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7 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff concludes his deep dive into reserve currencies and the U.S. dollar with the last chapter of in-depth analysis of why predictions of the dollar’s demise may be premature—and an added focus on China's prospects for a global reserve yuan.
I. THE REMAINING REQUIREMENTS FOR RESERVE STATUS
In Part 3 of this four-column series we discussed the first seven of eleven traits a country and its currency must exhibit to be chosen by world central banks and governments as a primary global reserve currency. The first seven can be found in that column at:
We continue with:
(8) A commitment to run consistent trade deficits.
This requirement may surprise trade hawks and disappoint President Trump himself. While the U.S. trade deficit is definitely too high and the result of overseas currency manipulation (by China in particular), export subsidies, import quotas, and protectionist tariffs, the reality is a United States that runs a trade surplus or even a zero trade balance will quickly lose reserve status for the dollar.
Why? The world economy is growing every year and trade between nations grows every year. Thus the world demands more and more dollars, year after year, to accommodate rising levels of international trade, and the issuer of the reserve currency has an implicit responsibility to supply the world with the means of settling global payments.
Therefore the U.S., or more specifically the Federal Reserve, has to provide the world with higher dollar balances every year. The COCEA’s rough calculation is that the world demands approximately 250 billion new dollars each year to fill the growing reserve holdings coffers of its central banks.
As we discussed in Part 2, there are three main ways to inject $250 billion into overseas central banks year after year. The first is the Fed can figuratively print the money and give it away, but U.S. policymakers and the public are hardly going to choose that option.
The second is to invest dollars overseas and the purchasing of foreign assets does happen on regular basis.
But the third and most common method for exporting $250 billion is to exchange it for all kinds of cool goods and services. Why give the money away when Americans can receive nice cars, fine foods and drink, TV’s, computers, and all kinds of other cool stuff in return?
Hence the moment the U.S. stops running a trade deficit or even runs a surplus, the supply of new dollars dries up overseas and the nations of the world will quickly search for an alternative and, if they find one, divest their dollar holdings.
A commitment to consistent trade deficits eliminates some competitors. China famously insists on running huge trade surpluses every year, making the yuan unsuitable as a global reserve currency.
The Eurozone is more complex as its member nations are a mix. Germany famously runs a consistent trade surplus while the troubled periphery nations do not. However if the euro is to provide any meaningful competition to the United States then the Eurozone region as a whole has to run trade deficits every year, also to the tune of US$250 billion equivalent or even higher.
(9) Democracy* and political liberalization.
There is an ongoing debate as to whether the issuing nation of a reserve currency must be a democracy. Traditionally dominant reserve currencies have always been issued by democratic governments—the U.S. dollar, the British pound in the 19th century, and the Dutch guilder even earlier.
However what is not open for debate is that the issuing nation must practice property rights, rule of law, and economic liberalization. No central banker wants to park large quantities of foreign reserves overseas in a nondemocratic country just to watch the dictator wake up one morning and arbitrarily seize their funds or nationalize all their assets. Once again, the established players like the USA, U.K, Eurozone, and Japan qualify. China’s political system doesn’t engender sufficient trust for central banks to hold the yuan as a major global reserve.
(10) Military superpower status.
It’s no coincidence that the traditional reserve currencies have been issued by strong military powers. Obviously the United States today, in the 19th century the British Empire, and the 17th and 18th centuries Dutch Empire had a formidable military force as well.
Some people mistakenly believe that military superpower status is required so that the issuing country can physically force (or at least intimidate) other nations into accepting its currency. While having great military might gives a country the political clout to apply some pressure, the truth is that military strength is much more important for a different reason: survival of the monetary regime itself. The 1980’s German mark provides an illustrative example:
In the 1980’s West Germany was the world’s second largest economy, it had had a commitment to low inflation since the days of the Weimar Republic (excluding the chaotic final days of the Third Reich), its government bonds and financial markets were considered transparent and trustworthy, and there was talk that the mark might become a viable competitor to the dollar as a reserve currency. Granted it was a long shot, but after the 1970’s and early 1980’s inflation era the world was looking for an alternative.
However at that time there were countless divisions of Warsaw Pact/Soviet tanks and infantry right across the border in East Germany threatening to roll into West Germany at any moment. No overseas central bank wanted to hitch its wagon to the mark just to watch the Soviets invade and occupy West Germany. All its securities, its financial markets, the Bundesbank, etc… would disappear or at a minimum be converted into less desirable (an understatement) communist equivalents.
In stark contrast very few people could envision Soviet tanks rolling into and occupying the United States. Thus America’s military superpower status gave central banks confidence that its reserve dollar holdings were safe from a foreign invasion effectively nullifying the soundness, indeed the very existence, of the U.S. dollar. The same couldn’t be said about West Germany so the mark never made reserve inroads.
Today a few countries might qualify having sufficient military power status to “protect” their currencies. The Russian and Chinese armed forces might not be as strong as America’s, but they are powerful enough that no one is going to invade them—especially when they have a nuclear deterrent. The U.K. isn’t considered a military superpower but it’s an island nation and has its own nuclear weapons. The Eurozone doesn’t possess a powerful military, and although France has nuclear weapons there are questions as to whether it could or would be willing to use them to deter invasion of a periphery nation like Greece or some of the Eastern European republics. Finally Japan relies heavily on the United States for protection and has no nuclear weapons at all.
(11) A central bank to act as lender of last resort.
