Currencies: Strength in reserve
By Alan Beattie
Published: February 8 2011 22:14
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Back in the 1960s, envious of America’s ability to borrow easily abroad, French finance minister Valéry Giscard d’Estaing denounced the reserve currency status of the dollar as an “exorbitant privilege”. A few years later, weakened by US fiscal profligacy, the Bretton Woods fixed exchange rate system anchored on the US currency collapsed.
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Half a century on, France is once again complaining about the imbalances and unfairness it says are caused by the greenback’s exalted position. President Nicolas Sarkozy of France said last year that the greenback’s domination of foreign exchange reserves and the pricing of commodities and international trade could not endure. Paris made a big fanfare about the need to redesign the international monetary order and muttered about having had private conversations with Beijing on the subject.
Half a century on, France is once again complaining about the imbalances and unfairness it says are caused by the greenback’s exalted position. President Nicolas Sarkozy of France said last year that the greenback’s domination of foreign exchange reserves and the pricing of commodities and international trade could not endure. Paris made a big fanfare about the need to redesign the international monetary order and muttered about having had private conversations with Beijing on the subject.
According to Barry Eichengreen, economics professor at the University of California, Berkeley, and a leading expert on the subject – whose new book takes Mr Giscard d’Estaing’s complaint as its title: “The dollar’s singular status is in doubt.”
But as the size of the task has come into focus, the revolutionary zeal emanating from the Elysée palace has grown distinctly more muted. As finance ministers and central bank governors prepare to gather in Paris for the first big meeting of this year’s French presidency of the Group of 20 leading economies next week, the debate has been thrown back to fundamental questions. Is the dollar’s dominance really a prime cause of global economic imbalances; or is a new reserve currency a solution in search of a problem?
In truth, the benefits to the US, in terms of support for its currency and its financial assets, are uncertain. Also unproved is the wider case that having just one reserve currency is inherently unstable, contributing to the global current account imbalances that are widening again as the world economy recovers from recession.
The case against a dominant dollar was made in a much-discussed 2009 speech by Zhou Xiaochuan, China’s central bank governor. He brought up the “Triffin dilemma”, identified in the 1960s by Robert Triffin, an economist who appropriately enough traded his own citizenship from Belgian to American and back again. Examining the postwar Bretton Woods system, Triffin argued that incessant foreign demand for a reserve currency would force its issuing country to run persistent current account deficits – the trade and investment income counterpart of the capital account surplus derived from borrowing money abroad – which would eventually destabilise its economy.
“The outbreak of the [financial] crisis and its spillover to the entire world reflect the inherent vulnerabilities and systemic risks in the international monetary system,” Mr Zhou said. The world needed “to create an international reserve currency that is disconnected from individual nations”.
On the face of it, a modern version of the Triffin critique explains recent persistent American current account deficits; they have been funded largely by foreign governments buying dollar bonds. But the causation is not straightforward. Under a floating exchange rate system, as long as countries accumulate only moderate amounts of currency reserves allowing them to intervene in any future crisis, the demand for dollar-denominated assets should be limited.
Many in the US, however, would point out that China has voluntarily acquired huge amounts of dollars in recent years as a byproduct of its interventions to keep its currency down and boost exports. There is nothing inevitable about the process – and furthermore Washington has tried strenuously to convince Beijing to stop. According to this view, Mr Zhou’s speech was a sleight of hand designed to shift blame to the US for borrowing great container-loads of capital and away from China for lending it to them. Super-loose monetary policy in the US may be pushing rapid private capital flows into emerging economies but no one is forcing them to import US monetary policy by linking their currencies to the dollar.
In fact, the current exchange rate system served the world relatively well during the financial crisis, according to Uri Dadush, a former senior World Bank official now at the Carnegie Endowment think-tank in Washington. “Governments often blame currency regimes for their own failures to enact domestic reforms,” he says, citing China’s limited success in shifting its economy to rely more on domestic demand and America’s struggle to reduce its fiscal deficit and raise national saving levels.
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The search for a rapid replacement for the dollar, particularly one not controlled by national governments, yields few plausible immediate candidates, in any case.
A superficially attractive option is the special drawing right, a form of reserve asset created in 1969 during another round of discussions about the dominant dollar. Mr Zhou fanned smouldering interest in the SDR in his 2009 speech, saying it could become a “super-sovereign reserve currency” and calling on governments to issue SDR-denominated financial assets and actively to promote it in international trade and commodities pricing.
