7 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff truly deep-dives into reserve currencies and the U.S. dollar with an in-depth analysis of why predictions of the reserve dollar’s demise may be premature.
I. FORECASTING THE RESERVE DOLLAR’S DOWNFALL: NOT SO FAST.
Since the 2008 financial crisis there’s been no shortage of speculation in the press and public discussion that the dollar is teetering on collapse from its perch as the world's leading global reserve currency.
In the early days of the crisis and Great Recession the euro was predicted to make major gains against the dollar or even replace its leading role in international payments transactions. However the 2011 Eurozone crisis dampened those expectations.
There was also speculation that a gold-backed Russian ruble, or a joint gold-backed Russo-Chinese reserve currency would displace the dollar. Neither government has since made good on its overtones to back any currency with gold, and the ruble remains an insignificant reserve holding.
Many have predicted that China’s ascent to world’s number two economy will catapult the Chinese renminbi (RMB, aka the yuan) as the world’s new reserve currency and dethrone the dollar. While China has made moves to sign some bilateral agreements to trade in RMB with Pakistan and a number of regional partners, and some Belt and Road Initiative countries have also increased their RMB holdings, the RMB mysteriously remains a global nonplayer. As of early 2018 the yuan represented less than 1.2% of all global reserve holdings.
Why has the dollar been so resilient and is it in as much danger as pundits predict of losing its leadership position?
The truth is that global reserve currency leader status is the U.S. dollar’s to lose. The dollar and the country that backs it—the United States— exhibit a unique set of traits that keep the greenback the preferred holding among world central banks, and that none its rivals can yet claim to fully duplicate.
II. WHAT IT TAKES TO BE (AND STAY) A GLOBAL RESERVE LEADER
In this section we’ll review the first seven of eleven attributes the dollar exhibits and which a foreign currency rival must also possess to be considered a legitimate competitor.
No one authority “decides” what these properties must be. Rather they are simply favored in the “marketplace” of global reserve currencies, a marketplace where the consumers or users of global reserve currencies are predominantly central banks. No one can pass a law that forces other countries’ central banks to accept dollars. Political pressure can slightly sway their decisions, but even the United States doesn’t have the political clout to pressure every central bank in the world to choose dollars if the dollar itself is unattractive.
So what are these characteristics that are so allegedly important and make a reserve currency attractive to central bankers?
In a nutshell they are:
1. Incumbency
2. A large economic zone
3. Large, liquid financial markets
4. Trustworthy, transparent, regulated financial markets
5. A commitment to low inflation
6. No capital controls
7. Free/floating exchange rates
8. A commitment to run consistent trade deficits
9. Democracy* or at minimum some political liberalization
10. Military superpower status
11. A lender of last resort central bank
For the sake of space we’ll discuss numbers 1-7 in this article and complete the remainder in the last installment.
(1) Incumbency
The sad reality for the dollar’s potential rivals is that the incumbent enjoys an enormous advantage simply by already being the reserve currency of choice. It’s jokingly referred to as “the Facebook effect” by economists since one user leaving Facebook loses far more in access to the network than he gains in autonomy.
The balance sheets of central banks are loaded up with trillions of U.S. dollars and replacing them is a complicated, expensive, and laborious matter. Every country already settles payments in dollars and for one or even a few countries to break away means incurring considerable costs to operate under an incompatible currency regime.
In short, those costs are related to what would become constant dollar-currency exchanges and foreign exchange movements and would be borne by the breakaway country’s commercial banking sector and exporters (making them less competitive globally) as well as consumers and even governments.
See Part 1 of this series for a primer on the costs of “going it alone” and leaving the dollar network at:
http://www.cautiouseconomics.com/2019/04/inflation-currencies01.html
So there remains a built-in incentive to “stay with the pack” and there are enormous financial incentives and pressures to remain on the international dollar standard.
(2) A large economic zone
Any competing reserve currency has to be issued by a country or bloc of countries that operates a large economy or economic zone.
Why? Because foreign central banks hold large quantities of reserves, well… (as the name itself implies) in reserve. They don’t drive their reserve balances to zero as doing so would suddenly make it impossible to import goods and services on a moment’s notice. So while they hold a buffer of tens or even hundreds of billions of dollars in reserve they prefer to put those dollars to work.
Likewise foreign commercial banks also prefer that their reserve currency holdings are accepted in a large economy where they can be put to work. As University of California Berkeley economist Barry Eichengreen puts it, “a reserve currency isn’t much good if you can’t do anything with it.”
(this is one of the reasons, incidentally, why SDR’s or Special Drawing Rights haven’t made a credible dent in global dollar holdings; you can’t buy or invest in anything with SDR’s)
Thus not only must there be a competing economy to “park” or invest your reserve holdings in, it must be a large enough economy to absorb the trillions of dollars equivalent that the entire world’s central banks hold.
Right away this rules out the Swiss franc, British pound, and Japanese yen for example. Even if those currencies are a stable and reliable measure of value, they can only be used in Switzerland, the U.K., and Japan which have GDP’s of US$731 billion, $2.18 trillion, and $5.22 trillion respectively.
As of 2018 world global reserve holdings of U.S. dollars were approximately $6.2 trillion, so none of those economies is large enough to back a franc, pound, or yen substitute to the dollar. And Russia, even if it backs the ruble with gold, is so small it’s not worth mentioning.
