US Decline Series: Are the dollar’s days as reserve currency numbered?

US Decline Series: Are the dollar’s days as reserve currency numbered?

Despite speculation that the days of the US dollar as the world’s reserve currency will soon be over, a number of factors make such a changing of the guard unlikely. This GRI series challenges the myth of the American decline.

The dollar was crowned as the king international method of payment and unit of account in the 1920s. Back then, the US had become a financial hub and a major trading partner to many nations, and although gold was the official reserve asset of the international monetary system, the US dollar was the global reserve currency. Since, the US dollar has maintained its status, but questions about the viability and likely future of this arrangement are starting to surface.

In particular, the rise of China and the renminbi has prompted concerns for some and hopes for others that the days of the US dollar as world reserve currency will be over soon. No such expectation is warranted in the foreseeable future. The reserve currency status comes with certain requirements – and the US dollar is still the only candidate for the task, given these prerequisites.

This is not so much due to any virtue of the dollar itself, as to the lack of any alternative. As Eswar Prasad, author of The Dollar Trap puts it:

“It’s simple: there are no good alternatives to the dollar. Any time you think of the dollar losing its dominance, you have to ask yourself: if not the dollar, then what? And there’s no good answer.”

Three key features are required of a reserve currency:

1) Liquid and deep market for securities denominated in the currency

This implies that these securities can be bought or sold quickly and easily, without affecting the price excessively. The US may not be the largest economy for much longer; in fact, China is “poised to pass the US” this year, but that does not in itself constitute a reason to switch.

The US still has the deepest, most open and most liquid markets in the world with assets traded in large amounts and often. China, with its closed financial markets and tight control of the exchange rate of the renminbi, is unlikely to pose a threat anytime soon.

The euro has better prospects, but given meagre growth projections for the Eurozone, combined with existing uncertainty and the recent risk of default, the case for the euro as reserve currency is much less compelling.

The pound sterling is another decent contender, and it does the job well for small countries needing reserves, but for a larger nation or a region, the market for sterling-denominated assets is too shallow. The yen is also occasionally mentioned as an option, but given Japan’s position as world champion in public debt as a percentage of GDP, valid concerns about fiscal soundness would rule the yen out.

2) Assets denominated in the reserve currency must not lose much in value

This implies that looming defaults and impending downgrades are major deterrents in the reserve currency game. The economy whose currency is used as reserve must be fairly stable and fiscally sound, and its political and financial systems have to be reasonably transparent and reliable.

This is definitely an argument against the euro, as well as a host of other currencies whose issuing body does not have the trustworthiness and reliability of the US.

3) Reserve currency issuer must be credible and indisposed to arbitrary policy changes

The commitment of the US to free markets, liberalization of finance and respect for property rights are soft values for which one cannot provide a table of hard  numbers. Yet, it takes little to see that this could be the trump card for the US.

For instance, the interest rate on a three-month Treasury bill is frequently used as the risk-free rate. Although no such thing as a truly ‘risk free’ rate exists, the Treasury rate is seen as the closest thing to it. This means that there is a great amount of trust in the ability of the US to always pay its debts.

Political, institutional and legal frameworks matter, and in combination with the other requirements, this means that the US dollar stands alone as a safe and trusted haven. Relative perceptions of safety still position the US as the preferred choice, when hedging domestic exchange rates with reserve buffers.

There is a difference between an absolute and a relative decline. Holdings of total foreign currency have increased dramatically over the past decade, but the share of US dollars has fallen. The dollar constitutes about 60 percent of identified currency reserves (see table and chart below), meaning that diversification has taken place, but not to such an extent as to dethrone the dollar.

Emerging markets demand reserves in part to protect themselves, and the fact is that there are no other financial markets that offer the credibility and liquidity of the US.

Currency composition of foreign exchange reserves

Note: Unallocated reserves denotes the difference between total foreign exchange reserves in the International Financial Statistics (IFS) (world table on Foreign Exchange, which is not broken down into currencies) and the total allocated reserves in the Currency Composition of Official Foreign Exchange Reserves (COFER). Unallocated Reserves includes foreign exchange holdings of those countries/territories that currently report to IFS, but do not report to COFER (Source: IMF).

Categories: Finance, International

About Author

Mikala Sorenson

Mikala Sorensen is an Economist with regional expertise in Europe. She holds a first class honours degree in Philosophy, Politics and Economics from the University of York and a Masters in Economics from the University of Copenhagen. Having interned at the Danish OECD-delegation in Paris and currently working at the Danish Ministry of Finance, she specialises in politics and macroeconomics. Analysis for GRI is an expression of her own views.