By Kati Suominen, Trans-Atlantic Fellow at the German Marshall Fund in Washington, cross posted from VoxEU
The global crisis has led some to question the dollar’s place as the dominant currency. This column discusses three camps in the literature: those advocating a new synthetic global currency, those arguing that a new reserve currency will emerge, and those suggesting a return to sharing the role. It concludes that talk of the dollar’s death – or even its decline – are exaggerated.
The global crisis and US economic travails triggered a firestorm debate on the future of the global currency regime.
* At the London G20 Summit in April 2009 China’s central bank governor Zhou Xiaochuan slighted the dollar-centric order, calling for a super-sovereign reserve currency – a reference to special drawing rights (SDRs) housed at the IMF.1
* Russian President Dmitry Medvedev called for a mix of regional currencies;
* Some western opinion leaders warmed to the euro’s leadership (see for example Zoellick 2009).
Washington refuted these notions. Instead it pledged fiscal discipline to help buttress the greenback. ECB head Jean-Claude Trichet also argued for the dollar’s importance in the world economy (Reuters 2009a).
At last week’s G20 Summit in Toronto, currencies went practically unmentioned. This reflects the US recovery; the fall of its most plausible contender, the euro, amid Europe’s economic woes; and perhaps China’s deflecting attention from its exchange-rate management. Despite this, the debate continues to simmer as US debt and trade deficits grow. In line with the Triffin Dilemma2, this raises concerns about the dollar’s viability and trade protectionism in America. Three main camps of literature explore the alternatives to the dollar as the global reserve currency – yet each has important drawbacks.
In his March 2009 comments, Zhou argued that Keynes’ vision for a global currency (expressed at the famous Bretton Woods conference that set up the IMF and World Bank) “may have been more farsighted” than the dollar-centric system that came into being.
Keynes envisioned an International Clearing Union (ICU) that would issue “bancor” – a currency based on the value of 30 commodities (including gold) and exchangeable against national currencies at fixed rates. Countries would maintain bancor accounts and draw from the ICU when experiencing balance of payments problems. In 1967, the IMF forecast that Special Drawing Rights (SDRs) would account for over half of total world reserves before the end of the 20th century (Polak 1967). Nobel prize laureate Robert Mundell (among many others) has advocated similar notions since the 1960s (Mundell 1968).3 The idea has gained momentum following Zhou’s comments.
* Bergsten (2009) and Wijnholds (2009) support a substitution account that would enable countries to reduce their dollar exposure by swapping dollars for SDRs.4
* More ambitiously, a UN commission (2009) led by Joseph Stiglitz suggests a “greatly expanded SDR” system akin to the bancor system.
* Strauss-Kahn (2010) argues that the IMF could in the long-run issue SDRs.
* An IMF team laid out detailed thinking on a global reserve currency issued by the international monetary institution – an independent central bank with an unrivalled AAAA rating (Mateos y Lago et al. 2009).5 Member states could issue bonds and other instruments denominated in this global currency.
* Stiglitz (2009) proposes a global reserve system whereby countries obtain paper gold (like bancor) from the IMF for their reserves as crisis insurance so as to attenuate reserve accumulation.6
These more ambitious proposals would provide exchange rate stability, global network benefits and scale economies, and be considered “fair” in that no nation would enjoy exorbitant privilege.
Authors acknowledge, however, the tall assumptions. The dedicated central bank would have impeccable judgement, and be able to reconcile independence with accountability to member nations. Practical constraints are enormous.
The G20 expanded the SDR pool by $250 billion, but even then SDRs make up only 4% of global reserves. Making SDR the principal reserve asset would require $3 trillion of fresh SDRs, more than the GDP of France. At the same time the IMF would need to be made a world central bank able to print money.7 It would take years for the SDR to be accepted across global transactions and reserves (Cooper 2009), particularly as the first SDR liabilities would face competition from existing assets.
Politics would be the thorniest part. The US would likely be opposed so as to protect the dollar, and Washington holds a veto at the IMF on SDR issuances. The composition of the SDR basket would also be contested. The current basket is composed of the dollar, euro, yen, and sterling – major emerging markets would push for inclusion of their currencies. Economists would argue for Australian, Canadian, Chilean, and Norwegian currencies so as to link SDRs to commodity price cycles.8 The larger the SDR system grows, the more fiercely its governance is likely to be contested.
