Is the US dollar waning in strength?

Even though America replaced Britain as the largest economic power since 1870, it was not until 1925 that the US dollar could claim international importance as a result of the steps the US took to stabilize their financial system by creating the Federal Reserve earlier in 1913.

Ever since that time the US dollar has come to be accepted not only as a medium of exchange in international transactions but has also established itself as a major reserve currency. The dollar holdings of the Chinese government for instance amount to more than US$1,000 per Chinese resident. In fact slowly the US dollar has occupied its role as world currency.

Now nearly 75% of the $100 notes circulate outside the US. Majority of Central banks have their reserves in US dollars. Over 80% of world transactions are in US dollars forging far ahead of the Euro, which is considered to be the number two currency involving international transactions.

Thanks to developing strategic planning and establishing strategic military relationships, enacting effective laws and agencies to lend stability to the dollar, the USA could even make New York the world’s financial hub replacing London. This has been the story of the US dollar over the last sixty years without any competition.

Japan was not keen on promoting the Japanese yen to become an international currency for fear of over valuation affecting its exports.  It is important, however, to note that the trend has been for international investors to migrate to dollar holdings in times of economic uncertainties. For a long time now, the dollar was considered as safe haven.  We witnessed the soundness of the dollar in 2008 when after the collapse of Lehman Brothers and during the recent financial crisis the dollar remained steady and even strengthened in global markets.

This unassailable position of the US dollar gave numerous benefits to America. The scramble for the dollar in the world enabled the United States to issue treasury bills at low cost and have access to cheap funds.  And American commercial transactions can be in home currency instead of being in a different currency. This situation was described by Valery Giscard Easting, the French Finance Minister in 1960 as its “Exorbitant Privilege”.  According to Berkley’s foremost economist, Professor Barry Eichengreen    the US dollar’s status as the world’s reserve currency is worth 3% in US national income per year and the reserve currency allows the US to run an annual $500 billion current account deficit. This easy way of raising money made it appealing for the US to run reckless fiscal deficits and threaten the position of the US dollar retaining its status. The enormous deficits over the last six years have called into question the long term solvency of the Unites States and its ability to pay its debts for the future. According to Eichengreen US, the federal debt stands at relatively 75% of GDP and when comparing this against  revenue relatively low at 19% of GDP, the situation is critically alarming.

Against this background let us look at the recent developments in the West Asian Arab world which accounts for 40% of the global oil output. It witnessed overthrow of long time rulers in Egypt and Tunisia. This was followed by large scale demonstrations in Algeria, Yemen and a Shia uprising in Bahrain. Libya is boiling. Syria is experiencing some restlessness. Oil prices have scaled new heights. Any further unrest in Saudi Arabia will threaten the oil market as much of Saudi Arabia’s oil reserves are in its eastern Shia dominated provinces in a Sunni ruled country. Saudi Arabia is trying its best to contain any uprising. With such uncertainties looming in the economic environment, one would have expected a thirst for migration to the US dollar and a resultant strengthening of the dollar. But what happened is quite different.  There was no rush for the dollar. This reminds us of the fundamental rule in economics that when the reaction to an event is different from what is expected there is often a major trend movement in the opposite direction The recent trend movements in the US dollar indicate such an event.

Mind you, as said earlier, without high demand for the dollar it will be extremely difficult for the United States to issue treasury bills to fund its deficit. Budget trimming will call for major cuts in social security, medicare and defense spending or raising tax levels – a more difficult scenario.  The dollar losing its value at this juncture will affect the reserve holdings in various central banks in real terms. It will produce enormous fiscal and economic hardships.

Meanwhile, the Chinese are envisaging building a world class navy and this would call for heavy investments. This may force them to divert their investments into the dollar, then, the US would be starved of its important source to fund its treasury bills.

Now, coming back to the West Asian uncertainty, we find the dollar remaining steady against the yen before the Tsunami and recording a sharp fall against the euro.  There was no strengthening of the US dollar.

Is there a positive move towards the euro as a reserve currency? Is the euro being considered as safe haven? This is in spite of the fact that the euro zone has its own tales of woe – inflationary pressure, fundamental differences lying within the euro group and sovereign debt problems of member countries like Greece, Portugal and Ireland.  There is confidence that the EU Zone will surmount these irritants which at present are at micro level as Greece, Portugal and Ireland account for less than 6% of the euro zone economy.  But the Euro Zone has not effectively addressed the core factor -removal of toxic assets in its financial institutions, fixing higher capital requirements on sovereign debts, applying real stress tests on its banks and extending the European Financial Stability Facility to recapitalize its banks to ensure financial stability.

