The dollar question: Where are we?

Kati Suominen, 9 July 2010

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The global crisis and US economic travails triggered a firestorm debate on the future of the global currency regime.

  • At the London G20 Summit in April 2009 China’s central bank governor Zhou Xiaochuan slighted the dollar-centric order, calling for a super-sovereign reserve currency – a reference to special drawing rights (SDRs) housed at the IMF.1
  • Russian President Dmitry Medvedev called for a mix of regional currencies;
  • Some western opinion leaders warmed to the euro’s leadership (see for example Zoellick 2009).

Washington refuted these notions. Instead it pledged fiscal discipline to help buttress the greenback. ECB head Jean-Claude Trichet also argued for the dollar’s importance in the world economy (Reuters 2009a).

At last week’s G20 Summit in Toronto, currencies went practically unmentioned. This reflects the US recovery; the fall of its most plausible contender, the euro, amid Europe’s economic woes; and perhaps China’s deflecting attention from its exchange-rate management. Despite this, the debate continues to simmer as US debt and trade deficits grow. In line with the Triffin Dilemma2, this raises concerns about the dollar’s viability and trade protectionism in America. Three main camps of literature explore the alternatives to the dollar as the global reserve currency – yet each has important drawbacks.

Global currency

In his March 2009 comments, Zhou argued that Keynes’ vision for a global currency (expressed at the famous Bretton Woods conference that set up the IMF and World Bank) “may have been more farsighted” than the dollar-centric system that came into being.

Keynes envisioned an International Clearing Union (ICU) that would issue “bancor” – a currency based on the value of 30 commodities (including gold) and exchangeable against national currencies at fixed rates. Countries would maintain bancor accounts and draw from the ICU when experiencing balance of payments problems. In 1967, the IMF forecast that Special Drawing Rights (SDRs) would account for over half of total world reserves before the end of the 20th century (Polak 1967). Nobel prize laureate Robert Mundell (among many others) has advocated similar notions since the 1960s (Mundell 1968).3 The idea has gained momentum following Zhou’s comments.

  • Bergsten (2009) and Wijnholds (2009) support a substitution account that would enable countries to reduce their dollar exposure by swapping dollars for SDRs.4
  • More ambitiously, a UN commission (2009) led by Joseph Stiglitz suggests a “greatly expanded SDR” system akin to the bancor system.
  • Strauss-Kahn (2010) argues that the IMF could in the long-run issue SDRs.
  • An IMF team laid out detailed thinking on a global reserve currency issued by the international monetary institution – an independent central bank with an unrivalled AAAA rating (Mateos y Lago et al. 2009).5 Member states could issue bonds and other instruments denominated in this global currency.
  • Stiglitz (2009) proposes a global reserve system whereby countries obtain paper gold (like bancor) from the IMF for their reserves as crisis insurance so as to attenuate reserve accumulation.6

These more ambitious proposals would provide exchange rate stability, global network benefits and scale economies, and be considered “fair” in that no nation would enjoy exorbitant privilege.

Authors acknowledge, however, the tall assumptions. The dedicated central bank would have impeccable judgement, and be able to reconcile independence with accountability to member nations. Practical constraints are enormous.

The G20 expanded the SDR pool by $250 billion, but even then SDRs make up only 4% of global reserves. Making SDR the principal reserve asset would require $3 trillion of fresh SDRs, more than the GDP of France. At the same time the IMF would need to be made a world central bank able to print money.7 It would take years for the SDR to be accepted across global transactions and reserves (Cooper 2009), particularly as the first SDR liabilities would face competition from existing assets.

Politics would be the thorniest part. The US would likely be opposed so as to protect the dollar, and Washington holds a veto at the IMF on SDR issuances. The composition of the SDR basket would also be contested. The current basket is composed of the dollar, euro, yen, and sterling – major emerging markets would push for inclusion of their currencies. Economists would argue for Australian, Canadian, Chilean, and Norwegian currencies so as to link SDRs to commodity price cycles.8 The larger the SDR system grows, the more fiercely its governance is likely to be contested.

A new reserve currency

Another camp sees the dollar as becoming supplanted by a new reserve currency. A number of analysts – Reisen (2009), Roubini (2009), Aiyar (2009) – hold that the renminbi could replace the dollar as a reserve currency in a few decades. Reisen sees 2050 as the tipping point away from the dollar, when the Chinese economy is projected to be nearly twice as large as that of the US (Goldman Sachs 2007).9

The euro has, since the 1990s, been seen as a possible dollar replacement, with the Eurozone’s size and prominence in world trade taken as the main drivers.10 Galati and Woolridgde (2008) find that the liquidity and breadth of euro financial markets are approaching those of dollar markets. Chinn and Frankel (2008) argue that given UK’s liquid financial markets, British accession to the Eurozone would be a tipping point. As the US economy stumbled, Zoellick (2009) saw prolonged problems as leading to flight to euro. De Cecco (2009) suggests that the euro would be to the 21st century what gold was to the 19th.

