The dollar's 70-year dominance is coming to an end

Within a decade, greenback's could be replaced as the world's reserve currency

By Liam Halligan

5:30PM BST 19 Jul 2014

A share trader takes a phone call as he is seen behind a false one dollar bill at the German stock exchange in Frankfurt
The dollar is currently boosted by being a reserve currency Photo: Reuters

In early July 1944, delegates from 44 countries gathered at the Mount Washington Hotel in Bretton Woods, New Hampshire. A three-week summit took place, at which a new system was agreed to regulate the international monetary and financial order after the Second World War.

The US was already the world’s commercial powerhouse, having eclipsed the British Empire several decades earlier. America was also on course to be among the victors of “Europe’s conflict”, even though its economy was largely unscathed by war. As such, Bretton Woods was US-dominated and produced a settlement largely on US terms.

Seventy years ago this week, that fateful summit ended. Its close marked the moment the dollar’s unquestionable supremacy was secured. Since then, global commerce has been conducted largely in dollars and leading economies have held the greenback as their primary reserve currency.

The same system remains intact today, with the lion’s share of commercial settlements worldwide still clearing the US banking systemeven if the parties involved have nothing to do with the States.

The dollar’s hegemony continues to be cemented, meanwhile, by the operations of the International Monetary Fund and World Bank. Founded at Bretton Woods, they’re both Washington based, of course, and controlled by America, despite some Francophone window-dressing.

The advantages this system bestows on the US are enormous. Reserve currency statusgenerates huge demand for dollars from governments and companies around the world, as they’re needed for reserves and trade. This has allowed successive American administrations to spend far more, year-in year-out, than is raised in tax and export revenue.

By the early Seventies, US economic dominance was so assured that even after President Nixon reneged on the dollar’s previously unshakeable convertibility into gold, amounting to a massive default, dollar demand kept growing.

So America doesn’t worry about balance of payments crises, as it can pay for imports in dollars the Federal Reserve can just print. And Washington keeps spending willy-nilly, as the world buys ever more Treasuries on the strength of regulatory imperative and the vast liquidity and size of the market for US sovereign debt.

It is thisexorbitant privilege” – as French statesman Valéry Giscard d’Estaing once sourly observed – that has been the bedrock of America’s post-war hegemony. It is the status of the dollar, above all, that’s allowed Washington to get its way, putting the financial squeeze on recalcitrant countries via the IMF while funding foreign wars. To understand politics and power it pays to follow the money. And for the past 70 years, the dollar has ruled the roost.

This won’t change anytime soon. Something just took place, though, which illustrates that dollar reserve currency status won’t last forever and could be seriously diluted. Last week, seven decades on from Bretton Woods, the governments of Brazil, Russia, India and China led a conference in the Brazilian city of Fortaleza to mark the establishment of a new development bank that, whatever diplomatic niceties are put on it, is intent on competing with the IMF and World Bank.

It’s long been obvious the BRICs are coming. The total annual output of these four economies has spiralled in recent years, to an astonishing $29.6  trillion (£17.3 trillion) last year on a PPP-basis adjusted for living costs. That’s within spitting distance of the $34.2 trillion generated by the US and European Union combined.

America’s GDP, incidentally, was $16.8 trillion on World Bank numbers, and China’s was $16.2 trillionwithin a whisker of knocking the US off its perch. The balance of global economic power is on a knife-edge. Tomorrow is almost today.

Consider also that the BRICs collectively hold sway over 50pc of global currency reserves, rising to almost three-quarters if you take the emerging markets as a whole. The G7 nations between them control only 20pc – and less than 8pc if you exclude Japan.

Based on such balance sheets, we’re now seeing institutional change. The new BRICs Development Bank, modelled on the IMF, will have a $100bn currency reserve available to lend around the world, giving distressed debtor nations an alternative to the “Washington consensus”.

For a long time, the BRICs have been paying in to the IMF, yet been denied additional influence over what happens to the money. Belgium has more votes than Brazil, Canada more than China.

The institutions governing the global economy have failed to keep pace with reality. Modest reforms giving the large emerging markets more power, agreed with much fanfare in 2007 and again in 2010, have been stalled by Washington lawmakers. The BRICs have now called time, setting up their own, rival institution based in Shanghai.

The key to the dollar’s future is petrocurrency statuswhether it’s used for trading oil and other leading commodities. Here, too, change is afoot. China’s voracious energy appetite and America’s increased focus on domestic production mean the days of dollar-priced energy look numbered.

Beijing has struck numerous agreements with Brazil and India that bypass the dollar. China and Russia have also set up rouble-yuan swaps pushing America’s currency out of the picture. But if Beijing and Moscow – the word’s largest energy importer and producer respectivelydrop dollar energy pricing, America’s reserve currency status could unravel.

That would undermine the US Treasury market and seriously complicate Washington’s ability to finance its vast and still fast-growing $17.5  trillion of dollar-denominated debt.

In May, Beijing and Moscow signed a huge multi-decade gas supply contract, to sit alongside a similar oil deal agreed in 2009. No one knows what share of this energy trade will be on a yuan-rouble basis – and the two governments aren’t saying. This question, seemingly inane, is among the most important diplomatic issues of our time.

