Is Dollar's Reign As World's Main Reserve Currency Near An End?
Posted in Finance Articles, Total Reads: 3120
, Published on 10 April 2012
The US dollar has become the most sought after currency in the world as all the major international trade from coal to crude and Gold to Grains takes place using it. After the World War II in 1944, the US Dollar got the status of the World Currency, or call it a Reserve currency. A global currency is one in which all key commodities such as oil, gold, steel and so on are priced; they are the primary currencies against which all others are compared; and they are the currencies that most national governments and central banks hold as part of their national reserves. However since last 67 years, US Dollar has seen major fluctuations in its value, experiencing a peak in 2000-2001 with a constant devaluation and long term decline since then.
Before analyzing whether Dollar’s reign as a global currency has come to an end, we need to identify the facts that led Dollar serve as world’s main reserve currency for decades. Next, we would analyze whether those factors still prevail, followed by analysing the alternatives available and finally the negative impacts of replacing dollar on the global economy.
How the US Dollar achieved the coveted status
When the World war II was still raging, 730 delegates from 44 Allied nations gathered in Bretton Woods, signed the Bretton Woods Agreements in July 1944. The significant features of the Bretton Woods system included an obligation for each country to adopt a monetary policy that maintained the exchange rate by tying its currency to the U.S. dollar, establishing the dollar peg with gold. The US Economist, Henry Dexter, thus negotiated in Bretton Woods Agreement, resulting in the US Dollar emerging as the global reserve currency.
After the end of World War II, of estimated total gold reserves of $40 billion, US held about $26 billion gold reserves which accounts to approximately 60% share. Also, the dollar was fixed to Gold at a price of $35 per ounce of Gold in order to bolster confidence in the system. The nations further agreed to buy and sell US Dollar to keep their currencies within 1% of the fixed rate. This additionally encouraged foreign governments and central banks to exchange dollars for gold.
Another impact of the World War II, was US emerging as the biggest importer of goods and services to maintain its economy by a trade deficit, thus helping foreign governments keep US Dollar in their exchange through trade surplus and prevent their currency from appreciating.
The US Dollar is also the currency with the most purchasing power and also the only currency backed with the power of Gold. Also after the World War II, all the major European Countries were highly in debt and thus exchanged large amounts of Gold with US Dollar, thus contributing to the supremacy of dollar’s power.
Do the Conditions prevail in the Present Economy
Unlike the past, the present scenario shares a different story. Here we need to analyse the fact that whether the factors that enforced US Dollar as the Global currency, still prevails.
The Bretton Woods System which gave the status of Global currency to the US Dollar does not officially exist today because on August 15, 1971, President Richard Nixon unilaterally terminated the convertibility of Dollar to Gold, which was a significant reason of its dominance. This action is referred to as ‘Nixon Shock’.
The US debt has almost doubled from 2002 to 2011 from $5.9 trillion to $14 trillion due to the subprime crisis and recession, leading the federal debt to about 75% of United States’ Gross Domestic Product, thus requiring more flexible fiscal policy.
The US has not remained a promising customer anymore and is already at the verge of insolvency. The inflation rate has hit a 3-year high of 3.9% in September. Unemployment is also held at nearly double its pre-recession level, keeping incomes under pressure.
The Dollar’s Golden Era seems to come to an end. Today only a handful of oil-producing nations in the Middle East hold a combined $2.1 Trillion in Dollars, which are solely a product of selling oil in exchange for Dollars. China with other BRIC countries has formed a secret coalition to end the pricing of oil in dollars by 2018.
Changes in technology are also undermining the dollar’s monopoly. Earlier traders may face difficulty in comparing prices of commodities in different currencies, but today nearly everyone carries handheld devices which can be used to compare prices in different currencies in real time.
Alternatives against Dollar
After analysing the position of US Dollar in the present scenario, we need to evaluate the alternatives available against Dollar as the Global or Reserve Currency.
Other Foreign Currency
China is moving rapidly to internationalize the Yuan, also known as the Renminbi. Although the Renminbi option seems quite possible, it is presently not the right answer. The rise of China’s economic power creates a case for the Renminbi revaluation to make it a global reserve currency but there are several fundamental barriers to this. The controls exerted by the Chinese government on the Renminbi, for export advantage, makes it devalued against the world’s other currencies, especially against dollar by 50%.
French President Nicolas Sarkozy once proclaimed, “Europe wants it. Europe demands it. Europe will get it." The "it" here is global financial reform”. Evidently Sarkozy did not have to wait for too long if Euro crisis had not disrupted the whole European Union. The Euro has the maximum power of eroding Dollar’s dominance because it represents a larger size economy and has the prospect of more countries adopting the euro as their national currency. The easiest way to introduce Euro as the global currency is by legalizing all oil trades in Euro, thus forcing all countries to keep Euro as their key reserve currency.
Special Drawing Rights
On 26 March 2009, a UN panel of expert economists called for a new global currency reserve scheme to replace the current US dollar-based system called Special Drawings Rights. SDRs represent potential claims on the currencies of IMF members and can be used to convert into whatever currency a borrower requires at exchange rates based on a weighted basket of international currencies with a weight of 44% for the dollar, 34% for the euro, and 11% each for the yen and pound sterling.
Basket of Commodities
Another possibility is a currency unit based on a basket of commodities. After all, raw materials are the one thing that every country absolutely has to have access to. And every form of money is a proxy for real stuff in one way or another. Hence, a unit that was one part gold, one part oil, one part iron ore, and one part rice, would look like something that was going to hold its value for a long period of time.
Negative impact of replacing Dollar
A sudden dollar collapse would create global economic turmoil because investors would then rush to other currencies, such as the euro, or other assets, such as gold or other commodities. Demand for Treasuries would plummet, driving up interest rates. Import prices would skyrocket, thus causing inflation. The natural consequence of these economic situations would be high rate of unemployment, further leading to the economy back to recession or worsening to depression.
United States is the largest domestic economy in the world. It has world’s largest and most influential financial market. High stability and low level of corruption are the key factors in the US political System. The US economic policies are highly flexible in nature, the biggest example being during recession where inspite of being a capitalist economy, it shifted to socialist economy by giving bailout packages and nationalizing the private entities.
Thus we see that inspite of some the negative implications, US Dollar still holds more than 60% of the foreign reserves of central banks and governments. The Organization of Petroleum Exporting Countries sets the price of oil in dollars.
Fortunately, it's highly unlikely that the dollar will collapse in the next two decades because any of the developed countries who have the power to make that happen - China, Europe and other foreign dollar-holders - don't want it to occur. It's not in their best interest. The US consumer occupies the major market share of the developed economies, so why bankrupt your best customer?
This article has been authored by Ruchi Gupta from IIT Roorkee.