Yet neither the renminbi nor euro is a perfect substitute to the dollar.

The renminbi is hardly used as a reserve currency, and plays a minor role in international exchanges.11 A global reserve currency requires liquidity and convertibility, but the Chinese government securities market is underdeveloped, illiquid, and the renminbi is not convertible. If it were, it would likely appreciate and torpedo the government’s export-led growth paradigm – not unlike Japan’s problem in the 1980s – and undercut its political grip. China is preparing Shanghai as a global financial centre by 2020, but Hong Kong, with its convertible dollar, seems far likelier to play the part (Steinbock 2009). The renminbi’s regional reach will be stunted by rivalries with India and Japan, the once-envisioned core of a yen bloc (Katada 2008).

The euro has become the unquestionable runner-up reserve currency, but it is now seriously weakened by the debt crisis and the tardy response to it. The euro is also constrained by fundamentals – a fragmented euro-bond market, Europe’s inverted age pyramid, lacklustre growth, and the absence of a Federal Reserve-like lender of last resort.12 Foreign policy concerns may also continue enticing countries even in the European periphery to peg to dollar instead of euro (Posen 2008). Europe’s debt problems, as well as its other issues, will likely persist longer and be thornier than those of the US (Cooper 2009 and James 2009). Germany in particular is unlikely to want a more prominent role for the euro should that entail appreciation. If the euro rose to rival the dollar in 2020, European extra-regional exports would decline by 10% (McKinsey 2009).

In turn, the yen is a long-shot as Europe’s growth and demographic problems meet with China’s market rigidities in Japan.

Co-currencies

Still another widely discussed idea is a system of co-currencies. Before 1914 several currencies periodically shared the role of the global reserve currency (Eichengreen 2005). Diversity could also produce healthy policy competition among issuing nations for investor confidence (Eichengreen 2009 and Genberg 2009).

Three factors could facilitate a co-currency world.

  • First, financial innovation could reduce the costs of converting currencies, lowering incentives to hold reserves in a single currency (Genberg 2009).
  • Second, further regionalisation of world trade could make China, Japan, Germany, and countries surrounding them, more decoupled from the US economy and thus less interested in holding dollars.13
  • Third, liberalisation and integration of Asian financial markets could eventually lead to a regional currency bloc, perhaps even the occasionally discussed monetary union.14

A system of regional currency blocs need not be trade-diverting (Eichengreen and Irwin 1993). Studies on the Eurozone, for example, find evidence of trade creation, not trade diversion (Micco 2003).15 But a system of equal co-currencies is leaderless and prone to conflict, as would be intra-regional currency competition (Cohen 2009 and Stiglitz 2009).16 An unmanaged system would lead to instability in the exchange rate (McKinsey 2009).

Perhaps the most feasible outcome in the next decade is some further diversification, with one or two regional currencies alongside the global dollar, and/or some type of SDR substitution account. To the extent that it alleviates the Triffin Dilemma and provides stability while also not undercutting confidence in the dollar or disrupting the network benefits the dollar provides, such a system could be favourable for the US.

Dollar’s death – even dollar doubts – are exaggerated

The greenback’s resilience has been questioned at least three times in the post-war era – in the 1960s as gold reserves ran short, amid Japan’s rise in the 1980s, and upon the founding of the euro in the 1990s. Yet, the dollar has always rebounded in a reflection of US economic prowess, unrivalled liquidity and stability of US financial markets, scale benefits of the dollar in global transactions, and sheer path-dependence. A tipping point has not occurred due to the lack of alternatives and need. Alternatives continue to be tenuous.

The dollar’s prominence is as indisputable as is US safe haven status.17 But the literature agrees that global reserves will need to grow robustly to keep up with import demand.18 This accentuates the Triffin Dilemma. The soaring US debt risks undermining the dollar and America’s enjoyment of its hard-earned exorbitant privilege, jeopardising US global economies.19

Whether pariah America or safe haven America will result depends on policy. Size, growth, liquidity, and solvency require fiscal discipline, non-inflationary policies, and capital investments. Yet solvency and central bank independence are not sufficient. If the US private sector deleverages and other countries accumulate dollar-denominated assets as reserves, the US government would re-emerge as the borrower of last resort (Wolf 2009, Posen 2008).20 The G20 drive to contain global financial imbalances is a means to avert such an outcome.

