dearth of good options at home.

Source: The Economist, 2008-10-02, ”The Resilient Dollar"