by Sara Eisen
The problem with this argument is that it misses the key point that international trade accounts for only a tiny fraction of total currency transactions, and that international capital flows dominate the currency markets.
In late 2010, the Bank for International Settlements (BIS) issued its latest “Triennial Central Bank Survey” on global foreign exchange transactions, which have registered a cumulative 220 percent growth since 2001, reaching US$4.0 trillion a day as of the end of April 2010. In comparison, global exports are around US$40 billion a day. This makes international trade a mere 2 percent of total currency transactions, suggesting that 98 percent of all currency transactions are related to capital flows, hedging, and other activities that are not directly linked to trade settlement. Figure 2-1 shows not only that international capital flows are 50 times as large as international trade flows, but that they have grown more than twice as fast as the rapid trade growth in the past decade (220 percent growth for capital flows, compared to 100 percent growth in international trade). (The ratio of capital flows to trade flows was 35:1 back in 2001.)
Figure 2-1 Trends in Foreign Exchange and Trade Transactions
Thus, even if the dollar may lose its international status as a trade settlement currency within Asia, it will take much more for it to lose the capital flow settlement currency status in Asia, in my opinion, as the dollar is still the dominant currency for capital flows.*
3. It Is a Mistake to Write Off the U.S. Dollar, Again
The world has underestimated the dollar’s hegemonic international currency status before; it just doesn’t remember that it has done so.
The IMF’s COFER* data have attracted a great deal of attention in recent years, in light of the multiyear dollar correction that began in 2001 and the sharp rise in the world’s official reserve holdings. With more than US$10 trillion in assets under management, what these central bank reserve managers do matters a lot for the dollar, or so the argument goes. These COFER data show a definitive and, many find, disturbing trend decline in the past decade in the dollar’s “market share” in the world’s reserve holdings. Coupled with the rise of the euro and emerging markets, talk of an early demise of the dollar as the dominant international reserve currency is ripe.
I think one reason that some investors are so excited about the imminent demise of the dollar is that they are looking at the COFER data outside of the context of historical perspective. Data on currency compositions of reserves are readily available for the period 2000 onward, and indeed many focus on this period and are worried by the declining trend in the dollar’s share of the world’s reserves. However, with a little more effort, one can construct a longer time series for these data, going back to 1973.
Figure 2-2 is based on data from the IMF. (You can find some of these figures for the period 1973–2000 in the various back issues of the IMF’s Annual Reports.) This longer time series, going back to the breakup of the Bretton Woods system in 1973, provides a proper historical context for thinking about the dollar’s international status.
Figure 2-2 Currencies’ Share of Official Reserves, 1973–2009
During the past 35 years, the dollar’s “market share” in the world’s official reserves has fluctuated between a low of 50.6 percent in 1990 and a high of 86.7 percent in 1976. Yes, it is true that its share has declined from 71.5 percent in 2001 to 62.8 percent as of Q2 2009; however, the magnitude of this recent decline is unimpressive, compared to the decline in the 1980s. Also, the current level of 62.8 percent is roughly in the middle of this 35-year range.
I have also plotted official reserves held in the euro, the German mark (DEM), the French franc (FRF), the European Currency Unit (ECU, which preceded the euro), the Japanese yen (JPY), and the British pound (GBP). These lines are clustered at the bottom of the chart. The fact that some of you will have to squint to distinguish them from one another makes the point that none of these currencies ever came close to rivaling the dollar’s international dominance.
Some investors may recall that in the 1980s and the early 1990s, there were plenty of discussions about the dollar’s losing its hegemonic status to the Japanese yen or the German mark, for several reasons. First, both Germany and Japan had emerged as manufacturing powerhouses that seemed to be on the path to challenging the United States’ economic standing in the global economy. Second, the dollar did indeed depreciate for much of this period, unnerving long-term investors.* Third, the United States began to run large external imbalances in the early 1980s, coinciding with the rise of Germany and Japan. Indeed, as can be seen in Figure 2-2, the shares of DEM and JPY in the world’s reserves did rise steadily during that period, at the expense of the U.S. dollar’s share.
However, in the end, the dollar managed to maintain its dominance.
Before the European debt crisis, several scholars and commentators had used the exact same arguments to assert that the euro would one day supplant the dollar as the dominant reserve currency in the world: that the euro would first become the settlement currency in Europe, and maybe Eastern Europe. The size of Europe’s population, its economic size, and the imminent demise of the U.S. empire were all used as arguments. Contrary to these confident predictions, which attracted some media attention several years ago, the euro now accounts for less than half the dollar’s market share as a reserve currency—and much of the rise of the euro has been due, ironically, to China’s buying, while the EMU is at risk of collapsing.* In short, many people had written off the U.S. dollar prematurely and erroneously declared that the euro would ultimately supplant the dollar’s international role, partly, just as others before them had erroneously and prematurely written off the dollar in the 1980s.