A new reserve currency
Another camp sees the dollar as becoming supplanted by a new reserve currency. A number of analysts – Reisen (2009), Roubini (2009), Aiyar (2009) – hold that the renminbi could replace the dollar as a reserve currency in a few decades. Reisen sees 2050 as the tipping point away from the dollar, when the Chinese economy is projected to be nearly twice as large as that of the US (Goldman Sachs 2007).9
The euro has, since the 1990s, been seen as a possible dollar replacement, with the Eurozone’s size and prominence in world trade taken as the main drivers.10 Galati and Woolridgde (2008) find that the liquidity and breadth of euro financial markets are approaching those of dollar markets. Chinn and Frankel (2008) argue that given UK’s liquid financial markets, British accession to the Eurozone would be a tipping point. As the US economy stumbled, Zoellick (2009) saw prolonged problems as leading to flight to euro. De Cecco (2009) suggests that the euro would be to the 21st century what gold was to the 19th.
Yet neither the renminbi nor euro is a perfect substitute to the dollar.
The renminbi is hardly used as a reserve currency, and plays a minor role in international exchanges.11 A global reserve currency requires liquidity and convertibility, but the Chinese government securities market is underdeveloped, illiquid, and the renminbi is not convertible. If it were, it would likely appreciate and torpedo the government’s export-led growth paradigm – not unlike Japan’s problem in the 1980s – and undercut its political grip. China is preparing Shanghai as a global financial centre by 2020, but Hong Kong, with its convertible dollar, seems far likelier to play the part (Steinbock 2009). The renminbi’s regional reach will be stunted by rivalries with India and Japan, the once-envisioned core of a yen bloc (Katada 2008).
The euro has become the unquestionable runner-up reserve currency, but it is now seriously weakened by the debt crisis and the tardy response to it. The euro is also constrained by fundamentals – a fragmented euro-bond market, Europe’s inverted age pyramid, lacklustre growth, and the absence of a Federal Reserve-like lender of last resort.12 Foreign policy concerns may also continue enticing countries even in the European periphery to peg to dollar instead of euro (Posen 2008). Europe’s debt problems, as well as its other issues, will likely persist longer and be thornier than those of the US (Cooper 2009 and James 2009). Germany in particular is unlikely to want a more prominent role for the euro should that entail appreciation. If the euro rose to rival the dollar in 2020, European extra-regional exports would decline by 10% (McKinsey 2009).
In turn, the yen is a long-shot as Europe’s growth and demographic problems meet with China’s market rigidities in Japan.
Still another widely discussed idea is a system of co-currencies. Before 1914 several currencies periodically shared the role of the global reserve currency (Eichengreen 2005). Diversity could also produce healthy policy competition among issuing nations for investor confidence (Eichengreen 2009 and Genberg 2009).
Three factors could facilitate a co-currency world.
* First, financial innovation could reduce the costs of converting currencies, lowering incentives to hold reserves in a single currency (Genberg 2009).
* Second, further regionalisation of world trade could make China, Japan, Germany, and countries surrounding them, more decoupled from the US economy and thus less interested in holding dollars.13
* Third, liberalisation and integration of Asian financial markets could eventually lead to a regional currency bloc, perhaps even the occasionally discussed monetary union.14
A system of regional currency blocs need not be trade-diverting (Eichengreen and Irwin 1993). Studies on the Eurozone, for example, find evidence of trade creation, not trade diversion (Micco 2003).15 But a system of equal co-currencies is leaderless and prone to conflict, as would be intra-regional currency competition (Cohen 2009 and Stiglitz 2009).16 An unmanaged system would lead to instability in the exchange rate (McKinsey 2009).
Perhaps the most feasible outcome in the next decade is some further diversification, with one or two regional currencies alongside the global dollar, and/or some type of SDR substitution account. To the extent that it alleviates the Triffin Dilemma and provides stability while also not undercutting confidence in the dollar or disrupting the network benefits the dollar provides, such a system could be favourable for the US.
Dollar’s death – even dollar doubts – are exaggerated
The greenback’s resilience has been questioned at least three times in the post-war era – in the 1960s as gold reserves ran short, amid Japan’s rise in the 1980s, and upon the founding of the euro in the 1990s. Yet, the dollar has always rebounded in a reflection of US economic prowess, unrivalled liquidity and stability of US financial markets, scale benefits of the dollar in global transactions, and sheer path-dependence. A tipping point has not occurred due to the lack of alternatives and need. Alternatives continue to be tenuous.
The dollar’s prominence is as indisputable as is US safe haven status.17 But the literature agrees that global reserves will need to grow robustly to keep up with import demand.18 This accentuates the Triffin Dilemma. The soaring US debt risks undermining the dollar and America’s enjoyment of its hard-earned exorbitant privilege, jeopardising US global economies.19
Whether pariah America or safe haven America will result depends on policy. Size, growth, liquidity, and solvency require fiscal discipline, non-inflationary policies, and capital investments. Yet solvency and central bank independence are not sufficient. If the US private sector deleverages and other countries accumulate dollar-denominated assets as reserves, the US government would re-emerge as the borrower of last resort (Wolf 2009, Posen 2008).20 The G20 drive to contain global financial imbalances is a means to avert such an outcome.