Any country that deals heavily in dollars will host commercial banks that deal in both its own domestic currency as well as dollars. Since that country’s domestic banking system will lend in dollars, and to an extent accept deposits in dollars, its banks will need access to a lender of last resort central bank in times of crisis. Unfortunately for them, neither the European Central Bank nor the Bank of Japan nor the Bank of England nor any central bank other that the Federal Reserve issues dollars. Therefore without the Fed, overseas central banks will refuse to use dollars as a primary international reserve currency.
Although the Fed QE’s, discount window loans, and the TARP occupied most of the USA’s domestic headlines during the 2008 financial crisis, the Fed also made extensive discount loans to foreign banks and issued dollar reserves to buy assets from overseas banks as well. To the extent the public was aware of the Fed’s export of vast quantities of dollars to international banks the practice was controversial. However the Fed’s LOLR role to foreign banks that deal in dollars was well established long before 2008 since it was a prerequisite for the dollar’s global reserve currency status.
(Note: The Economics Correspondent is not a big fan of the Federal Reserve, but “End the Fed” proponents should bear in mind that if the Fed is dismantled the world must first be weaned off the global reserve dollar. Otherwise a “cold turkey” end of the Fed would precipitate a rapid repatriation of the $6.2 trillion in overseas dollar reserve holdings and foster a major inflationary event)
II. HOW DO THE MAJOR CURRENCIES STACK UP?
When rating the viable candidates we assign a point for each of the eleven traits we've reviewed that a currency must satisfy to compete for leading global reserve currency status.
THE DOLLAR ITSELF. The dollar scores 11 out of 11 since the United States provides all the necessary characteristics to make its currency attractive to central banks and governments as a reserve currency.
THE BRITISH POUND. The U.K. scores about 6 out of 11, failing on several fronts. The pound doesn’t have the incumbent advantage, the British economic zone is not large enough to support a world reserve currency, its sovereign debt doesn’t provide a large enough securities market for over $6 trillion in reserves to be “parked,” its commitment to run a sufficiently large trade deficit falls into doubt, and it’s no longer a military superpower—although the British military does possess a nuclear deterrent.
THE JAPANESE YEN. Japan scores about 5 out of 11, also failing in many areas. No incumbency, an inadequately large economic zone, an inadequately large securities market, a history of manipulating foreign exchange rates to boost exports, a definite lack of willingness to run trade deficits, and a weak military that depends on the United States for protection all make the yen unattractive as a dollar alternative.
THE CHINESE YUAN. China scores about 5 out of 11. This may come as a surprise to many who see China as a rising power, but its governmental structure still makes the yuan untrustworthy in the eyes of central banks. While China has a large economy and a large and growing financial market, questions still exist about the reliability of Chinese government debt (as opposed to U.S. Treasuries). China’s financial markets are definitely not trustworthy and transparent enough, and central banks view its financial regulatory controls as inadequate. China still imposes capital controls, its authoritarian government is more able to arbitrarily expropriate foreign assets (they already do with intellectual property and technology), and it fails miserably on the currency manipulation and trade deficit fronts. The Chinese government famously engineers a system of massive trade surpluses year after year. Hence the number two world economy’s currency only represents about 1.5% of world reserve holdings.
THE EURO. The Euro scores 8 out of 11, making it the closest thing to a legitimate rival to the U.S. dollar out there. The Eurozone has a large economic zone with large, liquid, transparent, and regulated financial markets. The euro has a record of low inflation, European governments don’t impose capital controls (exception: Greece during its crisis), the euro exchange rate floats freely, and its governments generally don’t arbitrarily nationalize foreign assets. The euro’s weaknesses include non-military superpower status, its willingness as a bloc to run consistent trade deficits is in doubt (especially when its largest member, Germany, relies on annual trade surpluses), and there is some uncertainty just which country’s securities to park holdings in as evidenced by the last decade’s performance in Spanish, Portuguese, Italian, and Greek bonds.
All this is reflected in the euro’s 20% global share of reserve holdings and number two position after the dollar.
Thus the euro posed the greatest threat to the dollar’s dominance pre-2008. When the financial crisis struck in 2008 and the Fed launched quantitative easing the euro gained at the dollar’s expense as central banks began to doubt the Fed’s commitment to low inflation, but when the euro crisis struck in 2011 there was a flight back into the dollar which has enjoyed a consolidated leadership role ever since.
III. CHINA: STILL A LAGGARD (LIKELY BY DESIGN)
One more note about China. In a recent conference of international economists the China question was discussed and former Egyptian finance minister Youssef Boutros-Ghali asked a rhetorical question that explains why the yuan commands less than 2% share of global reserve holdings plus why the Chinese government isn’t interested in growing that share to any meaningful level anytime soon:
“Why would anybody [implying China] want their own currency as a reserve currency?”
“If I were China I would resist violently having my currency as a reserve currency in the world because it implicates my banking system, it forces me to eliminate all capital controls, if forces me not to intervene to fiddle with the exchange range. It puts so much stricture on the system that given their authoritarian infrastructure of government it would unravel their control system of the economy… it flies right in the face of their political system.”
Boutros-Ghali makes an excellent point. Reserve currency status doesn’t suit authoritarian regimes that manipulate their currencies very well. The Chinese Communist Party insists on strict control of its banking system, capital controls, currency manipulation, a strong export-driven model, and dictatorship in general.
The CCP would have to forgo all that command and control to convince the world’s central banks to accept the yuan as a leading global reserve currency and park large sums of RMB’s in Chinese securities markets. In today’s China, this is too unpalatable a political pill for the autocratic CCP to swallow.
So for now, China is willing to forgo the benefits and prestige of a global reserve yuan and, in the Economics Correspondent’s view, is content continuing to run large trade surpluses and accumulating large dollar holdings which it then uses to purchase overseas assets that further its own geopolitical interests.