[G20 summit agenda (14)] The dollar’s future as the key currency
2010-08-23 16:46
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The following is the 14th in a series of articles analyzing the major problems that the G20 leaders should tackle to stabilize the global financial markets and rebalance the world economy. -- Ed.
Jeong Young-sik
• The writer is research fellow of Macroeconomic Research
Department, Samsung Economic Research Institute.
• He was a visiting scholar at the University of California at Riverside
from September, 2007-December 2008.
• He was a research fellow of Financial Department of SERI from
December 1993-February 2007.
The past and the present of the dollar key currency system
Key currency refers to the currency used as the means of payment and investment in international trade and capital transactions. In particular, the term refers to the currency used by national governments to build up foreign reserves, to intervene in the foreign exchange market and as the standard for foreign exchange rates.
The U.S. dollar began to function as the world’s favored key currency defined by such parameters in 1944 when the Bretton Woods system was established.
The core of the Bretton Woods system is the Gold Exchange Standard, in which value of the dollar was pegged to specified amount of gold -- $1 equaling one thirty fifth of an ounce of gold -- and that of other currencies’ to the dollar. Up until this point, the gold standard under which each nation set the value of its currency in terms of gold, and foreign exchange rates were decided according to gold parity was in place.
With the introduction of the new system, the dollar came to be used as an international currency along with gold.
However, the Bretton Woods system collapsed in 1973, less than 30 years since its introduction, due to the financial deterioration of the United States.
The United States’ current account moved into the red at the beginning the 1970s, and the country’s long involvement in the Vietnam War resulted in the country’s budget deficit growing.
As result, the United States ended the dollar’s convertibility of gold in 1971, and the collapse of the Smithsonian Agreement that maintained the system in place by depreciating the dollar against other currencies resulted in the international currency system becoming one of floating exchange rate.
In the early 1980s, the United States’ suffered from deepening twin deficits due to Reaganomics and in 1985 the heads of G5 nations signed the Plaza Accord that depreciated the dollar against the yen and the Deutsche mark, causing the value of the dollar to drop significantly.
However, the dollar continues to function as the key currency despite the collapse of the Bretton Woods system and the depreciation of its value brought on by the Plaza Accord.
In terms of the dollar’s value alone, its position as the key currency has weakened significantly compared to the past. In 1970, yen-dollar and mark-dollar exchange rates respectively stood at 358 yen to the dollar and 3.69 marks to the dollar. By April 2010, the rates fell to 90 yen to the dollar and 1.45 marks to the dollar. In short, the changes mean that the dollar’s value against the yen fell by 75 percent, and by 61 percent compared to the mark over the period.
Despite such developments, the dollar key currency system remains firmly in place. This is evident in the fact that the dollar accounts for an overwhelming proportion of central banks’ foreign currency reserves and private sector banks’ foreign currency assets. As of September 2009, the dollar accounted for 61.6 percent of the world’s foreign reserves, while the euro only accounted for 27.7 percent. Although the figure for the dollar is lower than that recorded in the late 1970s when the figure stood at about 80 percent, there isn’t a continuous downward trend, as it is higher than that recorded during the mid 1990s.
In addition, according to the Bank for International Settlements’ data, 56.5 percent loans extended by major banks are dollar-denominated, while euro-denominated loans accounted for 22.9 percent at the end of September 2009.
Such data show that there has been little change in the dollar’s position despite the fact that the global financial crisis of 2008 originated from the United States. In contrast, the value of the dollar saw a significant increase as it came to be highlighted as a safe currency during the crisis.
Although the Bretton Woods system introduced in 1944 has long since collapsed, it would not be an exaggeration to state that a Bretton Woods II is now in place. If the dollar-based key currency system was maintained in name under the Bretton Woods system, dollar-based key currency system has been maintained since 1973 by the economic needs of the international community.
The reasons for referring to the current system as Bretton Woods II is that the United States continues to provide liquidity as the key currency nation as it did under the Bretton Woods system, while other countries continue to peg their currencies to the dollar and accumulate dollar-centric foreign currency reserves for their export-driven growth policies and to aid their efforts to stabilize macroeconomic conditions and to prevent a sudden stop.