But the SDR is closer to an accounting unit than a currency. It comprises a weighted basket of currencies – the dollar, sterling, the yen and the euro – whose values fluctuate according to the movements of their exchange rates. The International Monetary Fund has the authority to create SDRs and distribute them to member countries, which can then use them in transactions with one another. But since they are virtually unknown in private transactions, using SDRs to buy anything involves the time and expense of converting them back into the individual currencies. SDR assets make up less than 5 per cent of global foreign exchange reserves.
One way to broaden SDR usage is to revive an idea for a substitution account that would allow central banks to change their dollars into SDRs without selling them on the open market – attractive for a country such as China that wants to diversify out of dollar assets without causing a run on the currency. The US, however, is unwilling to accept the losses on the dollars that would be sold as a result.
Suggesting that emerging market currencies such as the renminbi be added to the SDR basket, as Mr Sarkozy did recently, has become a cliché of discussions about global governance. But for the SDR to be usable, the currencies in the basket have to be widely traded and freely convertible. Indeed, for precisely this reason, in 1981 the basket was shrunk from 16 currencies to five (later four), with currencies, such as the Saudi riyal and the South African rand, in which trade was thin or restricted, thrown out. At the end of last year, the IMF again reviewed the composition of the SDR and left it unchanged.
In order for the SDR to work as a proper global currency, Prof Eichengreen says, some organisation – probably the IMF – would need systematically to control its issuance beyond the current system of ad hoc one-off distributions. Any such proposal to globalise monetary policy would provoke explosions of disbelief in legislatures worldwide. As Prof Eichengreen concludes: “No global government, which means no global central bank, means no global currency. Full stop.”
An even less likely option is linking currencies to the price of gold, recreating one of the models of international gold standard used in the past few centuries. Following the rapid rise of the gold price in recent years, a phenomenon some investors claim is driven by fears about fiat currencies (those not backed by a physical commodity) being debased by inflation, interest in the subject was revived last year by Robert Zoellick. The World Bank president raised the eyebrows of economic policymakers – before rushing to clarify that he was not in favour of a strict gold standard – by arguing that the metal had become an “alternative monetary asset” and that governments should consider using its price as an “international reference point of market expectations” for inflation and currency values.
However, economists have long argued that linking currencies and price levels to the value of a fixed or nearly fixed stock of precious metal means forcing real variables such as growth and employment to bear the brunt of economic shocks – a socially and politically unacceptable outcome. Prof Eichengreen, in response to Mr Zoellick’s speech, pointed out that targeting the domestic price of gold would have caused the Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England to have tightened monetary policy sharply in recent years. “It is lunacy to suggest that in circumstances of weak growth and deflation risk, key central banks should simultaneously tighten [policy],”
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Whether this year’s discussions will produce concrete policy changes is doubtful. A widespread view among US experts is that Mr Sarkozy’s campaign is mainly political theatre, perhaps in anticipation of a challenge in the 2012 French presidential election from Dominique Strauss-Kahn, IMF managing director. Certainly Mr Sarkozy has been back-pedalling rapidly since last year’s noisy calls for a new reserve currency.
During a visit to Washington in January, he emphasised “how important the US dollar is as the world’s number one currency”.
The most likely change – a prediction also made by Mr Zoellick – is a gradual shift to a multipolar currency world, reflecting increased use of currencies other than the dollar in global trade and finance. China has been encouraging more international use of its currency – permitting, for example, the issuance of renminbi-denominated bonds in Hong Kong.
The euro, too, has the potential to take on greater reserve status if the eurozone can sort out its internal economic difficulties and build a government bond market that approaches the US Treasury market for depth and liquidity.
Arvind Subramanian of the Washington-based Peterson Institute for International Economics thinks the renminbi could within the next 10 or 15 years come to pose a serious threat to the dollar’s reserve status. Should America’s inability to restrain its fiscal and current account deficits persist even if the flood of capital into the dollar from foreign governments ebbs, the shift will only be accelerated. The US overtook Britain in economic heft in the 1870s, but not until the 1920s – when the burdens of war debt and other pressures on the UK economy had mounted – did sterling give way to the dollar. “Reserve currency status is not just about economic size and trade but about investors’ faith in policy credibility,” Mr Subramanian says.
The transition is likely to prove less dramatic than a grand international conference in which the dollar is ceremonially stripped of reserve currency rank and its spurs handed to gold or to the SDR. But it is a warning to Washington nonetheless. “The US should be worrying more about whether its economic policies are a threat to the dollar now,” says Mr Dadush of the Carnegie Endowment, “than whether a threat to the dollar will derail its economic policies in the future.”
