Dispelling dollar doubts

It seems to happen every other year, sometimes more frequently. Some matter or other reminds people of the dollar’s weak underpinnings, and headlines look for its imminent demise as the world’s reserve currency. Usually such claims associate the event with economic and financial calamities. This time, however, the concerns arise from continued frustrations with Washington’s fiscal mismanagement set against the Chinese yuan’s rise to prominence, particularly in the oil trade. Unlike many past such alarms, these have some substance. The yuan’s growing prominence is a matter to consider. But the dollar, for all its troubles, still looks secure in its reserve status, at least for the foreseeable future.

Underlying this latest round of dollar fretting is a long list of chronic domestic American disappointments. The economic recovery, never strong, has of late shown signs of still greater weakness, and Washington, never well organized, seems incapable of even beginning to get its fiscal house in order. Meanwhile, the Federal Reserve’s decision to finance much of the huge federal deficit has raised fears of future inflationary pressures and an erosion of the dollar’s value, as well as its prestige. Of course, such concerns have existed for a long while. Until now, the response to all, as far as the dollar’s reserve status was concerned, pointed to the absence of a viable replacement currency. For a while, the euro looked like a candidate, but the eurozone’s ongoing fiscal/financial crisis has disqualified it for the time being. Of late, however, three answers to this standard response about alternatives have presented themselves.

The first of these gained traction when Beijing formally proposed to the major developed economies known as the Group of Eight (G8) that countries diversify reserve currencies away from the U.S. dollar. Many have enlarged on this suggestion, suggesting that the world use a set basket of currencies as a reserve. Some look to the International Monetary Fund’s (IMF) special drawing rights (SDRs) as an example. The second response notes how regional powers have begun to establish trade-settlement arrangements in currencies other than the dollar. Most recently, China and Australia have made such arrangements for their bilateral trade. Brazil and China have arranged yuan-real swap arrangements for their central banks. The Shanghai Cooperation Organization (SCO), a group of Asian nations that includes China and Russia, has begun to investigate ways of holding reserves in each other’s currencies instead of the dollar. Third and last, China, soon to become the world’s biggest oil importer, has expanded its arrangements to bypass the dollar in its purchases from Iran, Saudi Arabia, and other members of the Organization of Petroleum Exporting Countries (OPEC).

Though, as mentioned, there is some substance in these concerns, much of present and past fears about the dollar’s status miss the true character of a reserve currency. The notion of diversifying reserves has, for instance, existed for a long time. SDRs were created in the 1960s. Most central banks have long held reserves in currencies other than the dollar. But such diversifications have never really challenged the dollar’s status. The SDR basket of currencies, for instance, has a large dollar component. SDRs have a further drawback in that central banks holding them cannot readily present them to their business community, as they can dollars, to support the payments required by trade. Much other reserve diversification links non-dollar holdings to the currencies of major trading partners. It is done to support needs of each nation’s major importers and exporters. On that basis, a diversification of the sort proposed by China to the G8 has already occurred, and is ongoing. But this diversification, tied as it almost always is to existing bilateral trade relationships, has always left the dollar as the more general reserve, the store of value, and the general source of exchange liquidity.

No doubt, as those bilateral trade relationships grow over time, they will come to dominate reserve holdings more and more and, accordingly, reduce the dollar’s relative weight in the equation. China looms large as a leader in this trend, especially where oil is concerned, but also in other aspects of trade. Someday, perhaps, the Chinese presence will grow so large that the yuan first supplants the dollar on bilateral reserve holdings and then more generally as the failsafe currency to back general global dealings—in other words, as the world’s reserve currency. But as fast as Chinese trade is growing, such a turn is far from imminent. The United States, for all the slippage in its once supremely dominant position, still accounts for more than twice the percentage of the world’s gross domestic product (GDP) as does China. What is more, the dollar still plays a role in more than 80% of the world’s international transactions, whether an American firm or individual is involved or not. It will take a long time to erode such a position and the practices that have grown out of it.

In all probability, even as the yuan gains prominence, the dollar will relinquish its status only slowly. During that time, the world could function round two reserve currencies. That certainly is what happened when the dollar replaced the British sterling. The process began in the 1920s and was not complete until the 1960s. During that whole time, the world had two reserves currencies and transactions easily flowed between them. Conceivably, the same thing could occur with the yuan and the dollar. Even if the change this time were to happen twice as fast as with the dollar and sterling, it likely would not reach completion until the 2030s. Meanwhile, there is much in today’s situation to suggest that it might take even longer to occur than the dollar-sterling change did.

Unlike the United States when its dollar challenged sterling as the global reserve, it’s notable to point out that China today lacks a financial system capable of supporting a world reserve currency. The home financial markets of a reserve currency must be broad, deep, active, and, critically, open enough to offer all, domestic and foreign players, quick, easy conversions into and out of all currencies. Those markets must also offer all who hold the reserve, domestic players and foreign, an array of investment opportunities for their holdings and sufficient liquidity to exit and enter them quickly and freely. Right now, China’s financial markets have no such advantages. On the contrary, they are cumbersome, controlled, if not effectively closed, and bereft of the necessary array of investment opportunities. Indeed, China’s financial structure is so limited that even today that country’s exporters and importers must funnel much of their trade finance through Hong Kong dollars. China could change all this, of course, but it would take time, even with the greatest commitment in the world, and so far, Beijing has rather shown a commitment to closed and controlled financial markets that parallel Beijing’s equally controlled, top-down approach to economic management.

Meanwhile, it is far from clear that China really wants its yuan to supplant the dollar as the global reserve. Reserve status certainly would thwart Beijing’s ongoing efforts to promote exports by holding down the foreign exchange value of its yuan. If the yuan were to become a reserve currency, central banks and international business would hold yuan in amounts far in excess of those required for simple trade needs. Such additional demands would drive the yuan’s value (as the reserve role has the value of the dollar) far above the fair market values connected to trade, much less the advantageous low exchange rate Beijing has long preferred. Of late, Beijing has talked about deemphasizing exports in favor of domestic development and, accordingly, has allowed the yuan to rise in value against other currencies. Just recently, it announced that it would widen the range over which it will allow the yuan to fluctuate on foreign exchange markets. But China, for all the change Beijing contemplates, still depends heavily on exports for growth and employment, making the country’s leadership highly reluctant to embrace the high valuations that would inevitably come with reserve status.

Beijing clearly likes the prestige of the yuan’s greater stature, as well as the bragging rights it gives over Washington. But the adverse effect on the country’s long-standing currency policy and exports will likely keep China from pushing matters too far too fast. (American exporters, of course, would be delighted, as it would relieve them of the disadvantages of an expensive currency with which the dollar’s reserve status has long confronted them.) Even if Beijing were willing to accept the associated trade disadvantages and the need to open its financial markets inways that it clearly still finds uncomfortable, the transition would take a long time, freeing global markets and the world’s economies from the shocks about which the alarmists speak and write.

Milton Ezrati, is a partner, senior economist and market strategist at Lord Abbett & Co. LLC.