What then is the secret behind the dollar maintaining its status as the key currency despite the numerous incidents that threatened such functions? The answer is that the dollar has the characteristics required of a key currency. The requirements are global leadership as a superpower, liquidity, the currency’s confidence and network externalities. In short, the dollar of today satisfies all such requirements. First of all, the United States has a firm hold on political and military leadership as a superpower. The United States’ defense spending is much larger than those of other nations, accounting for 45 percent of that of the world’s defense expenditure in 2008. In addition, the U.S. functions as a sort of intermediary of the world’s economic policies through the IMF and the G7, and boasts the largest economic scale of any single nation. In 2008, the U.S. accounted for 20.6 percent of the world’s nominal GDP, while the Eurozone accounted for 15.7 percent and China 11.4 percent in that year.
Secondly, the U.S. is the world’s most advanced country in terms of financial development. For instance, in 2009 its stock markets accounted for 30 percent of the world’s market capitalization. Finally, network externalities also contribute to maintaining the dollar as the world’s key currency. This is made evident by the fact that the use of the dollar has not decreased despite the fact that the proportion of the world’s GDP accounted for by the U.S. economy and the country’s share of international trade have decreased over the years.
The dollar’s confidence, however, has been made weaker tahn other requirements due to the United States’ twin deficits.
2. Future of the key currency
Given such conditions, what will happen to the dollar key currency system in the future? Although the dollar’s position will be weakened in general, the system is expected to be maintained for some time to come. In particular, the dollar will be weakened in terms of economic scale and confidence.
The U.S. GDP is projected to fall below that of China from about 2018. The U.S. GDP is projected to go from $14.3 trillion (20.1 percent of the world’s GDP) in 2009 to $21.2 trillion (17.8 percent of the world’s GDP) in 2018, while that of China’s is projected to rise from 2009’s $8.9 trillion (12.6 percent of the world’s GDP) to $21.5 trillion (18.1 percent of the world’s GDP) by 2018.
In addition, the problem of twin deficits is also expected to continue. While the country’s budget deficits will improve in the mid- to long-term, achieving normalcy is likely to be difficult due to population aging pushing up the burden of medical costs for the U.S. government’s medical costs and weakening the government’s fiscal soundness.
Network externality effect sustaining the dollar’s position is also expected to be weakened. Members of ALBA (Alternativia Bolivariana par alas Americas) including Venezuela and Bolivia have agreed to use the regional currency Sucre in inter-member trading from 2010, while four members of the Gulf Cooperation Council (Saudi Arabia, Kuwait, Bahrain and Qatar) signed an agreement to introduce a common currency in December 2009. Talks for introducing Asian Currency Unit as a regional currency for Asia are also underway. In addition, efforts to reduce dollar dependency by using local currencies are also being made. Argentina and Brazil in MERCOSUR, China and Russia, Brazil and China have agreed to increase the use of their currencies in trade conducted between them.
Although these conditions are weakening for the dollar, the dollar key currency system is likely to be sustained for some time to come by the U.S. political and military influence, the competitiveness of the U.S. financial sector, lack of an alternative currency and the inertia of the system.
Even if China raises its defense budget, it is unlikely that China will be able to match the United States’ military might for a long time. In 2008, the United States’ defense spending was 10 times larger than that of China.
Taking into account the system, human resources and operating know-how of the United States’ financial sector, it is unlikely that another country will be able to replace the United States in this field for some time.
Next, although the standings of currencies that are being discussed as possible alternatives to the dollar including the euro, yuan and SDR will improve over time, it will be difficult for one to replace the dollar for some time to come.
Looking at each of these separately, while the euro’s position will be strengthened, the currency is unlikely to be able to replace the dollar key currency system in the near future. The economic scale of the euro zone is projected to expand as the number of countries adopting the currency rises. The number of countries using the euro is expected to rise above 20 by 2015 from the 16 in 2009, and the EU has become a political union as well as an economic one with the Treaty of Lisbon taking effect in December 2009.
As if in reflection of the rising status of the eurozone, the euro’s share of the international bonds market has overtaken that of the dollar. At the end of September 2009, the euro accounted for 48.1 percent of the market, while that of the dollar stood at 35.5 percent.
Despite such developments, the euro is not ready to replace the dollar. As made evident by Greece’s recent financial crisis the eurozone, which had in the past been more stable than the U.S. in terms of current accounts and fiscal balances, has recently been weakened.