4. The Excessively High Foreign Official Reserve Holdings by Many Central Banks Are a Problem
One reason that the world’s central banks are diversifying their foreign reserves away from the dollar is because they have too much of them. In other words, the U.S. dollar may still be the preferred intervention currency, and the fact that central banks are diversifying away from it may reflect more their inappropriately high reserve holdings, rather than flaws in the dollar itself or its undesirability. Fixating on the dollar losing its hegemony misses the point that the cause of the diversification lies somewhere else.
Our calculations show that, out of the US$10 trillion in official reserves held by emerging-market economies, close to US$6.5 trillion may be considered “excessive,” that is, in excess of the traditional reasons for a country to hold foreign reserves. A portion of the excess reserves was accumulated for self-insurance purposes following the Asian currency crisis of 1997, and a part has been the result of Asia’s currency policy of quasi-pegs vis-à-vis the dollar. As the dollar depreciated in the past decade, Asian central banks have had to buy massive amounts of dollars to maintain this “de facto dollar peg.”*
Many of these foreign reserves are not good financial investments. After the Great Recession, with developed markets being mired in disinflation and emerging markets in inflation, for the first time in recent history, Asian central banks are running a negative carry on their reserve holdings.† We calculate that it is costing China about US$110 billion a year in negative carry to hold its reserves. In general, we see merit to the notion that the countries with savings surpluses have distorted the incentives in the rest of the world through their abnormal accumulation of foreign assets. Just because a country can make money does not mean that it knows how to invest the wealth.
The definition of “foreign official reserves” needs to be clarified before a valid conversation on diversification and reserve currencies can be conducted. If more than half of the world’s US$10 trillion in official reserves are excessive, conceptually, one could divide up the official reserves into two tranches: a liquidity tranche and an investment tranche, with the latter being invested the way a sovereign wealth fund (SWF) might invest: in equities, other emerging-market currencies, and so on. If the term reserves is properly and strictly defined
as the part of the foreign reserves that is needed to meet liquidity requirements, the U.S. dollar still absolutely and definitively dominates, since potential speculative runs on the Korean won, Chinese yuan, Brazilian real, and Indian rupee will take place through the U.S. dollar, not through any other currency.
But if the Asian central banks have accumulated far more reserves than they need for liquidity purposes, and if they diversify the excess reserves into nondollar currencies and assets other than sovereign bonds, it would be misleading to conclude that this is due to the dollar and U.S. Treasuries losing their shine as reserve assets, since these assets are technically no longer reserves, defined in the strict sense. I think some people may have confused the cause and the effect in this discussion on the dollar and reserves. For what it is worth, I am of the opinion that the overaccumulation of reserves by Asia is a major policy mistake whose negative consequences will become clear over time.
5. Challenges That the Chinese Yuan Faces
In the past decade, China has risen with quiet confidence: never having boasted about what it was going to achieve, China quietly took steps to improve its economy and let the results do the talking. The scale of the eradication of abject poverty in China in the past decade is nothing less than spectacular. Domestically, the consequences of this include greater social order, ethnic cohesion (China has very diverse ethnicities), and political stability. Internationally, the rise of China has inspired other emerging economies to become more confident. Furthermore, general economic prosperity in China has encouraged risk taking, which is the fuel that propels entrepreneurship, innovations, and productivity. Moreover, the seemingly single-minded focus on the build-out of infrastructure and education assures China’s future competitive standing in the world. This having been said, China faces several challenges in allowing the yuan to rise to become the new hegemonic international currency.
First, the transition out of mercantilism will be a delicate one. Related to this is the “Triffin dilemma,”* which posits that the world’s reserve currency needs to be issued by a country that runs large protracted current account deficits, in order to provide sufficient international currency for the world to use. It does not seem likely that China will start running persistent and large savings deficits any time soon.
Another key challenge is demographics. China’s economic size may have just surpassed that of Japan, but China’s per capita income is only one-tenth of Japan’s. In 10 to 15 years, China is expected to hit a demographic turning point that is no less sharp than what Japan has experienced. This makes China at risk of getting old before it gets rich. Extrapolating from the experiences of the last decade without accounting for the powerful demographic headwind that China will face seems odd and uninformed.
I would also add that China faces yet another challenge: an ideological transition in policy. Capitalism rests on trust in prices doing the work to equilibrate supply and demand, whereas communism distrusts prices and trusts quantity controls. While China may seem like a capitalist society on the surface, there are prevalent macroeconomic price controls. First, the price of money is controlled: China does not yet have a meaningful yield curve, as we’ve already mentioned. Interest rates are defined as the prices of money and liquidity, and they are still mostly preset in China.* Second, the prices of energy inputs are subsidized. Third, the price of the currency is distorted. In other words, three of the most important macroeconomic prices are controlled in China. For China to be able to develop a liquid and viable financial sector, it will have to somehow develop more trust in prices rather than quantity.