References

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Bergsten, C Fred (2009), “We Should Listen to Beijing’s Currency Idea”, Financial Times, 8 April

Bergsten, C Fred (1997) “The Dollar and the Euro.” Foreign Affairs 76, 4:83-95.

Chinn, Menzie D and Jeffrey A Frankel (2008), “The Euro May over the Next 15 Years Surpass the Dollar as Leading International Currency”, NBER Working Paper 13909 (April).

Cohen, Benjamin J (2009), “Toward a Leaderless Currency System”, in Eric Helleiner and Jonathan Kirshner (eds.), The Future of the Dollar, Ithaca: Cornell University Press.

Cohen, Benjamin J (2008), “A One-and-a-half Currency System”, Paper Global and International Studies, UC Santa Barbara, 1 July.

Commission of Experts of the President of the UN General Assembly on Reforms of the International Monetary and Financial System (2009), “Recommendations” (19 March).

Cookson, Robert (2010), “China Plans Route Back for Offshore Funds in Hong Kong”, Financial Times, 1 July.

Cooper, Richard N (2009), “The Future of the Dollar”, Policy Brief 09-21, Peterson Institute for International Economics (September).

De Cecco, Marcello (2009), “From Monopoly to Oligopoly: Lessons from the Pre-1914 Experience”, in Eric Helleiner and Jonathan Kirshner (eds.), The Future of the Dollar, Ithaca: Cornell University Press.

Deutsche Bank Research (2008), “The Euro Hits Big Time”, Reports on European Integration, EU Monitor No. 58, 26 June .

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Eichengreen, Barry (2005), “Sterling’s Past, Dollar’s Future: Historical Perspective on Reserve Currency Competition”, NBER Working Paper 11336 (May).

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1 The SDR is a virtual currency whose value is set by a currency basket made up of the dollar, the euro, the pound, and the yen, all of which qualify as reserve currencies, with the dollar being the leader. Zhou Xiaochuan argued that financial crises resulted from a clash between the domestic imperatives of the country issuing a reserve currency and international needs for stability.
2 For an extensive multi-author survey of the dollar’s future, see Helleiner and Kirshner (2009). Under the dilemma: while the US needs to supply the world with its currency so as to meet the global demand for reserves, the more dollars are supplied, the likelier confidence in the dollar is to erode – which, in turn, jeopardises the dollar’s role as a reserve currency. The corollary of the dilemma is that since the US runs current account deficits and foreigners invest in America, the dollar tends to be consistently overvalued. This, in turn, hurts US exports, worsens the trade gap, and sparks anti-trade sentiments. Escaping the trap is practically impossible without another currency: if the US stopped running current account deficits, the world would lose its main source of fresh reserves, and global growth could be seriously stunted.

3 Under his system, each country would exchange its currency at par with the world unit “intor.”

4 The idea was discussed at the IMF in the late 1970s. The account would be only 44% dollars, the share of dollar of the SDR basket, and thus would prevent a drop in the dollar upon diversification, and no currency – euro, yen, and sterling – would appreciate sharply (Bergsten 2009). It would of course not allow for full diversification out of the dollar.
5 Unlike bancor, the GRC would not be based on commodity values.

6 Hufbauer and Suominen (2010) explore, even if as distant, revaluing gold to create overnight a new pool of reserves.

7 For China to elevate SDRs to a reserve-currency status would require Beijing to create a liquid market in SDRs – issue its own SDR-denominated bonds, rather than buying them from the IMF (Eichengreen 2009). It would also need counterpart, as there is no market for SDRs.

8 The four currencies proxy the price fluctuations of copper, iron ore, gold, and oil (see Riesen 2009).

9 Angus Maddison and Harry Wu (2007) predict that China’s economy will surpass that of the US prior to 2020 in purchasing power parity terms. Goldman Sachs (2007) argues that by 2040, Russia, Brazil, and India, while trailing far behind the US and China, are each larger than the economies of America’s G7 partners Japan, Germany, UK, France, Canada, and Italy; by 2045, also Mexico will grow larger than these developed economies. By 2050, Nigeria’s economy will be larger than that of France and South Korea’s almost as large.