Due to the large disparity between members of the EU and its administrative body’s limit capacity to deal with emergencies, the euro’s stability is no longer as firm as previously believed. On top of this, in order to establish a euro-key currency system the eurozone needs to supply the world with liquidity through currents accounts deficit, but the euro zone appears to be very reluctant in this respect.
The yuan is also unlikely to be able to replace the dollar despite its status continuously rising. In 2009, China overtook Germany to become the world’s largest exporter, and its GDP is projected to overtake that of the U.S. within the next 10 years. In addition to such developments, China is stepping up the efforts to raise the yuan’s status through international collaboration projects and by pushing to take the currency global.
The Chinese government strengthened the yuan’s function as an international settlement currency and its status by forming local currency settlement agreements with a number of countries including Brazil, Russia and Vietnam. To this end, China also began using the yuan as the settlement currency in trading with Hong Kong, allowing the issuance of yuan-denominated bonds in Hong Kong and signed currency swaps with South Korea, Argentina, Belarus, Hong Kong, Indonesia and Malaysia. In addition, China is also strengthening its role as a policy mediator within Asia by boosting international collaboration through the Chiang Mai Initiative, and by strengthening its role within international organizations such as the International Monetary Fund.
However, due to the fact that the yuan has little convertibility and the government continues to control capital transactions coupled with the fact that significant time is required for the financial markets to develop and to introduce a floating exchange rate system, the yuan is unlikely to become the key currency for some time.
Despite this, the yuan’s status will be significantly improved, especially in third world countries on which the U.S. exerts relatively little influence, and in Asian regions that are geographically close to China. In short, the yuan will be established as a regional currency faster than expected.
As for Special Drawing Rights issued by the IMF, while its status will be strengthened, its rise as a key currency is likely to be difficult. A SDR-centric system will help reduce the imbalance as such a system does not require currents accounts deficit of the country providing the currency. Furthermore, as a basket of currencies the SDR’s exchange rate does not fluctuate much, and through currency basket adjustment the confidence in the value of the currency can be improved. As such, main emerging nations including China, the UN and the IMF have been increasing the call for a new key currency system after the global financial crisis, citing that the dollar key currency system is fundamentally limited due to its heavy reliance on the U.S. economy. However, the possibility of an SDR-based key currency system being established does not appear high. The reason is that SDR severely lacks liquidity, and there are conflicts of interest between the nations linked to the SDP issuance system. At present, SDR has lacks the function of a means of settlement as it is only used in capital transactions between IMF member nations, and it only accounted for 0.4 percent of the member nations’ foreign reserves at the end of June 2009.
What’s more, even if the status of the euro, yuan and SDR rise sufficiently to replace the dollar, the dollar key currency system is likely to be maintained for some time by inertia. This can be clearly seen from past examples. Although the United States overtook the United Kingdom in terms of economic scale in 1872, and in 1915 in terms of export volume, the dollar only replaced the pound as the key currency completely in 1944.
Taking a longer perspective, the following changes are expected for the key currency system: 1. strengthening the function of SDR, 2. the euro and the yuan rising, 3. establishment of a multi-polar system such as the introduction of regional currencies, or a new single-currency key currency system could arise if significant changes take place in the international community similar to World War I and World War II while the multi-polar system is being established.
Although a key currency system based on a new single currency will not replace that based on the dollar in the near future, various risks will be amplified as the dollar’s position weakens. First, it is likely that the flow of capital will change due to the weakness of the dollar. In other words, international capital will flow into China and Europe, and into the markets for gold and raw materials. In this process there exist risk factors such as the formation and bursting of bubbles in emerging and raw materials markets.
There are also risks that come with contraction of dollar usage brought on by the introduction of regional currencies and diversification of settlement currency. Diversification of the settlement currency comes with the possibility of causing exchange rates and other financial indexes to fluctuate wildly, leading to a reduction in financial and trade transactions.
Regarding the formation of various regional blocs, fueled by the push to introduce regional currencies, while such developments will stimulate trade within these regions they could also give rise to regional protectionism.
A shift from the dollar key currency system does not simply mean the weakening of the dollar and its replacement. It means the dawn of a new era, and preparations are required.
By Jeong Young-sik
http://www.koreaherald.com/national/...20100823000776