Bottom Line
From a multidecade perspective, the Chinese yuan, or an Asian currency unit that is centered on the yuan, will almost certainly become a major reserve and international currency one day. But for the yuan to supplant the dollar as the hegemonic reserve currency in the world within the decade, China will need to do everything right and the United States will need to do everything wrong. While the former seems likely, the latter is unlikely, at least within the decade.
In my opinion, the current debate between the yuan and the U.S. dollar is less about China versus the United States than is perhaps widely thought. It is also not a discussion about the dismal state—economically, politically, and perhaps militarily—in which the United States finds itself in this post–2008 era. Rather, it is a debate about whether the Americans, as a people, still have the tenacity and the resilience to rise from the funk they are in. There is no debate on China’s bright prospects in the foreseeable future. However, I contest a popular view that Americans are soft, confused, and no longer inspired. None of the problems in the United States is insurmountable. A short decade ago, the United States had great fiscal statistics; it is not clear to me that fiscal prudence and global competitiveness can never be restored in the United States. The United States still leads the world in innovation and higher education. All it takes, in my view, for debate about the dollar’s hegemonic status as the world’s currency to be put to bed is for the Americans to rediscover their hard Calvinist core.
* The yield curve is the relationship between the level of the interest rate and the time to maturity. Specifically, it is the array of short-term and long-term interest rates.
† Emerging-market central banks accumulate foreign reserves-mostly in U.S. dollars-to guard against sudden capital flight triggered by a loss of confidence on the part of foreign investors. This is called self-insurance because many emerging-market central banks have tried to minimize the use of resources from the International Monetary Fund (IMF) or other international institutions by stockpiling foreign reserves themselves.
* I note that the actual currency settlement arrangement is much more complicated than what one might assume. It does not entail Brazilian exporters receiving BRL (Brazilian reals) from Chinese importers. Rather, the process entails a complex series of transactions and guarantees from the official sectors of the two countries.
† China liberalized its foreign exchange settlement arrangements with Malaysia, and McDonald's issued bonds in yuans to finance its operations in China. Previously, nonfinancial foreign-owned entities had to borrow in dollars to fund these operations. China is also relaxing its restrictions on foreign central banks and investors participating in the interbank bond market. These steps should help provide an investment opportunity for foreign entities that have accumulated yuan through trade.
* In this note, we discuss global exports rather than global trade, as the former is simply half of the latter.
* According to the BIS “Triennial Central Bank Survey,” for the past 15 years, the market share of the U.S. dollar in cross-border transactions has remained unchanged at around 85 percent, despite globalization and multipolarism of the global economy, and the yuan currently accounts for about 0.3 percent of the total currency turnover, despite the size of the Chinese economy.
* Currency Composition of Official Foreign Exchange Reserves, published by the IMF on a quarterly basis. The IMF collates data from its member central banks on their foreign official reserve holdings, and these holdings are broken down into different currencies. Investors use these data to analyze how much of a particular reserve currency central banks are holding and how these market shares evolve over time.
* The United States' current account deficit, which reflects primarily its trade deficit, has been a negative factor for the dollar. Large external imbalances need to be financed. If the net capital inflows into a country struggle to finance this external imbalance, the currency needs to depreciate to reequilibrate the external account.
* This is ironic because EUR/USD has been supported precisely because China has accumulated too much reserves, and part of the excess reserves needed to be diversified away from the dollar.
*To peg one currency to another, the “pegger” needs to constantly adjust the relative supply of the local currency vis-à-vis the anchor currency. If demand for, say, the Korean won is large, and the Bank of Korea wants to prev
ent the won from appreciating, then it will need to increase the supply of the won and decrease the supply of the dollar. Central banks conduct market interventions by buying U.S. dollars from the market and paying for these purchases with their home currency. This is how a currency peg can be maintained. But if there is sustained strong demand for the won, then the Bank of Korea will need to be constantly in the market buying dollars. This is one way in which a central bank can end up with excess foreign reserves.
† In other words, the interest rate that China's central bank pays on the domestic bonds it issues is higher than the interest rate it earns on its U.S. Treasury holdings.
* This was an idea first proposed by economist Robert Triffin in the 1960s. He suggested that, for a country to supply enough of its currency for the rest of the world to hold, it will need to run persistent trade deficits to allow foreigners to “earn” the currency.
* Interest rates are the cost of borrowing, and therefore the “price” of money.
CHAPTER 3
THE EURO: PAST, PRESENT, AND FUTURE1
JÖRG ASMUSSEN
“It is a big success. We have given European citizens a single currency, which is in line with what was promised: a currency which retains its value, which inspires confidence, a stable currency, at least as stable as the legacy currencies. Ten years ago, many believed this promise could not be fulfilled.”
—Jean-Claude Trichet, European Central Bank President, January 2009
