EDITOR'S NOTE: This analysis is written by Dr. Bento Lobo, First Tennessee Bank Distinguished Professor of Finance, with research support from Matthew Crawford, Justin Dorris, Brittany Justice and Kristin Miller, all students in his International Finance class at UT Chattanooga this past spring semester.
The dollar is a leading transaction currency in the foreign exchange markets and a key invoicing currency in international trade. About 85 percent of foreign exchange transactions world-wide are trades of other currencies for dollars, even among trades among companies outside of the United States.
“When a South Korean wine wholesaler wants to import Chilean cabernet, the Korean importer buys U.S. dollars, not pesos, with which to pay the Chilean exporter,” University of California at Berkeley Economist Barry Eichengreen recently wrote in the Wall Street Journal. “Indeed, the dollar is virtually the exclusive vehicle for foreign exchange transactions between Chile and Korea, despite the fact that less than 20 percent of the merchandise trade of both countries is with the U.S.”
According to the U.S. Treasury Department, about 65 percent of all U.S. banknotes circulate outside the country: roughly 75 percent of hundred-dollar notes, 55 percent of ﬁfty-dollar notes, and 60 percent of twenty-dollar notes are held abroad. Dollar banknotes used abroad provide some foreign households and businesses with a more stable store of value, and a sounder transaction currency, especially during periods of turbulence overseas.
Between 1990 and 2008, 65 percent of bonds issued by firms from developed countries other than the U.S. were denominated in U.S. dollars. By comparison, only 6 percent of such bonds were denominated in pounds, and 7 percent were denominated in yen. More than 60 percent of the foreign reserves of global central banks and governments are in dollars.
Quite simply, the U.S. dollar is the most important currency in the world. It plays a central role in international trade and finance, both as a store of value and as a medium of exchange.
However, the end of dollar preeminence has been predicted for a long while. Here we explore the reasons for the dollar's central role, the threats to the dollar and the implications of a change in the dollar's status.
When representatives from 44 nations converged at the Bretton Woods conference in 1944 to design the new international financial landscape and ensure a fair and orderly post-war market for cross-border trade, an agreement was reached which produced a new exchange rate system - partly a gold exchange system and partly a reserve currency system. With the U.S. emerging as the strongest economy in the post-war era, the U.S. dollar became the de facto global reserve currency.
Today the dollar's dominant status is supported by its size - the world's largest economy with a GDP of $14.7 trillion, about a quarter of the $62.9 trillion global economy - as well as a dearth of viable currency alternatives.
Underlying the dollar's central position is the role of money in conveying information about relative prices. By using money, individuals reduce the amount of information that they must acquire and process, and the number of transactions in which they need to engage. Money, in its capacity as a transmitter of information, performs a function analogous to that of an international language.
The utility of money depends, in part, on how many others use it. The medium of exchange, unit of account and store of value functions of money give rise to “network externalities” as larger numbers of people use the currency thereby making it more beneficial to all users. Even if individuals should have an incentive to switch to another currency, they would have to convince many other agents to make the same switch before it would become worthwhile to do so. The “switching cost” is one reason why the British pound continued to be widely used internationally years after the United Kingdom lost its position as the world's preeminent economic power.
Indeed, the dollar's established and deep role in international markets post-Bretton Woods gives rise to inertia in the use of currency as pointed out by Krugman in the early 1980s. Further contributing to this phenomenon, is the fact that key commodities such as oil and metals are priced in dollars. OPEC, for instance, prices oil in dollars which gives rise to enormous demand for U.S. dollars. As a result, many Middle Eastern oil exporters carry large surpluses of dollars which they in turn reinvest in the U.S. By some estimates, as much as $1.6 trillion of foreign exchange reserves are held in the Middle East.
The allure of the dollar over time also reflects the depth of markets in dollar-denominated securities. Almost 84 percent of the notional amount of all OTC derivative securities is denominated in U.S. dollars, according to 2010 statistics provided by the Bank for International Settlements. The liquidity in these markets, coupled with the reputation of U.S. Treasuries for stability, has made the U.S. dollar the safe haven for investors in times of crises.
Users are also predisposed to use the dollar because the dollar is linked to their own currency through their exchange rate regime. Reinhart and Rogoff reported seven countries that are dollarized or have currency boards using the dollar and eighty-nine countries that have a pegged exchange rate against the dollar.
Another indicator of the dollar's status is its role as a reserve currency. These reserve balances, held by foreign governments and central banks in the form of U.S. dollar deposits and bonds, have grown sharply over the past decade. IMF statistics show that in 2009, dollar assets accounted for about two-thirds of the reserve assets of industrialized and developing countries. This proportion, however, is down from over 80 percent in the 1970s. Currently, the central banks of China and Japan hold about 22 percent of U.S. debt making them the largest creditors to the U.S.
In the 1960s, former French Finance Minister Valéry Giscard d’Estaing famously charged the United States with enjoying an "exorbitant privilege" because of the dollar's reserve currency status.