This leaves really only three players on the world stage that are large enough. The United States, the Eurozone which uses a single currency in a bloc GDP of about US$14 trillion (not to be confused with the larger European Union), and China whose economy is approximately US$14.2 trillion and growing at the fastest rate of the three.
(3) A large and liquid financial market
When foreign central banks “park” their reserve holdings in a large economic zone, they want to earn interest on securities. They don’t want to park their holdings in corporate or real assets like an airline or housing which are burdensome, require expertise to manage, and are hardly liquid when central banks need to cash out.
In other words, foreign central banks want a large securities market to park their reserve holdings and deep liquidity that allows them to “cash out” at an instant when they need immediate access to settle balance of payments.
The United States provides the largest, most liquid financial securities market in the world: U.S. Treasuries. As of 2018 overseas central banks and financial institutions hold $6.21 trillion in U.S. Treasury securities. Easy access and the perceived safety of Treasuries boost the dollar’s appeal to overseas institutions.
Once again, the number of potential competitors who can offer their own correspondingly-sized financial market is very low. The Eurozone has a large and liquid market, but the Eurozone is comprised of over a dozen countries each issuing their own sovereign debt. So does a central bank choose to park its euro holdings in German government debt? French debt? Or does it run the risk of losing its shirt because it picks the wrong sovereign debt such as bonds from Greece, Spain, Italy, or Portugal?
China has its own growing financial markets but they aren’t as mature and established as those in the West. Also the Chinese government hasn’t issued the same levels of sovereign debt as the U.S. or Eurozone countries. Low government debt loads might be a good thing for China’s fiscal position, but it comes at the cost of being unable to offer a large securities market for yuan holders to park funds in.
(4) Transparent, trustworthy, regulated markets
Of the large financial market players, only the U.S. and Eurozone are considered transparent and regulated enough for central banks to trust parking their funds. Chinese securities still don’t engender enough confidence to risk investing tens or hundreds of billions of dollars (or reserve yuan) just to watch a giant scandal slash the value of those holdings overnight.
British, Japanese, Canadian and Australian markets are considered sufficiently transparent, regulated, and safe, but neither their economies nor their financial markets are large enough to support a global reserve currency.
Note: Those who have read the COCEA’s past columns may recall that history shows the most deregulated financial markets (save regulations for countering fraud) have actually been the most stable—notably the nearly laissez-faire Canadian system of 1817-1935 and the even freer Scottish system of 1721-1845, neither of which ever experienced a financial crisis—while the more tightly regulated U.S. and English systems of the same period were basketcases, plagued by repeated crises and bank runs that wiped out fortunes. However, whatever the merits of the “free banking” arguments, the present-day reality is foreign holders of global reserves are not economic libertarians. They’re central banks. And central bankers demand transparency and regulation to consider a financial market a sound investment.
(5) A commitment to low inflation
No one wants to hold or park large holdings of global reserves just to watch the issuing nation’s central bank inflate away its value by 10%, 20% or more per year. Therefore foreign central banks want a currency with a track record of low inflation. Of all the major players—the U.S. dollar, the euro, the British pound, the Japanese yen, and the Chinese yuan—all but the Chinese yuan have experienced relatively low inflation rates going back to the end of the global inflation era of the 1970’s.
In recent years Chinese inflation has fallen to the 2%-3% range which works in the yuan’s favor. However less than a decade ago China was experiencing 8% and 9% inflation rates. Thus China’s track record of low inflation is too short for central banks to entrust their reserve holdings to the yuan.
(6) No capital controls
As mentioned earlier, foreign central banks value liquidity in their reserve holdings’ financial markets. Therefore no one wants to acquire large foreign holdings balances, invest them in the issuing country’s markets, and then watch that country’s government slap capital controls down that prevent or limit the quantity of funds that can enter or more typically leave the country.
The U.S., U.K., and Eurozone members have not imposed capital controls for a very long time (exception: Greece which halted the panic withdrawal of euros from the country when investors anticipated Greek voters would choose to leave the Eurozone and convert euro balances to devalued drachmas). In fact, capital controls are a tool typically used by smaller, developing economies that rely heavily on foreign investment inflows. However, even today China still utilizes capital controls to dictate the flow of investment funds in/out of its economy which makes the yuan unattractive as a global reserve currency.
(7) Free/floating exchange rates (no manipulation)
Foreign central banks don’t want to hold large quantities of global reserves and watch the issuing country intervene in foreign exchange markets to (typically) depreciate its currency. If the Canadian central bank obtains and holds large quantities of Japanese yen, and the next day the Bank of Japan dumps yen to buy Canadian dollars on foreign exchange markets, the Bank of Canada will eat a loss on its yen holdings when they (or their banks or citizens) try to convert them back to Canadian dollars.
Yet again, the established western players such as the U.S., U.K., and Eurozone countries don’t intervene directly in foreign exchange to manipulate their currencies. And while Japan and China both officially claim to no longer intervene, they are not sufficiently trusted (particularly China) for central banks to hold yuan or yen in large enough quantities to be considered a global reserve currency.
In Part 4 we'll review reasons 8 thru 11 why the dollar should remain the world's top reserve currency for a while longer and discuss what's holding back the euro and particularly the Chinese RMB from taking its place.
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