King of the World: Why the Almighty US Dollar Dominates
Rumors of the dollar’s demise have been greatly exaggerated. Its status as the world’s reserve currency is not under siege. In many ways, it is under less pressure than it has been in quite some time. Most recently, the Yuan or RMB has been cited as a possible replacement. Before that, it was the Euro threatening to dethrone the dollar. And before the Euro, it was the Yen. Yet there never seems to be any real, tangible shift in the global trading system. With $3.8 trillion dollars held in reported reserves in 2013, the dollar remains the world’s reserve currency.
It is often tempting for economists to point out the most intriguing trends and predict the most extreme destruction and doom scenarios. Remember when the Japanese economy was set to overtake the US? Japan spent the next decade with GDP and price level growth of about 0 percent. Sometimes, it is difficult to state a continuation of the status quo.
The data on currency reserves is less than comprehensive. The IMF Currency Composition of Official Foreign Exchange Reserves (COFER) provides some level of detail but has a number of sources missing. (The report analyzes the currency composition of assets—so a US Treasury Bill denominated in dollars counts as dollars). But there are some interesting takeaways from the data. The US dollar constitutes 61 percent of all reported reserves. While this is certainly far from its peak of 72 percent in 2001, it is similar to the levels seen in the mid-90s. In 2013, the dataset covered 53 percent of official reserves—down from a peak of 79 percent in 1997. In other words, the data does not suggest an end to the dollar’s run as the predominant reserve currency. Granted, the 47 percent of reserves labeled “unallocated” could be hiding something, but it is unlikely they are hiding anything momentous.
It is worth understanding how the US dollar won the role of reserve currency in the first place. Though the exact timing is debated (and in this debate time is denominated in decades, not years), the best evidence—from Eichengreen and Flandreau—is that the dollar overtook the sterling somewhere in the mid-1920s, lost it briefly, and then regained it in 1929. The Great Depression saw the sterling regain its prominence only to lose its status again to the dollar soon after. France, the China of its day in terms of foreign currency reserves, largely tipped the scales towards dollar dominance.
There is no clean shift from one currency to another. In considering how the dollar could lose its reserve status someday, it is necessary to understand what the shifts look like. It is a slow process, typically accompanied by a crisis. We might reasonably ask why the Great Recession did not have more of an effect on the dollars dominance. The simple answer is that there is, at the moment, no viable alternative. The RMB is heavily manipulated, the Euro has the overhang of its possible dissolution hanging over it, and the Yen is impaired by the Bank of Japan’s relentless easing. Granted, the US Dollar has not performed ideally for a reserve currency, but no currency ever will.
It takes economic stability and the ability to hold value across time to seize and maintain the mantle of reserve currency. The era of quantitative easing could have brought the dollar’s durability as a store of value into question. But it didn’t. The US dollar lost value—but it was never at risk of dissolving. And the only currency with markets liquid enough to challenge the US dollar—the Euro—had deep, idiosyncratic issues of its own. In essence, there was no alternative to the dollar during the crisis, and there remains no alternative now.
Any potential replacement must have enough debt and a large enough economy and a liquid enough market to support it. After all, other countries need to place tremendous amounts of money into the currency—in 2013 official foreign exchange reserves reached just under $11.7 trillion. In other words, being a country with a strong economy and stable currency is not enough. It must have deep and reliable debt markets and be able to support tremendous amounts of asset purchases. The Euro is the only currency with a market of similar depth to the dollar. China does not have the open system necessary for the RMB to be a reserve currency, and would require significant liberalization of currency movements. It may be able to develop a deep market in RMB—we simply do not know. These are not steps China is keen on making while attempting to avoid a slowdown of its own economic growth.
At the moment, the US dollar looks like a far less risky bet than the currencies bandied about to be its replacement. At the moment the Euro is inept, and the RMB is incapable of taking the mantle. The dollar will lose its place as the hegemon of currencies at some point, but it should continue to dominate for the foreseeable future.
Image: Flickr/Creative Commons.