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Dollar Status as Reserve Currency Not at Risk

By Hans Parisis
Monday, 19 Oct 2009 09:57 AM Current | Bio | Archive

Sumitomo Mitsui Banking Corp chief currency strategist Daisuke Uno said the dollar will drop to 50 yen and lose its role as the world’s reserve currency.

He also said the U.S. economy will decline in 2011 as the U.S. consumer and financial sector will continue to adjust, and also concluded that after the dollar loses its reserve currency status, the world will fall into three trading blocks — the United States, Europe, and Asia — with volumes of global currency trading destined to fall in the long run.

Meanwhile, Treasury Secretary Timothy Geithner said he expects the dollar to retain its role as the world's reserve currency, but he acknowledges that entails "special obligations and responsibilities" to keep the dollar’s value from eroding.

Geithner also added that "we have to do everything we can to get our fiscal house in order" and to keep inflation low.

Yesterday, former Fed chief Alan Greenspan, speaking at a Council on Foreign Relations conference, said: “I'm not overly concerned about the most recent decline in the dollar, for example, because remember, the dollar surged when the crisis began, as we still are conceived of as a safe haven. And we're now back to the levels of just prior to the crisis.”

So, let’s be honest. It’s understandable that a lot of investors get seriously confused with all these comments on the dollar and its role as the world’s first reserve currency. I’ve thought it couldn’t hurt to refresh our memory with a short historical perspective on the reserve currency status of the dollar so we can better understand what all this is really about.

The U.S. dollar has now been the world’s dominant reserve currency for over 60 years under the Bretton Woods system. That was the first fully-negotiated monetary order that was really intended to govern monetary relations among independent nation-states.

World War II was still raging in July 1944 when 44 nations, excluding of course Germany and Japan, the two future strong currency nations, gathered at the Mount Washington Hotel in Bretton Woods, N.H. for the United Nations Monetary and Financial Conference and signed the Bretton Woods Agreements. Those agressments established an international economic system whereby the dollar was pegged to gold, and most other currencies were pegged to the dollar.

Dollars were used as the main intervention currency and, hence, reserve currency. Limits on convertibility of some currencies, particularly in the early years of the Bretton Woods system, also supported the use of the dollar as a reserve currency.

In 1971, the Bretton Woods system collapsed when President Nixon ended the dollar gold peg whereby central banks could exchange their dollars for physical gold, which then initiated fluctuations in the dollar’s exchange rate.

Since then, we’ve also seen the rise of other global economic powers like Germany and Japan.

It’s also important to note that since these years, there have been various predictions of the demise of the dollar as the primary reserve currency. Yet data on currency composition of reserves indicate that the dollar’s share of reserves today is roughly the same as it was 30 years ago.

The same is true for the euro when we use euro-equivalent values for the period before January 1999, which is when the euro came to life. There have been variations in the dollar’s share, but it has never fallen below 50 percent.

The rise of Germany and Japan as major economic powers led to the view that the German mark and the yen would rival the dollar, dividing the world into three currency blocs, which is somewhat similar to what we hear today. The yen’s share of global foreign currency reserves did rise in the 1980s, but peaked at close to 9 percent in 1991.

Since then it has declined to less than 3 percent. The German mark was the main reserve currency among the euro legacy currencies and accounted for the largest share of reserves after the dollar. The share of reserves held in marks ranged from 10 percent to 18 percent between 1979 and 1998.

The establishment the European Monetary Union also led to further predictions of the dollar’s demise. The euro is currently the only other major reserve currency, accounting for one-fourth of foreign currency reserves.

Throughout the 1980s, the combined share of the euro legacy currencies plus the European Currency Unit hovered at around 30 percent.

Don’t overlook the fact that the dollar’s role as the primary reserve currency, and, more generally, as the primary international currency, was not established by decree but, rather, because of the emergence after WWII of the United States as the world’s major economy.

