Despite potential challenges from the euro, yen, and yuan, the Dollar remains the world’s reserve currency of choice.
The last decade has given rise to much discussion about the role of the U.S. dollar in the global economy. Criticism of the dollar’s position as the world reserve currency is nothing new and dates back at least to 1965 when French president Charles De Gaulle claimed the dollar enjoyed an “exorbitant privilege.” Today, the relative decline of America, in part precipitated by the Global Financial Crisis, has stoked the fire of this decades old debate. Russia, under Vladimir Putin, has taken measures to “de-dollarize” their economy and Russia’s priorities for the 2013 St. Petersburg G20 include diversification of world reserve currencies and the development of local currency bond markets. It is no secret the eurozone has long seen itself as issuing a global currency and China has recently begun an effort to encourage the use of its currency outside the borders of the mainland. Tesco issued yuan denominated bonds in Hong Kong in 2011 to fund its Chinese expansion, and The Economist recently reported that the company would start paying some Chinese supplies in the local currency.
Yet, the dollar continues to account for one side in 85% of all foreign exchange trades, including 80% of all trades involving the yen or yuan. While the economics of the situation would point toward this number decreasing, the politics tell us that the dollar is not going anywhere soon. Traditionally the main challengers to the dollar have been the yen and the euro (previously in the form of the deutschmark). Today, the yuan must also be included in this calculation. That leaves three potential dollar challengers, each of which I explore below.
The yen has long been limited by sluggish growth and the deflationary tendencies of the Japanese economy. Part of the appeal of a world reserve currency is the transactional network that exists due to its size and its proclivity to be used in the private sector. Japan would need to grow its economy significantly to make that a reality. On a side note, it is limited economic size that also holds back the pound in the UK. A more recent factor underlying the yen’s potential is “Abenomics” (the expansionary economic policies of newly elected Japanese prime minister Shinzo Abe). The Bank of Japan recently announced a plan to double Japan’s monetary base and the currency has since fallen to a 100-1 rate against the dollar (from a historical rate of about 78-1). Analysts at USB believe the slide might be only halfway done. Currency volatility, and in particular a sharp currency deprecation, are the exact opposite of what most nations look for in a reserve currency. While Japanese monetary expansion has been great for their equity markets and may turn out to be a boost for the domestic economy, it does not lend itself to the yen’s expansion abroad.
The euro certainly has the size to be a world reserve currency. When all eurozone countries are taken together they form the world’s largest economy with a GDP of about 17 trillion USD in 2012. The recent economic crisis has certainly hurt the chances of a broader adoption of the euro, yet it is the European political crisis that has done more long-term damage. The crisis has exposed serious rifts in the eurozone that cannot be easily solved, and it has illustrated that Europe cannot be trusted to respond to crises nimbly and swiftly. In essence, it has severely undermined the notion that a stable currency union can exist without a significant degree of fiscal and political integration as well. These worries about the eurozone will linger for decades and will undermine its potential use abroad.
The Chinese yuan is often cited as the reserve currency of the future. Depending on the assumptions used, China should overtake the U.S. as the world’s largest economy by the end of this decade and could be double America’s size by 2030 (see interactive chart here). That speaks well for its adoption abroad. In the short term, it is severely limited by capital controls and underdeveloped financial markets. Yet, as China continues its dynamic economic growth those factors should improve. A more limiting long-term constraint is likely to be the Chinese political system. The authoritarian nature of the communist party and Chinese government lends itself to corruption, cronyism, and economic distortions in the form of payoffs to power brokers and state owned enterprises. Recent reports about the vast wealth accumulated by former premier Wen Jiabao’s family hammer home this point.
A more abstract but equally important issue is the incompatibility of an authoritarian regime and economic accountability to investors and creditors. The ability of individuals, particularly the wealthy, to punish politicians for inappropriate behavior such as default, restructuring, or unfair regulatory enforcement is essential to a currency’s adoption. In a study by Schultz and Weingast (2003), the authors demonstrate a “democratic advantage” enjoyed by more liberal regimes in the form of lower borrowing costs. They attribute this advantage to the ability of lenders to punish politicians by voting them out of office. While their study primarily looks at domestic lenders and does not specifically look at the use of a currency as an international reserve, there is reason to believe the logic holds. The ability of markets to hold national leaders accountable (directly or indirectly) is a critical determinant of the faith individuals will put in a specific national currency. Unless China undergoes significant political reform, its brand of authoritarian politics will likely hold back the yuan’s adoption as a global reserve currency.
That leaves the dollar as the last currency standing. Mounting debt, political paralysis, and the move to a multi-polar world would suggest a diminishing role for the dollar. Yet, the reality remains that there currently exists no credible alternative. Thus, while the dollar may be less attractive than it once was, it is likely here to stay as the world reserve currency.