The dollar staged a dramatic comeback this week, putting in its best performance for 16 years as the focus of investor concerns switched back across the Atlantic to the woes facing the European financial system.

The dollar index, which tracks its progress against a basket of six leading currencies, rose 5 per cent over the week, its largest gain since September 1992.

Previously, the dollar had been under pressure on fears over the US fiscal position if the Bush administration’s $700bn financial rescue package passed through Congress.

However, those concerns took a back seat as news emerged that authorities in the eurozone and the UK were forced to step in and rescue ailing banks.

“The credit crisis may have originated in the US but, as shown by the series of high-profile government bail-outs in the UK and eurozone, the ripple effects are deepening and cement the perception that currencies aside from the dollar have more bad news to price in,” said Mike Moran at Standard Chartered.

The dollar was also supported as interbank lending dried up. Heightened concerns over counterparty risk in the financial sector saw banks hoard dollars, forcing institutions who could not borrow the US currency to buy it directly in the foreign exchange market.

“Despite the best efforts of global central banks to inject dollar liquidity in a co-ordinated manner, such actions have only had a limited impact on money markets, where access to funding remains difficult,” said Divyang Shah, at Commonwealth Bank.

He said that, in spite of the growing use and importance of the euro, the dollar remained the world’s reserve currency. “When it comes to liquidity and market depth, the tendency is to favour the dollar,” said Mr Shah.

The dollar rose 5.6 per cent to $1.3788 against the euro over the week, having hit a one-year high of $1.3702 in Friday’s session, gained 3.8 per cent to $1.7750 against the pound and rose 4 per cent to SFr1.1339 against the Swiss franc.

The dollar also advanced against emerging market currencies as economic data across the globe deteriorated, heightening fears of a global recession.

The Brazilian real fell 8.4 per cent to R$2.0204 against the dollar over the week, the Korean won dropped 5.6 per cent to Won1,225.50 and the South African rand lost 4.8 per cent to R8.4457.

“Emerging market currencies have sold off sharply this week, not from panic but from the growing realisation that global recession risks are rising,” said Marc Chandler, at Brown Brothers Harriman.

He said he believed that risk aversion would remain high. “That plus the risk of falling commodity prices are likely to continue weighing on emerging market currencies.”

The euro was undermined, down to a two-year low against the yen, by comments from Jean-Claude Trichet, president of the European Central Bank. Although the central bank left interest rates unchanged at 4.25 per cent after its policy meeting on Thursday, Mr Trichet warned about growth in the eurozone and conceded that inflation risks had diminished.

The euro dropped 2 per cent to £0.7768 against the pound on the week and fell 5.8 per cent to Y145.88 against the yen.

The yen was the only major currency to advance against the dollar, rising 0.2 per cent to Y105.72.

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