This article contains commentary which reflects the author's opinion
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The Dollar is the Glue Holding International Trade Together
In the previous two parts of this series, I’ve examined how the dollar became the world’s dominating reserve currency and the types of instabilities such a role unwillingly or willingly create in an interconnected international monetary system. In this third and last part, I will address potential alternatives to the dollar as a global reserve currency and try to evaluate how each would, if possible, rectify the status quo.
Undoubtedly the lack of safe investment alternatives is supporting the dollar’s monopoly status as de facto reserve currency, allowing US consumers to fuel excessive consumption without having to worry about savings. Due to the structure of the global financial system, the rest of the world’s demand for dollars to lubricate international economic activity sends money back to America via purchases of US debt securities. In fact, foreign investors hold about half of the outstanding U.S government debt.
Consequently, the dollar has become the indispensable glue which holds the international monetary system intact. A fundamental question must be asked before we can even consider the alternatives to the dollar paradigm: Would a shift to another reserve currency improve the international monetary system or would it merely breed more of the same?
The Chinese Dragon vs. the American Eagle
If we considered economic growth as the primary indicator of a strong reserve currency, the Chinese yuan ought to be alongside the dollar. China’s remarkable economic growth has persisted for over 20 years. Despite such impressive economic growth and excessive trade surpluses, however, the yuan can’t be considered as a reserve currency. Why? This is because it is currently inconvertible. Therefore, there is little benefit for foreigners to use the yuan in international financial markets.
America is far ahead when it comes to financial market depth, liquidity, and legal protections.
In purely technical terms, the likelihood of the yuan replacing or even challenging the dollar is rather small. On top of it being inconvertible, the yuan is neither under a flexible exchange rate regime nor an open capital account structure (i.e., no restrictions on capital movement), both of which are essential characteristics for a dominating reserve currency.
To challenge the dollar, China’s ruling communist party must ironically commit its currency and monetary policy to the following free-market caveats:
- Internationalization of the yuan — used as a medium of exchange
- Capital account convertibility — no restrictions on financial flow
- Reserve currency utilization — central banks hold the yuan as protection against balance-of-payments crises
In recent years, Chinese officials have taken modest actions in positioning the yuan for a larger international trade and investments use. For example, certain central banks have agreed to currency swap lines with the Chinese central bank (PBOC) and added the yuan to their foreign exchange reserves. Unfortunately for China, such agreements and swap lines are not even slightly comparable achievements to the network value of the dollar.
The depth, breadth, liquidity, and financial market sophistication will serve as strong buffers against threats to the dollar’s status as the de facto reserve currency. Although China has caught up with the US in the sheer size of its economy (i.e., gross domestic product), America is far ahead when it comes to financial market depth, sophistication, liquidity, and legal protections. China simply will not command the faith of global finance and investors in the same way as the United States.
The Euro: A Currency Without a State
What about the European common currency known as the euro? The official currency of 19 of the 28 member states of the European Union and its 343 million citizens surely would challenge the dollar’s exorbitant privilege. If the dollar represents approximately 61% of all global reserves, the euro comes up second at 21%. That’s quite the distance to catch up for an economic federation that exports twice as much as the US. As argued in the case of China, however, raw economic numbers do not alone sway the sentiment of investors and institutions.
A competitive reserve currency is also backed by a credible and strong central bank. Although the European Central Bank (ECB) certainly had its hands full during the Great Recession, and later when Greece was on the verge of leaving the eurozone, the ECB proved during the crisis how the euro today has a more resilient and determined central bank than before.
If the markets had lost confidence in the euro in terms of safety and stability, it would not represent 21% of the world’s reserves, 31% of all international bond issues, and 12% of global trade settlements. So why hasn’t the euro dethroned or even challenged the dollar?
The reason why the euro has not been successful in challenging the dollar derives from the fact that it is a currency without a state. The euro is a currency of an incomplete political union as opposed to a credible currency union. Without full backing by a single government and rejected by some EU members, the dream of the euro being the largest reserve currency remains unfulfilled.
Therefore, if the European community faces a looming financial crisis, cooperation is required among the member states. The interests of each state, however, are different; hence, a quick response to an acute crisis is far from assured. A strong sentiment toward sovereignty in each state prevents prompt reforms from being implemented.
Can global investors rely on a project, which is managed by dozens of dissimilar interest groups representing not only just different political fractions, but also varied economic cycles within different countries? Further, if several beneficiaries are engaged in serious debates about leaving the eurozone and returning to their sovereign currency, how can rest of the world rely on a currency that lacks internal confidence?
Special Drawing Rights: Funny Money
Apart from the dollar, there is only one existing alternative that resembles a truly global currency. The International Monetary Fund’s Special Drawing Rights (SDR or SDRs) consists of a synthetic basket of major currencies, which all play an influential role in global economic activities. The currencies included are:
- The U.S dollar – 41.73%
- The euro – 30.93%
- Chinese yuan – 10.92%
- Japanese yen – 8.33%
- British pound – 8.09%
The weights of each currency fluctuate on a weekly basis based on the differences on exchange rate movement. As you can see, the dollar’s share even in a global basket of currencies is overwhelming.
The fundamental shortage and deficiency of SDR is its incapacity both in quantity and quality. Currently, SDR accounts for less than 5% of global reserves, hence the utility of using SDR is minuscule. The usefulness of SDR is limited given the fact that it can be used only between governments and the IMF to settle debts or provide solutions for balance of payments issues. Therefore, SDRs can’t be utilized between private parties because there are no private markets where the currency instrument can be traded. Furthermore, SDR is not backed by fiscal powers of taxation to generate real revenue.
Therefore, utilizing SDR would require an establishment of solid, deep, and liquid markets. Easier said than done. Who would oversee creating new SDR? Who would back SDR fundamentals during times of crisis? How would large holders of dollar-denominated assets/liabilities substitute their SDR current holdings without wreaking havoc in global financial markets? And most importantly, why should the U.S dollar give away its power and privilege for the sake of an alternative, which in its current form would not bolster confidence and stability?
Long Live the Dollar
At the end of the debate, the dollar continues to rule. One reason is that U.S legal structure of checks and balances among the nexus of legislative powers is well-defined and often self-correcting. For an investor, it makes sense to invest in an asset that is hosted by a predictable, reliable, consistent, and fair system.
The international monetary system under the dollar will prevail, but history has proven how the dominance of one currency is not eternal. We can expect the international monetary system to move toward a system where multiple reserve currencies operate within their regions, but still rely on the dollar for safety and liquidity. The dollar is likely to remain at the top of the pyramid, however, thereby facilitating the distribution of economic power.
And that’s the bottom line, because Uncle Sam said so.
The material for the series has been compiled from the author’s own 2013 graduate school thesis titled “Instabilities in the International Monetary System and the Prospect of Special Drawing Rights as a Stabilizing Tool.“ The full work with a bibliography is available upon request.