Sudip Bandyopadhyay’s Blog

For years the connection between the dollar and the size of the US
government debt has inspired one of the scariest scenarios in international
finance.  The US depends on foreign investors to finance its budget
shortfalls : 47% of Treasury bonds are held abroad.  When foreigners buy
this debt they support the US currency, since they need dollars to buy
T-bills and other US government debt.  But if foreigners get spooked by the
deterioration of the US budget deficit they might demand higher interest
rates or even dump the US paper in favour of bonds denominated in yen or
euros or yuan.  If the great dumping occurs, the foreign investors don’t
need or want as many dollars anymore and the US dollar  takes a hit.  The
scenario hasn’t played out yet: The dollar has declined but not crashed.
The patience of foreign investors, however, has started to wear thin,
Foreign central banks already showed their concern by urging the US to take
over Fannie Mae and Freddie Mac.  Now if foreign holders of US equities and
bonds don’t like the way the bailout or the economy is headed, Hank Paulson
and Ben Bernanke could have a dollar run on their hands.