Here are several key factors that determine the use of a currency for reserves:

  • The size of the domestic economy

  • The importance of the economy in international trade

  • The size, depth, and openness of financial markets

  • The convertibility of the currency

  • The use of the currency as a currency peg

  • Domestic macroeconomic policies

    As you can see, most of these factors suggest that the dollar and the euro would account for equal shares of global reserves. The size of the euro-area economy is only slightly smaller than the U.S. economy. Both the euro area and the United States account for about 50 percent of the global trade.

    Both the euro and the dollar are freely convertible, and both economies have a history of sound macroeconomic policies. In addition, the dollar and the euro are the only currencies to which other currencies are regularly pegged.

    Please take into account that the key factor that also may explain the smaller share of the euro as a reserve currency is the size and depth of government bond markets.

    Although total sovereign debt outstanding in the euro area rivals that of the United States, there is no common euro-area sovereign debt market. This reduces the ease with which holders of euro-denominated securities can buy and sell them, compared with U.S. Treasury securities.

    These factors also explain why no emerging market currency accounts for a visible share of global foreign currency reserves.

    A few emerging markets have become large economies and global trading powers. Likewise, several of the emerging markets have established a history of sound macroeconomic policies resulting in low inflation and sustainable public debt levels.

    Emerging economies typically, however, do not have well-developed and open domestic financial markets. In some cases, they limit convertibility. Over time, financial markets in many emerging markets are almost certain to become more developed and integrated with global capital markets.

    Financial market development combined with sound macroeconomic policies and open markets should lead to an increased international role for emerging market currencies and a greater diversification of foreign currency reserves.

    Nevertheless, as long as the United States maintains sound macroeconomic policies and deep, liquid, and open financial markets, the dollar will continue to be the major reserve currency.

    All that said, in China, the State Administration of Foreign Exchange (SAFE) says in a 40-page statement on China's first-half balance of payments: "In the near future, it's difficult to see strong yuan (CNY) appreciation expectations re-appearing as they did a few years ago."

    To support its case, SAFE cites the yuan's limited movement in the Non-Deliverable Forward (NDF) market and in the onshore currency market in the first half of the year. SAFE adds: "At present, the CNY's exchange rate has maintained basic stability. Expectations for the yuan to rise have weakened or diverged."

    In its semi-annual report to the U.S. Congress on currency practices of key trade partners, the Treasury says: "The stability of the yuan against the dollar over the past year ... continuing productivity growth in the Chinese economy, and the acceleration of foreign reserve accumulation this year all suggest that the yuan remains undervalued." The report notes that China has about $2.1 trillion worth of foreign reserves, and that they rose $186 billion the first half of this year alone. It adds: "Both the rigidity of the yuan and the reacceleration of reserve accumulation are serious concerns which should be corrected to help ensure a stronger, more balanced global economy consistent with the G20 framework."

    As you can see on the chart hereafter, the yuan, after its de-pegging in July 2005 it has gone up nicely (paying less CNY per dollar) it hasn’t moved further up at all compared to the dollar since July 2008 as the USD/CNY has only moved in a 0.6 percent range:

    Putting all this in context, the G20 meeting in November could prove a critical one. The two key players in this story, the United States and China, are now setting out their respective cases, and with an advisor to Japan’s minister, weighing into the fray with a call for trilateral cooperation by the three nations to support the dollar.

    Nevertheless, we should not overlook the fact that the positions of the United States and China appear moving, once again, in opposite directions. That doesn’t bode well and we could see new frictions and interventions coming up in exchange markets. The United States wants the yuan to appreciate. The Chinese, at least for now, say they can’t.

    Investors shouldn’t lose their head but should remain calm. There is currently no alternative to replace the dollar as the world reserve currency. That situation isn’t going to change as quickly as many seem to predict these days.

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    Sumitomo Mitsui Banking Corp chief currency strategist Daisuke Uno said the dollar will drop to 50 yen and lose its role as the world’s reserve currency. He also said the U.S. economy will decline in 2011 as the U.S. consumer and financial sector will continue to adjust,...
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