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By M. Isi Eromosele
For many years, there has been continued speculation about
the end of the U.S. Dollar’s role as the world’s main reserve currency.
This has partly been a function of a rebalancing world
economy in which new economic powers are emerging. But it is also linked to
growing concerns about the significant fiscal problems facing the world’s
largest economy and their effects on interest rates and currencies around the
world.
The Dollar’s influence will diminish over the long term, but
in the short term, there is still no viable alternative to the U.S. Dollar for
the world’s reserve currency. There are risks posed by a dollar-based reserve
system as well as implications of a gradual transition to a diversified model of a basket of several international
reserve currencies.
The U.S. Dollar As The World’s Reserve Currency
The U.S. dollar has enjoyed a privilege as the world’s
leading reserve currency since it displaced the British Pound from the top spot
in the aftermath of World War II. Today, the Dollar accounts for 60% of global
currency reserves and is involved in more than 42% of all foreign exchange
transactions
At present, there are few challengers to the Dollar’s
supremacy.
Each of the most commonly suggested alternatives all have
limitations of their own. The Euro is plagued by the sovereign debt crisis in
the peripheral economies within the EU; the Japanese Yen never circulated
broadly because Japan is a relatively small country with a shrinking population
and a stagnant economy; the Chinese Renminbi is still not fully convertible and
the gold market is too thin and illiquid to be the basis of the international
monetary system.
Proposals for a new currency based on Special Drawing Rights
(SDR) at the International Monetary Fund are also a non-starter, since the Dollar and
Euro comprise nearly 80% of the SDR-basket. Consequently, the SDR would offer
little protection if the Dollar and Euro lost value over time. Thus, almost by
default, the dollar’s international role seems secure in the short term.
However, over the long term, the Dollar’s dominance will
gradually erode. The Dollar’s use as a store of value, a key characteristic of a
reserve currency has already been called into question as growing fiscal deficits and a
reliance on foreign borrowing have conspired to drive down its trade-weighted value by
one-third since 2002.
The recent downgrade of the U.S.
sovereign rating from AAA to AA+ by Standard & Poor’s has added to the
negative global sentiment. Therefore, it would not be surprising to see some
decline in the Dollar’s international role over time.
Indeed, a transition from a single- to a multi-polar reserve
system is in the best interest of the global economy. Yet, a global portfolio
rebalancing on this scale would not be without its costs. There would be
implications for not only the value of the U.S. Dollar, but also for the global
economy and fixed income markets.
Risks Posed by a Dollar-Based Reserve System
Roughly two-thirds of the $10 trillion in official foreign
exchange reserves held globally are concentrated in emerging markets,
especially in Asia . In the aftermath of the Asian
financial crisis of 1997, the region built a war chest of reserves to protect
their economies against a repeat of the capital flight that resulted in
disruptive currency devaluations during that period.
Official reserves in Asia grew from
$225 billion in 1997 to $3.5 trillion in 2010. This level of reserves is far
more than can be justified for balance of payments purposes as it amounts to
two years of import coverage and is more than three times the amount of
external debt outstanding in Asia .
Instead, Asian reserve accumulation appears to be mostly a
byproduct of the desire to stem an appreciation of their currencies.
To the extent that Asian currencies are managed, most track
the Dollar or a basket that is heavily weighted toward the Dollar. As a result, the
majority of these reserves are held in U.S. dollar-denominated assets, particularly
Treasuries.
Insofar as Asian reserve accumulation suppresses U.S.
interest rates and supports U.S.
demand, while simultaneously encouraging Asian investment and exports through
an artificially low exchange rate, it aggravates global imbalances. The longer
this pattern continues, the greater the risk of economic or financial market
instability.
The decision to allocate a large portion of one’s portfolio
toward Treasuries at a time when U.S.
interest rates are already at rock bottom and the United
States is running very loose fiscal and
monetary policies could prove costly in the long term.
The Federal Reserve has expanded its balance sheet through
quantitative easing from $900 billion in August 2008 to $2.8 trillion in
October 2011.
At the same time, U.S.
gross debt to GDP is poised to top 115% by
2015.These policies increase the risk of inflation and suggest that Treasuries
may be overpriced at current valuations.
Even if the United States
manages to get its fiscal house in order and the Fed removes policy accommodation in a timely manner, large allocations
to U.S. Treasuries do not appear to be warranted in light of more attractive risk-adjusted
opportunities elsewhere.
For instance, China
is currently losing money on its $1.1 trillion investment in U.S. Treasuries, given
the negative carry between China ’s
three-month government
bill rate, which stands at 3.05 percent versus the 0.02
percent yield on a U.S.
three-month Treasury bill as of October 2011.
And this does not include losses associated with a modest appreciation
of the Renminbi vis-à-vis the Dollar over the past year. Hence, the decision to
invest in U.S. Treasuries makes little sense from a return perspective.
As such, it is to be expected that global Central Banks may
have an incentive to gradually reduce their Dollar reserve holdings. The U.S.
currency will continue to play an important international role, but it may have
to share the stage with other currencies.
The transition from a single to a multi-polar currency
regime could enhance global financial market stability. Although the Dollar’s
prominent status has allowed the U.S.
to borrow cheaply in international markets, it has also lessened the
effectiveness of domestic monetary policy by keeping market rates low even at
times when the Federal Reserve was attempting to tighten policy.
Additionally, a more diversified portfolio of reserves would
lessen the exposure of any individual Central Bank to adverse changes in the U.S.
economy, financial markets or government policy.
Few Alternatives to the U.S. Dollar in the Short Term
Today’s reality is that there are few alternatives to the U.S.
dollar. A currency must have certain attributes before it is accepted as a
reserve currency. The three most basic are that it must serve as a 1) medium of exchange, 2) store of value,
and 3) unit of account for comparing the prices of goods and services.
However, these necessary conditions by themselves are by no
means sufficient for the international banking community to regard a currency
as a reserve currency.
The closest viable alternative to the Dollar in the short
term is probably the Euro. Not surprisingly, it is already the second most
important reserve currency after
the U.S. Dollar.
However, the global financial sector is skeptical about the
Euro’s suitability as the world’s main reserve currency until the sovereign
debt crisis in peripheral Europe is fully resolved, especially
since Europe ’s economic fundamentals are not much better
than those of the United States .
The debt dynamics for some of the peripheral economies, particularly
Greece , appear
unsustainable in the long term. This threatens the European banking system
given large cross holdings of peripheral sovereign debt.
Until European leaders find a comprehensive solution to
these problems, the Euro will not be seriously considered as a replacement for
the Dollar as the world’s reserve currency.
Long-Term Scenario
Though there appear to be few alternatives to the Dollar
today, this may not remain so in the long-term. European leaders are addressing the
problems that plague the Eurozone and the Chinese are gradually liberalizing
their capital account by encouraging the development of an offshore Renminbi
market in Hong Kong .
There are signs that the process of reserve diversification
has already begun, as a number of foreign Central Banks, particularly those in
emerging markets, have started diversifying their reserves away from the U.S.
currency.
The dollar’s share of global currency reserves has declined
from more than 70% a decade ago to around 60% today. Valuation adjustments
account for some of this decline, but by no means all of it.
M. Isi Eromosele is
the President | Chief Executive Officer | Executive Creative Director of Oseme
Group - Oseme Creative | Oseme Consulting | Oseme Finance
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2012 Oseme Group
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