Indeed, the dollar's international status helps insulate the U.S. economy from foreign shocks, reduces transaction costs in trade for American businesses, and contributes to the international transmission of U.S. shocks and monetary policy effects.
The U.S. government is perhaps the single largest beneficiary, gaining lower interest payments on public debt as well as seigniorage revenue.
Seigniorage revenue - the effective interest-free loan generated by foreign holdings of U.S. banknotes - is estimated to be in the range of $10 billion to more than $30 billion.
The U.S. government's ability to borrow relatively cheaply due to large purchases of U.S. Treasury securities by foreign governments and government agencies is estimated by some to have reduced the U.S. borrowing rate by 50 to 60 basis points in recent years, generating a financial benefit of about $90 billion.
The U.S. has enjoyed another advantage in its ability to borrow in its own currency. A normal debtor country, such as Argentina, has to borrow in foreign currency, so while a devaluation will help to reduce its trade deficit, it will also increase the local currency value of its debt. In the case of the U.S., by contrast, foreign creditors carry the currency risk on America's gross liabilities.
However, McKinsey Global Institute (MGI) finds evidence contradicting the d’Estaing assertion. Reserve currency status imposes costs on exporters and sectors that compete with importers. This is because dollar exchange rates tend to be 5 to 10 percent higher than would otherwise be the case because the reserve currency is a magnet to the world's official reserves and liquid assets. This harms the competitiveness of U.S. exporting companies and companies that compete with imports, imposing a net cost of an estimated $30 billion to $60 billion and a reduction in employment by 400,000 to 900,000 in the affected sectors.
MGI found that in 2007-2008 - a “normal” year for the world economy, the net financial benefit to the United States was between $40 billion and $70 billion or 0.3 to 0.5 percent of U.S. GDP. In a “crisis” year such as 2008-2009, the net financial benefit fell to between -$5 billion and $25 billion because the dollar appreciated by an additional 10 percent due its status as a safe haven.
The post-WW II system was riddled with a fundamental dilemma, known as Triffen’s Dilemma: on the one hand, the U.S. has had to print more dollars and run a balance-of-payments deficit to satisfy that growing global demand for liquidity as the de facto reserve currency; on the other hand, the continued balance of payments deficits threatens the credibility of the U.S. dollar as a sound reserve currency.
Today, because of their dollar reserves, Asian central banks, for instance, are exposed to enormous potential losses in local-currency terms should their currencies appreciate against the dollar. The U.S., on the other hand, needs a weaker dollar to stimulate the economy and improve its net foreign investment position, but doing so jeopardizes the reserves of foreign countries whose currencies have appreciated against the dollar. How much longer can this system survive?
Threats to the U.S. dollar
The most serious threats to the dollar's continued dominance lie in the emergence of alternative reserve currencies, the euro and yuan in particular, and in the erosion of the U.S.'s credibility in world financial markets.
Since its inception in 1999, the European euro has emerged as an alternative to the dollar. Common currency to seventeen nations as of 2011, the currency has withstood numerous political shocks and gained roughly 30 percent on the U.S. dollar. The eurozone economy rivals the U.S. in size and the euro’s share in global currency reserves has increased from 18 to 26 percent since 1999. Recent sovereign debt problems brought on by the credit crisis of 2007-2008 have undermined the common currency to a limited extent. However, the decision to issue “e-bonds” backed by the full faith and credit of the euro-zone governments as a whole, are seen as a step in the direction of an integrated bond market which could provide an alternative to U.S. Treasuries.
China, too, is moving rapidly to internationalize the yuan. Standard Chartered Bank reports that 2010 saw a quadrupling of the share of bank deposits in Hong Kong denominated in yuan even as yuan-denominated "dim sum" bonds are gaining in popularity. Moreover, in January 2011 the Bank of China began offering yuan-deposit accounts in New York insured by the Federal Deposit Insurance Corp. thereby allowing Chinese companies to make cross-border settlements in yuan and freeing them from having to undertake costly foreign-exchange transactions.
But the most important threat to the U.S. dollar is the very real danger that the dollar's safe-haven status will erode further.
Foreign investors hold dollars and dollar-denominated assets not simply because of the liquidity they provide but because they are secure. The U.S. government has a history of honoring its obligations, and it has always had the fiscal capacity to do so.
But confidence in the currency and the safety of U.S. government debt is undermined by a $12.3 trillion national debt, trillion dollar budget deficits, unfunded obligations for programs such as Social Security, Medicare and Medicaid, the threat of a federal government shutdown and the possibility of default. Eichengreen emphasizes, “…as the burden of debt service grows heavier, questions will be asked about whether the U.S. intends to maintain the value of its debts or might resort to inflating them away. Foreign investors will be reluctant to put all their eggs in the dollar basket.”
Recent turmoil in the Middle East and North Africa, a nuclear crisis in Japan and fiscal troubles in Portugal and Greece all failed to send investors seeking out the dollar as a safe haven to the same extent as in the past.
On Aug. 5, Standard and Poor’s downgraded its rating on U.S. debt by one notch from AAA to AA plus. S&P said the U.S. has “very large budget deficits and rising government indebtedness and the path to addressing these is not clear to us."