However, fundamentally, the Euro Zone is stronger, its external account is far better and there is the political will to cut fiscal deficits.  On the other hand in the US, there is GOP and Democrat differences to restoring public finances indicating lack of political will to cut fiscal deficits. Recently the EURO CENTRAL BANK signaled intent to increase its benchmark interest rate in the near future indicating soundness of euro financials. JP Morgan’s forecast of the US first quarter real GDP growth is also not encouraging for the US. The euro firming up against the dollar and any changing status of the euro is likely to instigate a gradual replacement of the dollar as the world’s reserve currency besides garnering a bigger share as a trading currency in global trade. For the first time since World War II, the US dollar is showing signs of instability. The dollar and gold are related but in opposite directions. Has the recent surge in the price of gold indicated a rush for new haven discarding the dollar?

Apart from the above facts indications are that the Chinese renminbi is slowly and steadily becoming Asia’s major trading currency with China’s neighbouring countries resorting to the use of the Chinese currency in recent years. Northern Thailand, Northern Vietnam, Myanmar and even eastern Russia are all already using renminbi in their transactions. Prior to the financial crisis, the Chinese government did not appear to have a policy on convertibility of the renminbi. Yet the surge of currency swaps and renminbi – dominated lines of credit extended to neighbouring countries and bilateral currency swaps that have been signed recently suggest a long term Chinese strategy of ensuring a dominant position for the Chinese renminbi in the region.

A currency swap is an agreement in which two parties exchange specific amounts of two currencies as well as series of interest payments. Such swaps have durations of one to five years as they are designed to hedge against interest-rate risks in foreign currency-denominated bond, loans and other types. It is expected that China’s yuan (renminbi) currency swap volume could double in 2011. Slowly and steadily  renminbi  is growing in popularity as a currency for trade between China and the rest of the world after Beijing decided in June 2010 to expand a pilot scheme that enables onshore importers and exporters in 20 provinces to invoice their cross-border trades in renminbi.  Now about 70,000 companies are settling international transactions in renminbi. China is also exhibiting ambition to project Shanghai as a predominant world financial center by 2020. Two major US multinationals, MacDonald’s and Caterpillar have issued renminbi based bonds. China’s ties and trade with a Beijing friendly  party (led by Ma) ruled Taiwan is also growing with inter/intra trade recording manifold increases. As Taiwan business connection with the mainland grows its current isolation will wane. Business growth will render political issues irrelevant and CHINA gains one more commercial hub as an addition to Hong Kong, Shanghai and Macau.

Will the Chinese renminbi pose a formidable challenge to the US dollar?  Firstly, it would take time for China to overtake the US as the world’s largest economy.  Secondly, there are fundamental corrections required in the renminbi. China keeps the value of the renminbi on a fixed parity basis by not letting it to float as the dollar and the euro. This allows China to peg its currency at low value and keep its goods cheap. At the recent G8 summit, President Obama elaborately talked about it. The renminbi needs to become freely convertible and like the US in 1913, China needs to develop deep liquid capital markets.  Otherwise, it would be a long time before it can replace the dollar

In his book “ Exorbitant  Privilege” Professor  Barry Eichengreen  warns that the dollar would lose its shine only if the United States repeats the mistakes that led to the financial crisis and only if it fails to put its fiscal and financial houses in order. The dollar’s fate therefore hinges not on how the Chinese close in, but on the economic policy of the United States itself. In the Wall Street Journal (March 2, 2011) Mr. Eichengreen discusses “why the dollar’s reign is near an end”.  While there will not be a sudden collapse of the dollar, according to Mr. Eichengreen a change in the international monetary order is all but inevitable within a decade. Ironically China has the highest exposure to the US dollar dominated assets.

Is the multi-polar economic world heading for a multi polar transition to three principal currencies: the US dollar, the euro and the Chinese renminbi?

Recent developments indicate that the economic cycles which brought the sterling’s dominance in the 19th Century and the dollar’s dominance since in 1945 is running even faster to usher in a new phenomenon.

 

By S. Srinath

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