At the moment, although Russia’s export partners do sometimes settle in roubles, most Sino-Russian trade is still in dollars. But the combination of this new gas deal, and western sanctions on Russia – has seen Moscow and Beijing step up bilateral efforts to facilitate large-scale non-dollar settlement.

With western anti-Russia sanctions likely to be tightened again after the tragic shooting of a Malaysian passenger plane over Ukrainian airspace, Beijing’s response will be closely scrutinised. I, for one, expect the Chinese to say little until it’s clearly established who grounded the plane and why.

Although the dollar’s reserve status won’t end overnight, the global payments system is now moving inexorably towards that outcome. The US currency accounted for just 33pc of all foreign exchange holdings in 2013, on IMF numbers, down from 55pc in 2001.

Within a decade or so, a “reserve currency basket” may emerge, with central banks storing wealth in a mix of dollars, yuan, rupee, reals and roubles, as well as precious metals. Perhaps some kind of synthetic bundle of the world’s leading currencies will be developed, with emphasis placed, after years of western money-printing, on assets backed by commodities and other tangibles.

I also believe central banks may include cyber-currencies (such as bitcoin) in their reserves. If you think that’s mad, consider that mankind has long sought scarcitybe it with shells, stones or metallic elements – to store wealth. Now the money-printing taboo has been broken by yet another generation, it makes sense to use complex computer algorithms to ensure that only a certain amount of a particular currency unit can ever exist.

The dollar’s status is a big question. Judging the outcome is more akin to star-gazing than scientific economics. But the establishment of this BRIC Development bank, timed to coincide with the anniversary of Bretton Woods, is an audacious and significant move. The world’s emerging giants now have thumbscrews on the West

The Fed in Denial

Simon Johnson

JUL 22, 2014
Janet Yellen

WASHINGTON, DC The United States Federal Reserve System is one of the most powerful governmental organizations in the history of the world. America’s central bank has control over the supply of dollars, and currently exerts great influence over interest rates, both for short-term and long-term borrowing. And, though the Fed was partly responsible for the regulatory failures that led to the global economy’s near-meltdown in 2008-2009, post-crisis reform has left it with even greater authority and more responsibility for overseeing the financial system.

That is a worrying outcome, because senior Fed officials seem to have slipped back into their pre-2008 ways, ignoring concerns about dangerous financial-sector behavioreven when those concerns are expressed by members of the US Senate Banking Committee. This is not only unfortunate; it is also dangerous, because the Fed’s political position is much more precarious than its leadership seems to realize.

In many countries, people on the right of the political spectrum provide a bastion of support for the central bank. In northern Europe, for example, the European Central Bank’s independence is seen as essential for price stability – and politicians on the right typically attach a higher priority to this goal.

The situation is quite different in the US. Here, the right, represented by the Republican Party, has long been suspicious of the Fed, reflecting its opposition to a powerful federal government, as well as nostalgia for the days of the gold standard (particularly the version that operated before the Fed was created in 1913). The Fed as it currently operates is being protected by the left (the Democratic Party).

For example, I recently testified at a hearing of the House Financial Services Committee on Republican-proposed legislation that would impose on the Fed greater limitations on both monetary policy and regulation. House Democrats oppose the bill and invited me to the hearing, where I explained that the proposed constraints would, in my view, greatly hamper the Fed’s effectivenessincluding its ability to help the economy return to full employment and to prevent the financial system from spinning out of control again.

Under current circumstances, the Democrats are strong enough – with control of the Senate and of the presidency – to fend off these assaults. Consequently, senior Fed and White House officials seem rather confident that nothing dramatic will happen that would undermine the Fed’s independence.

I would not be so sure. The main problem is that the Fed has not moved with alacrity to implement fully key provisions of the Dodd-Frank financial reforms, which were passed in 2010.

For example, the Dodd-Frank legislation specifies that all large financial institutions should draw up meaningfulliving wills” – specifying how they could be allowed to fail, unencumbered by any kind of bailout, if they again became insolvent.

Creating such living wills is not an option; it is a requirement of the law. Yet, in a recent speech that reviewed the landscape of financial reform, Fed Vice Chairman Stanley Fischer skipped over the requirement almost completely.

Fischer appears to prefer to rely on the resolution powers of the Federal Deposit Insurance Corporation, which is empowered to takeover failing financial institutions, with the expectation that it will impose losses on creditors in such a way that will not cause global panic. (I am on the FDIC’s systemic resolution advisory committee, but I am not responsible for the agency’s plans or potential actions.)

Unfortunately, as currently constructed, these resolution powers are unlikely to work. They do not apply across borders, there is not enough loss-absorbing capital in large complex financial institutions, and the funding structure of big bank holding companies remains precarious.

Senior Fed officials emphasize that big banks fund themselves with more equity now than they did in the past. But the Global Capital Index constructed by Thomas Hoenig, the FDIC’s vice chairman, indicates that the largest US banks are still 95% debt-financed. With that much leverage, it does not take a lot to create fear of insolvency.