The downgrade to the U.S.'s AAA rating is feared to cause negative effects. Interest rates in the U.S. could rise, although they initially have not. The U.S. government would have to pay more to borrow since there would no longer be as big an appetite for U.S. Treasury securities on the part of foreign central banks and institutional investors. The rise in borrowing costs would exacerbate the debt problem and could put a damper on credit creation and growth in the U.S. By some estimates, the international trade dynamics could cause U.S. living standards to be reduced by as much as 1.5 percent of GDP.
Moreover, some pension funds and investment trusts that are legally bound to invest only in AAA-rated debt could be forced to dump U.S. holdings. Banks that do the bulk of their business in the U.S. could also face downgrades. And of course, the U.S. consumer would have to pay more for all goods imported into the country possibly leading to a significant inflation problem.
Historically, international exchange has been based upon the use of currencies of dominant creditor countries. It is seemingly unsustainable for the international monetary system to be dominated by debtor nations, and especially by the world's largest debtor.
Executives surveyed by McKinsey expect greater future volatility in exchange rates as well as significant changes to global exchange rate arrangements in the coming years - only 18 percent predicted that the U.S. dollar would still be the dominant reserve currency in 2025.
The displacement of the dollar as the world's reserve currency would force American companies to cope with some of the same exchange-rate risks and exposures as their foreign competitors. They would have to be much more watchful of currency market developments if they have to give up the convenience of using the dollar in trade and overseas operations and in translating foreign-currency earnings into dollars. They may have to more actively engage in currency market hedging using forward contracts and options to protect against financial losses due to changes in the exchange rate.
If not the U.S. dollar, then what?
In a May 2011 report, the World Bank indicated that the U.S. dollar would likely lose its dominance in the global economy by 2025, as the global financial system evolves into a new “multi-currency” monetary system. The shift is expected to be driven by the increasing power and strength of emerging market economies, with six countries - Brazil, China, India, Indonesia, Russia and South Korea- accounting for more than half of global growth in 14 years. According to the report, in the “most likely” scenario:
“The current predominance of the U.S. dollar would end sometime before 2025 and would be replaced by a monetary system in which the dollar, the euro and the renminbi would each serve as full-fledge international currencies.”
China, backed by other emerging economies such as Russia, is making clear they want a global economic order less dominated by the U.S. Premier Wen Jiabao expressed “worries” over China's significant holdings of U.S. government bonds. Central bank governor Zhou Xiaochuan argued that moving to a type of “super sovereign” reserve currency that belongs to no individual nation (a la the IMF’s Special Drawing Rights) would make it easier for all nations to manage their economies better, because it would give the reserve-currency nations more freedom to shift monetary policy and exchange rates.
However, an SDR-type solution is unlikely to work. Transaction settlements are usually specified in a single currency - few sellers want to receive a payment in a bundle of currencies, and few buyers will find it convenient to pay in multiple currencies simultaneously. Moreover, SDRs must be underwritten by the central banks that issue these currencies. Who would control the issue of SDRs? No central bank will want to create large amounts of money over which it has no control.
What about other currency alternatives? Neither the European euro nor Chinese yuan fit the needs of a global reserve currency.
The Chinese yuan is unlikely to be a global reserve currency for the foreseeable future because while China is expected to overtake the U.S. as the world's largest economy by 2025, it takes more than economic might for a currency to assume the role of reserve currency. Two key features that China currently lacks are a well-entrenched democracy and long-term political stability.
The Eurozone, on the other hand, is unlikely to assume the primary reserve currency mantle for different reasons. The prospect of a permanently stronger euro is likely to be unattractive in that it would impose a burden on member states such as Italy, Greece, Portugal, and Spain that are already suffering from the euro’s strength. Moreover, export dependent countries like Germany that sell over half of their exports outside the Eurozone, will also be exposed in the event of a structural appreciation in the euro. Perhaps unsurprisingly, the European Central Bank is a supporter of a strong dollar policy.
Indeed, the U.S. Treasury continues to articulate a “strong dollar” stance. The truth, however, is that the U.S. faces a trade-off: the benefit from a lower cost of capital will grow larger as US government borrowing requirements expand. But the United States could face increased economic and employment costs if maintaining primary reserve currency status constrained the depreciation of the dollar needed to stimulate growth. In a sluggishly-growing economy, politicians are likely to view the benefits from the dollar's reserve currency status as modest, making it less likely that the United States will be willing to pursue policies to meet the implicit responsibilities associated with that status.
Even with the tug and push of conflicting incentives the status quo will persist due to factors such as inertia in currency use, the dollar pricing of oil and other commodities, the large size and relative stability of the U.S. economy, and the dearth of realistic reserve currency alternatives.
Could it be that years from now global reserve portfolios will be denominated in real, rubles, rupees or renminbi? While it is certainly possible, any secular change resulting in the “demise” of the dollar is likely to be gradual and more than likely will be driven by the politics of international relations, not economics.