Safe havens and seigniorage
Doubtful benefits and modest perks of being top dog
Is reserve currency status all it is cracked up to be? While some modest benefits are undeniable, those perceived to be the big ones are more questionable.
There are essentially three gains from global use of dollar bills and dollar-denominated assets, and from trade and commodities such as oil being priced in dollars. First, the US receives more “seigniorage” – the profits from investing the interest-free loans central banks receive from banks in return for issuing currency. Second, the US government can borrow more cheaply, as other countries bulk-buy dollar bonds for their official reserves. Third, US businesses trading internationally or buying commodities save on the cost of exchanging currencies and hedging against exchange rate movements.
The benefits of seigniorage from banknotes held abroad are unquestionable. For example, the eurozone’s decision to issue a €500 note made it easier to carry stashes of cash in the single currency than in dollars, whose largest denomination is $100. That enables the bloc to grab some of the market in cash-for-drugs deals and money laundering (though even this is not an unalloyed benefit as it increases attractiveness to counterfeiters). But overall seigniorage gains are modest. Profits on the stock of dollar bills held abroad are generally about $30bn a year, less than 0.5 per cent of US gross domestic product.
Gains from cheaper borrowing may be more substantial. Economists estimate that central banks’ purchases of US assets knocked between half and a full percentage point off long-term US interest rates in the mid-2000s.
Having a currency regarded as a safe haven may prove particularly valuable in a crisis. For example, investor money fled towards the dollar during last year’s sovereign debt crisis. Nonetheless the UK, which lost reserve currency standing to the US in the 1920s, has been able to issue bonds cheaply during the global crisis in spite of a large current account deficit, with about one-third held by foreigners.
Finally, the benefits to American businesses are limited. Deep and liquid foreign exchange markets mean the cost of changing currencies and even forward hedging against foreign exchange movements is only a small fraction of the value of large-scale transactions anyway.
And if commodity prices move in relation to exchange rates, as at least in part they seem to, US companies still need to hedge against currency movements even if bills are invoiced in dollars.
Moreover, in spite of occasional stories about the Opec oil producers’ cartel shifting pricing to euros to punish the Great Satan, such moves would create only fleeting transactional demand for euros, which would do almost nothing to damage the dollar.
Doubtful benefits and modest perks of being top dog
Is reserve currency status all it is cracked up to be? While some modest benefits are undeniable, those perceived to be the big ones are more questionable.
There are essentially three gains from global use of dollar bills and dollar-denominated assets, and from trade and commodities such as oil being priced in dollars. First, the US receives more “seigniorage” – the profits from investing the interest-free loans central banks receive from banks in return for issuing currency. Second, the US government can borrow more cheaply, as other countries bulk-buy dollar bonds for their official reserves. Third, US businesses trading internationally or buying commodities save on the cost of exchanging currencies and hedging against exchange rate movements.
The benefits of seigniorage from banknotes held abroad are unquestionable. For example, the eurozone’s decision to issue a €500 note made it easier to carry stashes of cash in the single currency than in dollars, whose largest denomination is $100. That enables the bloc to grab some of the market in cash-for-drugs deals and money laundering (though even this is not an unalloyed benefit as it increases attractiveness to counterfeiters). But overall seigniorage gains are modest. Profits on the stock of dollar bills held abroad are generally about $30bn a year, less than 0.5 per cent of US gross domestic product.
Gains from cheaper borrowing may be more substantial. Economists estimate that central banks’ purchases of US assets knocked between half and a full percentage point off long-term US interest rates in the mid-2000s.
Having a currency regarded as a safe haven may prove particularly valuable in a crisis. For example, investor money fled towards the dollar during last year’s sovereign debt crisis. Nonetheless the UK, which lost reserve currency standing to the US in the 1920s, has been able to issue bonds cheaply during the global crisis in spite of a large current account deficit, with about one-third held by foreigners.
Finally, the benefits to American businesses are limited. Deep and liquid foreign exchange markets mean the cost of changing currencies and even forward hedging against foreign exchange movements is only a small fraction of the value of large-scale transactions anyway.
And if commodity prices move in relation to exchange rates, as at least in part they seem to, US companies still need to hedge against currency movements even if bills are invoiced in dollars.
Moreover, in spite of occasional stories about the Opec oil producers’ cartel shifting pricing to euros to punish the Great Satan, such moves would create only fleeting transactional demand for euros, which would do almost nothing to damage the dollar.
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Copyright The Financial Times Limited 2011.
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