Yet, despite repeated and responsible expressions of concern – including from Senate Democrats – the Fed continues to ignore these profound problems. If anything, in his most recent speech, Fischer seemed to brush aside any such fearsassuring his audience that there is great social value in continuing to have extremely large financial firms that operate with so very little equity capital (and therefore a great deal of leverage).

This is more than disappointing. It is profoundly dangerous to the economy. And it imperils the Fed’s future ability to take action as needed.

In recent interviews, including with The New Yorker, Fed Chair Janet Yellen has indicated at least general concerns about financial-sector behavior and the vulnerability of big banks. But unless the Fed acts on such concernsincluding by implementing the requirement that large financial institutions adopt meaningful living wills – its independence will come under even greater pressure.

Simon Johnson, a former chief economist of the IMF, is a professor at MIT Sloan, a senior fellow at the Peterson Institute for International Economics, and co-founder of a leading economics blog, The Baseline Scenario. He is the co-author, with James Kwak, of White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.

Markets Insight

July 22, 2014 3:15 am

Chinese moves trump Fed’s effect on US bonds

Efforts to devalue renminbi could push up Treasury yields

All eyes are on the future path of US Federal Reserve policy and what it means for the economy and asset prices. But growth trouble across the Pacific may have a much bigger impact on US yields in 2015 and 2016 than the expected pace of US central bank tightening.

China holds $4tn of foreign exchange reserves, of which $1.3tn was invested in long-dated US government bonds in 2013, according to US Treasury data. For a long time the threat that Beijing might sell US Treasuries rang hollow, but no longer.

China is struggling with an overvalued renminbi, which has hurt corporate profits and caused growth to slow sharply over the past two years. An expensive currency in a world of weak demand makes it impossible for China to rebalance its economy without a collapse. Beijing knows this and has already intervened in the foreign exchange market to lower the renminbi in a bid to discourage currency speculation and support growth.

But nominal depreciation of just over 3 per cent, coupled with producer price deflation of about 2 per cent, is not enough to eliminate the renminbi’s overvaluation, which we estimate at 15-25 per cent. China needs further renminbi weakness; the question is how to achieve it. More currency intervention risks provoking Washington’s ire. After all, the International Monetary Fund reckons the renminbi is still 5-10 per cent undervalued.

Liberalise capital flows

The best solution would be to liberalise capital flows. Chinese citizens have been denied free access to foreign assets for years. Money has seeped through porous capital controls, but if Beijing opened the flood gates, asset diversification would cause huge outflows that would swamp inflows.

The good news is that President Xi Jinping’s administration has made more progress on this front in one-and-a-half years than the previous leadership did in a decade. Financial market reform is a daunting task, which Beijing could easily bodge or abandon. For now the omens are positive and implementation swift by Chinese standards.

But if growth were to stall and unemployment to rise, a nervous Beijing might well repeat its 2008-09 stimulus by throwing money at unproductive investment. In such an event, the renminbi would come under pressure. China’s current account surplus, about 2 per cent of gross domestic product, could easily turn into a deficit. Capital outflows would follow as people saw through the futile policy response and headed for the exit.

We modelled the impact of these possible outcomes on the 10-year US Treasury yield. If China continues opening the capital account in the next couple of years, we assume 5-10 per cent of domestic bank deposits would be switched mostly into other dollar assets through either portfolio or foreign direct investment. The People’s Bank of China would intervene to smooth the renminbi’s decline, running down its dollar reserves and so pushing up the 10-year Treasury yield by 18-50 basis points.

Lethal combination

The alternative is a stalling of reforms, with either major intervention to weaken the renminbi or an investment binge. The result is likely to be a re-run, on a greater scale, of the selling of long-dated Treasuries witnessed in 2012. Yields could rise 10 basis points. These outcomes would slow but not derail the US recoveryyields rose by almost a percentage point in the second half of 2013.

Moreover, these scenarios assume all other things are equal. But they are not. Renminbi devaluation and higher US yields would be a lethal combination for the eurozone. Most European countries have modestly improved their trade positions with China thanks to stronger German capital exports and soft consumer spending, which has capped imports. But a much weaker renminbi would reverse the trend, thus subtracting from growth.

The eurozone’s peripheral economies would be hurt most as they have a larger export share of lower value-added manufactures and are more likely to compete with China. But Germany’s export-led growth would also suffer if China reduced its excessive reliance on investment.

In addition to the currency effect, a rise in US yields transmitted to the eurozone would represent just the “unintended tightening of monetary conditions” that Mario Draghi, European Central Bank president, has identified as one of three contingencies that would warrant a monetary policy response.

In this context, any major financial market dislocation in Europe or Asia would be likely to trigger a flight to the safety of US Treasuries. If such haven flows were half as great as they were after the euro area debt crisis in 2010-11, our model suggests they would offset the impact on US Treasury yields of a decline in the renminbi.

Diana Choyleva is head of macroeconomic research at Lombard Street Research

Copyright The Financial Times Limited 2014.