For six years the world has been borrowing dollars to bet on property, oil, metals, emerging markets, and every bubble in every corner of the globe.

By Ambrose Evans-Pritchard
Last Updated: 3:48PM BST 23 Oct 2008

The strong rebound in the dollar has surprised some analysts

This has been the dollar "carry trade", conducted on a huge scale with high leverage. Now the process has reversed abruptly as debt deflation - or "deleveraging" - engulfs world markets. The dollars must be repaid. Hence a wild scramble for Greenbacks which has shaken the global currency system and shattered assumptions about the way the world works. The unwinding drama reached a crescendo yesterday as the euro fell to $1.28, down from $1.61 in July. The slide in the Brazilian real, the South African rand, the Indian rupee, and the Korean won, among others, has been stunning.Stephen Jen, currency chief at Morgan Stanley, said US mutual funds, pension funds, and life insurers invested a big chunk of their $22 trillion (£13.5 trillion) of assets overseas to earn a higher yield during the boom. They are now in hot retreat as the emerging market story unravels. "There is a complete rethink going on. People are bringing their money back home," he said. Hedge funds are 75pc dollar-based, regardless of where they come from. Many are now having to repatriate their dollars as margin calls, client withdrawls, and the need to slash risk forces them to cut leverage. The hedge fund industry had assets of $1.9 trillion at the peak of the bubble.Data collected by the Bank for International Settlements shows that European and UK banks have five times as much exposure to emerging markets as US and Japans banks, with surprisingly big bets in Latin America and emerging Asia - where they rely on dollar funding rather than euros. The fear is that deflating booms in these frontier economies will have an 'asymettric' effect on the currency markets, setting off another round of frantic dollar buying. "It is not impossible that the euro could collapse completely against the dollar, going back to 2001 levels," said Mr Jen.He said the "composite" dollar-zone including China, the Gulf oil states, and other countries locked into the US currency system, will together have a current account surplus next year. The de-facto euro bloc of the core euro-zone and Eastern Europe is moving into substantial deficit. This creates a subtle bias in support of the dollar.Of course, much of the currency shift this year is a natural swing as the crisis rotates from the US to Europe and beyond. The dollar was pummelled in the early phase of the crunch when economists still thought Europe, Japan, China and the rest of the world would decouple, powering ahead under their own steam. The Federal Reserve's dramatic rate cuts were seen then as a reason to dump the dollar. The decoupling myth has now died. The euro-zone and Japan appear to have fallen into recession before the US itself, led by a precipitous fall in German manufacturing. The ultra-hawkish stance of the European Central Bank - which raised rates in July - is now viewed as a weakness. Foreign exchange markets are no longer chasing the highest interest yield: they are instead punishing those where the authorities are slowest to respond to the downturn. A hard-hitting report by Citigroup this week said the ECB had unwisely ignored screaming signals from the bond markets earlier this year for a rate cut. "The ECB did not listen. Not only did they no reduce rates as they should have but they increased them in one of the biggest policy mistakes of 2008," it said. The spectacular dollar rebound has geostrategic implications. Heady talk earlier this year that dollar hegemeny was coming to an end - or indeed that the US was losing its status as a financial superpower - now seems very wide of the mark.