The end of the dollar era not in sight

Popular perception endows the phrase “the almighty dollar” with the arrogant strength of the U.S. currency, which has been for some 60 years now the universal medium of exchange. However, its first uses had little or nothing to do with its temporal association with America. Indeed, these date back to a time when America was centuries away from being the largest economy in the world and global commerce functioned in ways far removed from the present. Washington Irving might or might not have coined the phrase after Ben Jonson’s “almighty gold” in a 1616 poem,  but even when he used abot 200 years later, all he intended was to satirize an obsession for material wealth, the phrase implying that money is a kind of deity, and obeisance to it was a moral flaw, not a risky financial decision.

Enough of archival pedantry. More relevant are the persistent questions on why the USD should not be jettisoned as the world’s reserve currency – thus formally losing its “almighty” status, something that has been severely dented by its declining purchasing power in recent times. China’s post-crisis great leap forward has made the questions more persistent. However, to paraphrase what Mark Twain said when he saw his obituary in the New York Journal, reports of the dollar’s demise may be greatly exaggerated; stilll, many are straining their ears to catch the death rattle.

Asked early in January about the risk of the dollar losing its reserve currency status this year, the IMF chief, Mr. Dominique Strauss-Kahn said he did not see “the role of the dollar in the global economy changing rapidly in the direction of a smaller role”. But he quickly added that this may change in the coming decades, with a possible ger role for the euro and other currencies. He said he would wish that the IMF quasi-currency, the special drawing rights, could also become a reserve currency, though that would be technically difficult. China had already suggested this, before the last G-20 meeting.

Five or six factors determine a premier global reserve currency: the size of the economy, its importance in global trade, the size, depth and openness of its financial markets, its convertibility and domestic macroeconomic policies. The euro area is as large as the US in terms of gross domestic product and is important in world trade, but the size and depth of the government bond market in euros are woefully short of the US version. It will be at least another decade before the Chinese yuan becomes a reserve currency; even in Hong Kong, it is used only in about 2 per cent of trade.
It was only after World War II that America’s economic dominance became unquestioned and unquestionable. For 25 years after that, all exchange rates were fixed in relation to the USD and the price of gold was  pegged at USD35 per ounce. Some nations, most notably France, used this peg to exchange USD for gold. American gold holdings were getting depleted, and the exigencies of the war in Vietnam finally forced the U.S. Government in 1971 to abandon the fixed price for gold at which it would exchange dollars. With this began the practice of most  international trade and financial transactions being expressed in USD terms. The awesome size and power of the US economy persuaded the world to park its surplus funds in treasury bonds and other U.S. investments. This incessant inflow of foreign funds in turn encouraged the USA to spend in excess of revenues. It fought prolonged wars without any domestic economic policy revision. Few realised that  much of government, business and individual expenditures in the USA was being paid for with foreign funds.

All this changed when the bubble burst in 2008 and America understood that it had to live within its means and increase savings. The rest of the world was jolted to find that parking their savings by using the USD as a reserve currency might no longer be a brilliant idea. But what other currency comes close to replacing it? The euro is not accepted as currency even in some European Union countries. The SDRs created by the IMF in 1969 have the possibility of freely being used by its members, but clearly and obviously, they are not currency, nor is the IMF a bank. They are something like “paper gold”, credits that nations with balance of payment surpluses can ‘draw’ upon nations with balance of payments deficits. They are accounting transactions and, most importantly, there can be no expansion of the total amount of SDRs. They are also not available to individuals or businesses, but only to governments. All this makes replacing the USD by SDRs as reserve currency an impractical suggestion.

Besides, the USD as reserve currency offers flexibility to countries, both lenders and borrowers. The continuous expansion of dollars in circulation has enabled the volume of financial transactions to be many times a multiple of actual trade in goods and services. It also leads to considerable currency speculation with myriad financial products. None of these is possible with the SDR. If there is no reserve currency, countries that have stocks of important commodities can use them as ‘hard’ assets, pushing up their prices and playing the market. Some commodities like oil may take the place of the USD if another reserve currency does not replace it. Opec, and certainly Venezuela under Hugo Chavez, will like nothing better.

But for that to happen, the strength of the USD, real or perceived, has to be seen to have become drastically less, and there is a Catch-22 in this. No matter what their long-term ambition is, countries holding USD assets, foremost among them China, cannot but ensure that the USD value remains intact, as if the apple cart is upset, their own interests will be damaged. A switch from the USD to any other reserve currency is improbable until such time as international USD holdings come down, a process that has to be slow and gradual, and a path that will have to be trod gingerly and with finesse.

Of course, there will be imponderables, largely political developments. But until such time as China and other emerging economies take on ger roles in global economic forums and alter the world order assertively and not just tangentially, the value of the USD and perceptions of global market and economic risks will continue to be inversely correlated: as risk aversion increases, the value of the USD will appreciate against other currencies for global investors  will keep seeking the safety of the greenback. As risk appetite increases, however, and investors take bets on other global markets (mainly emerging economies), the USD will depreciate. 

Data on the composition of foreign exchange reserves show that for over 30 years, the share of the USD in central bank reserves has never fallen below 50 per cent. Before the euro came into being in 1998, the German deutschmark and other European legacy currencies accounted for about 18 per cent of these reserves, and the Japanese yen for 9 per cent. The dollar, even today, accounts for about 62 per cent of all central bank reserves; the euro amounts to about 28 per cent, and the yen accounts for a paltry 3 per cent. So the USD may no longer be king, but there is no one else near the throne. The “almighty” has merely shed some flab.