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Will Dollar survive as a Reserve currency

Posted in Finance Articles, Total Reads: 4508 , Published on October 30, 2010

US dollar is not the world’s key currency by policy design, just as English is not the leading global language by policy design. It is the evolutionary outcome of practice and experience. However the scenario has changed drastically in the past few years; the US trade deficit, federal budget deficit, low interest rate, and low GDP growth compared to the high – GDP growth rest–of-the-world has caused the dollar to decline against the world’s major currencies. Current US fiscal and monetary policies have propelled that deterioration forward. So it comes as no surprise when many leading economies of the world have questioned the status of dollar as reserve currency. But still by end of 2008 the dollar accounts for 61.54 percent of central bank reserves (Source IMF).

To analyze future of dollar further; let’s first observe what prime characteristics of a reserve currency/its issuer are. The currency must have a stable value along with a backing of economic power that has credibility and fundamental strength enough to support the currency. The issuing country should have deep financial system that attracts capital from different parts of the world. Finally, the global financial infrastructure must be dependent on the global currency to function. Apart from these economic factors, a global currency must be issued by a nation that has significant political and military power because many smaller nations choose to ally with such a power, and the natural outcome of such alliances is greater dominance for the currency of the bigger partner.

Does dollar still posses these qualities?
Although it has been fluctuating recently, its value is mostly stable. Over the last one year (EURUSD) has moved from 1.51 to 1.18 and again come back to 1.3 and presently trading at 1.27 but is still stable in volatile forex markets. The financial system of the U.S is still the deepest, most flexible, and liquid one in the world and global trade is still dependent on U.S. dollar to function smoothly. These discussed points support the point that U.S. Dollar as reserve currency is still feasible. Then why are these questions pondering time and again about alternative Reserve currency.
Need for an alternative to U.S. Dollar
• The persistent and growing imbalance in the American external accounts.
• Current account deficits of the magnitude of the American deficit would have provoked the collapse of any other currency
• The aggressive policy adopted by the Fed in order to avoid the collapse of its financial system
• Establishment of a new currency would protect emerging markets from the “confidence game” of financial speculation.
• Dependency on a single economy will decrease.
• Better opportunities for developing countries.

Dollar as Reserve Currency

These are few of the reasons cited by the countries which are pressing for an alternative reserve currency. The Developing economies are the more concerned ones; India, Russia, Brazil and China are few who have suggested this. They account for more than $2.5 trillion of reserves. Among all the nations that have raised concerns; the most bothered nation is China. China is the largest U.S. creditor, holding $900 billion of U.S. debt as of August 2010, according to Treasury Department figures. Japan is second with $784 billion. Brazil holds $126.6 billion, while Russia has $138.4 billion.
Nations such as China are also dependent on the U.S. as a market for their exports, so they seek to suppress the value of their currencies with purchases of dollars. China’s exports to the U.S. were $366 billion last year.

China as Reserve Currency
China actually is America’s bank and America basically says there’s nothing you can do to me.  “If I go down you don’t get paid.”
Chinese  officials  are  frustrated  at  their  financial  dependence  on  the  U.S.  China has significant holdings of U.S. government bonds. It holds $2 trillion in dollar assets, accumulated through years of exports to America and massive purchases of Treasuries by the Chinese government. The size of those holdings means the value of the national rainy-day fund is mainly driven by factors China has little control over, such as fluctuations in the value of the dollar and changes in U.S. economic policies If U.S. can't rein in its mounting budget deficit, both Treasuries and the greenback could weaken considerably—and the Chinese could be big losers as a result also the collapse in demand for the nation's exports has shuttered factories and left millions jobless.
So to summarize, China is in a quandary; if it stop lending to U.S. it may see the value of its existing reserves plummet. Continue lending, it may get the same result.
So, China and other countries with similar dilemma called for the creation of a new currency to eventually replace the dollar as the world's standard, proposing a sweeping overhaul of global finance.

The proposed alternatives for the reserve currency include
• Yen
• Special Drawing Right (SDR)

Euro: - The second largest held reserve with growing percentages every year. The euro is still too tenuous. There’s no guarantee that the euro will survive in the long run. But again at present there’s only one currency in the world which can ever pretend to take over the role of the dollar, and that is the Euro. Although the Euro fulfils most of the requirements of becoming the global currency, the powers that back it are not enthusiastic about seeing it assume the role of the reserve currency, and certainly do not possess the political or military power necessary for undertaking such a large project. Without the support of the EU, it is unlikely that the Euro will replace the dollar. And indeed, when nations discard the dollar as the commercial medium, they do not substitute the Euro in that role - they choose to trade in their own currencies.  That  model  can  work  on  a  small  scale,  but  clearly  not  on  an international basis. But if the EU (European Union) gets larger and the support from various other  nations  is  provided  we  can  see  EURO  as  alternative.  Presently EU has only 15 countries; inclusion of more to become a unit of 30 odd countries will help EURO. It will also reduce dependency on any one economy.

Meanwhile, the YEN isn’t widely used enough (the carry trade notwithstanding), and Japan’s long-term economic decline suggests that its currency will also loose significance. Moreover investing in Japanese Government Bonds (JGBs) instead of U.S. Treasuries is hardly appealing, given the low yields on offer for such a high debt pile (170% of GDP).

Yuan: With Japan being overshadowed by a rising China, it is thus natural to speculate about the possibility of a YUAN block in Asia. If Chinese were to bring the Yuan into competition with the dollar as a medium of international trade, they would have to turn the Yuan into a convertible currency whose value would be dictated by the market, with traders, investors, governments, and companies around the world freely buying and selling it. It would mean lowering all kinds of financial trade barriers, allowing foreign access to Chinese securities markets and more. Even if this will eventually change, it’s difficult to see it outshining the dollar – especially on a popularity level.

SDRs (Special Drawing Rights): A kind of synthetic currency created by the IMF in the 1960s. Its value is determined by a basket of major currencies. Originally, the SDR was intended to serve as a shared currency for international reserves, though that aspect never really got off the ground.
If international trade switches to SDR, it will have two consequences. US would no longer be able to run massive current account deficits and the countries that have generated growth by running massive current account surplus would no longer to do that. The other problem how will you make the transfer? The IMF can do it one of two ways. It can take the dollars and give out SDRs, but it would run a massive balance-sheet mismatch that would bankrupt it in a week. Or it can sell the dollar and buy euro, yen, pound and Swiss franc to create the SDRs which would mean that the value of the dollar would drop significantly against the euro, yen, pound and Swiss franc. And all of those countries would find themselves running very large trade deficits while the US may actually run a trade surplus.

To conclude the US dollar is likely to remain the dominant international currency for many years, certainly the next decade and probably longer. Technical (market) grounds, none of the other leading currencies in the world today is ready to replace the US dollar in its international role. The only currency area that comes even close to the US in size is the Euro area. However, trend growth in the latter, is slower than the US, and therefore the relative size of the US economy is actually increasing with respect to the Euro area. The Chinese and Indian economies are growing much faster and rapidly bridging the gap with the US, but are still a small fraction of the latter at market. Japan’s long term decline has made yen unattractive.
The SDR is currently simply an accounting unit and not a payments currency. To implement SDR as a reserve currency is a much further long term plan but IMF’s susceptibility in past 40 years has raised concerns for same. Reverting to the gold standard is not practicable since governments and central banks would lose flexibility in use of monetary and fiscal policies to stabilize the economy.

The inescapable conclusion is that there is no alternative currency that can rival, let alone replace, the US dollar as the international reserve currency in the foreseeable future.

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