10 Portes and Rey (1997) argued that the euro could replace the dollar as the leading currency by 2020. To be sure, with the exception of Bergsten (1997), most US observers were sceptical (for example Summers 1997 and Frankel 1995). Arguments about the euro’s coming were not ludicrous, however. The preceding thirty years had been hard on the dollar, from the inflation of 1973-1981 to flagging productivity growth from the early 1970s through to the beginning of the 1990s and growing external deficits in 1982-87 and 1998-2000. Forecasts deemed the economic benefits of the single European currency sizable, fuelling Asian aspirations for regional financial integration.

11 Although China’s fiscal policy is conservative, the country has a meaningful amount of outstanding government debt, almost as much as Germany (Cooper 2009). Renminbi-denominated bonds have been sold only in China and only by Chinese banks and multilateral banks such as the Asian Development Bank and International Finance Corporation. The Chinese swap agreements forged in 2009 are shallow: in 2008, US-China trade alone amounted to almost four times their value.

12 For thorough analysis, see Pisani-Ferry and Posen (2009). Cohen (2008) calls the status quo a one-and-a-half currency system; Deutsche Bank (2008) sees the euro as “undisputed No. 2.”

13 As countries around the EU, such as the former Soviet Republics, develop stronger ties with the Eurozone, they may be further induced to hold euros. Russia increased the share of euros in its reserves from 42% to 47.5% in 2008 and 2009, while in a mirror image reducing the share of dollars from 47% to below 42% (Reuters 2009b). The dollar is especially prominent among issuers in the Middle East, Latin America, and Asia-Pacific, while issuers in new EU member states, Scandinavian countries, the UK, and Africa tend to split evenly between dollar- and euro-denominated bonds.

14 Intra-regional trade integration in Asia, if continuing, could encourage the region to move toward monetary integration, as suggested by dozens of observers, including Mundell just two years following the launch of euro. Such schemes would be very political, however.

15 Studying the 1930s, Eichengreen and Irwin (1993) find that the sterling-bloc promoted intra-group trade without diverting trade away with non-members, while exchange controls and bilateral clearing arrangements implemented by Germany and central- and eastern-European countries were trade-diverting. The chances of trade diversion will be diminished by full convertibility and free trade between the blocs.

16 Kindleberger (1978) argued a leaderless currency order in the 1930s led to the collapse of world trade.

17 It is employed in nine of every ten transactions, serves as a currency peg for 89 nations, and makes up nearly two-thirds of global reserves. In contrast, a quarter of global reserves are in euros, and slightly less than 5% in each of the two other stalwart currencies, yen and sterling; the small remaining share is divided between the Hong Kong dollar, the New Zealand dollar, the Swiss franc, the Norwegian krone, the Australian dollar, the Swedish krona, the Polish zloty, the Chinese renminbi and the Indian rupee.

Global debt markets also primarily run on the dollar: according to Linda Goldberg of New York Federal Reserve, 39% of all debt securities issued anywhere in the world are denominated in dollars, about the same as 42% in 1999, and above 32% for euro-denominated issues. The dollar is especially prominent among issuers in the Middle East, Latin America, and Asia-Pacific, while issuers in new EU member states, Scandinavian countries, the UK, and Africa tend to split evenly between dollar- and euro-denominated bonds. And great amounts of dollars are also held in cash overseas: almost 60% of 20- and 50-dollar notes and more than 70% of 100-dollar notes are abroad. See Goldberg (2010) and ECB (2008).

18 Hufbauer and Suominen (2010) calculate that just to keep up with global import growth at 10% annually, official global reserves should grow by another $13 trillion by 2020. Assuming a responsible creation of $4.5 trillion of new dollar reserves over the next decade, the global reserve gap would be $8.5 trillion. See also Eichengreen and Flandreau (2009) for lessons from the 1930s, when sterling rebounded globally amid dollar woes.

19 McKinsey (2009) calculates that “liquidity discount” – US ability to finance larger deficits for longer and at lower interest rates than other nations – amounts to 25-60 basis points or $90 billion in annual savings, and seigniorage provides another $10-20 billion annually. However, since the dollar overvaluation undermines US exports and domestic goods that compete with imports at the order of $30-$60 billion annually, the net benefit for the US from serving as the reserve currency issuer is about $40-70 billion, or 0.3 to 0.5 percent of US GDP.

20 The very Triffin dilemma stipulates that the international role of the dollar could make it hard for the US to manage its fiscal policy even if it wanted to.

Topics: Global governance, International finance
Tags: dollar, global currency regime, reserves

Kati Suominen

Founder and Partner at U.S. Export Capital, LLC