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Towards a new global reserve currency…the end of the U.S. dollar?

Dollar2

Maybe we should start with a quick reminder about the meaning of “a reserve currency”. Well, a reserve currency could be defined as a foreign currency held by central banks and other major financial institutions as a means to pay off international debt obligations, commodities such as gold or oil, or just to influence their domestic exchange rate.

Considering this definition, there are many questions that rise automatically: do we really need a reserve currency? Why the US dollar and not another currency? Could any other currency replace the US dollar?

Do we really need a reserve currency? What is the point of having one?

What’s the point of having a reserve currency? From its meaning, it serves first of all as a standard unit for international payments and thus it protects national currencies against shock. But more importantly, manipulating reserve levels can enable a country’s central bank to intervene against currency volatility  and thus help to adjust exchange rate. If demand for the  yen drops,  for example,  Japan can use their extra US dollars to buy up the unwanted yen, thereby propping up its value.

Why the US dollar and not another currency?

The first currency to be held in foreign reserves was the British pound, during the 18th and 19th centuries. That changed after World War II, when the major economic powers met at Breton Woods and established the exchange-rate system and the International Monetary Fund to oversee it. Under that system, the US dollar became the “de facto reserve currency”, partly because the United States was an economic power and partly because the dollar was backed by gold (In other words, any country could trade its dollars back in exchange for gold). As a result, the US dollar was considered extremely stable. Nowadays, the dollar still makes up more than 50% of global reserves, trailed by the euro, which constitutes about 25%.

Does any privilege accrue from being the reserve currency? Certainly. Part of the privilege is that the US can borrow in its own currency and later pay back the debt in its own currency even when the dollar has decreased in value. Furthermore, commodities and international invoices are priced in the reserve currency (US dollar),  so for the US economy there is no additional cost in the event of currency fluctuations.

So, if there is a need for a reserve currency, and if the US dollar is the most stable currency at the moment, why are China and Russia calling for a new global currency?

It was reported recently that two of the world’s superpowers, Russia and China , have called for a new global currency. I believe they’re doing this because they know that the US is printing (or planning to print) huge amounts of dollars right now to pay down its own massive debts (debts that other countries, like China, have been financing for years by purchasing US Treasury Bonds).

But, what America tends to forget is that: “the more paper money you print, the less it’s worth” and right now, with the Americans’ new stimulus plan, the federal reserve is planning to print many more paper money. (Don’t forget this is the country of “yes we can”).

So, how does it work?

You see, when a country buys a bond, in fact, it is loaning money and charging interest to the issuer of that bond to be paid upon maturity.

Well, for years now, other countries have been buying US bonds so the USA could in turn buy all of their made-overseas stuff. They were essentially loaning their biggest customer the money it needed to buy from them. For instance, US owes China alone over a trillion dollars. That’s just one of many countries that the United Stated owes money to.

So now, to get America ’s bills paid, The Federal Reserve is purchasing those US Treasury bonds that other countries used to buy. To do that, a lot more dollars have to be printed to buy them.

So, the fact that china is asking for a new reserve currency is a clear sign that China , as the largest holder of US dollar financial assets (bonds), is concerned about the potential inflationary risk of the US Federal Reserve printing money. Indeed, US dollars could decrease in value very soon, because The US Federal Reserve would print many of them to loan out. Logically, “the more there is of something, including money, the less it’s worth”.

What is the Chinese argument with regards to the new reserve currency system? Well, according to China , to better insulate countries from the ills of one country or one currency, they are pressing the IMF to create a “reserve currency” based on shares in the body held by its 185 member nations, known as special drawing rights (SDRs). The thing is, at present, the currencies in the SDR basket are by weight, the US dollar (44%), the Euro (34%), the Japanese Yen (11%) and the British Pound (11%). So ultimately, this new reserve system would not make that much difference except that, in addition to the US dollar, China would have the chance to diversify the basket of their reserves, keeping the US dollar at the top (just like now). Their argument nevertheless does make sense.

Could any other currency or reserve currency system replace the US dollar?

Not so sure. Why? Because first of all there is always an advantage to an individual central bank  holding its reserves in the same currency as other central banks. By far, the US dollar remains the main portion of central banks’ reserves around the world including China (approximately, the US dollar would make up more than 50% of global reserves, trailed by the Euro). Thus central banks  find it attractive to hold US dollars because other central banks hold US dollars. With everyone doing likewise, the market in dollars is deep, liquid and likely to last for long time ahead. Secondly, oil and many commodities are priced in dollars. Business deals around the world are done in dollars. Also, the US dollar is still considered by most investors as the more stable currency  compared to others such as the Euro or the Yen. Finally, it would require acceptance from nations around the world that have long used the US dollar and hold huge stockpiles of the US currency, before shifting over to any other reserve system. Can this happen suddenly?

Let’s finish this paper by pointing out that the idea of creating a new global reserve currency isn’t new. For decades there has been talk about creating an international reserve currency and it has never really progressed. Why? Because managing such a currency would require balancing the contradictory needs of countries with high and low growth or with trade surpluses and deficits.  Probably, in the end, the most powerful currency will predominate. This would be the US dollar again considering its stability and availability around the world.

Anyway, countries aren’t required to keep their reserves in dollars, they do it because they want to (The dollar’s “primary reserve currency” status is more de facto than official.) So, if China decided to dump its reserve of dollars, it would not only jeopardize its relationship with the United States , but other countries wouldn’t necessarily do the same.

So, Dear China, would you like to take the risk?

Related Article:

GOLD STANDARD: YES OR NO?

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April 9, 2009 - Posted by | Articles In English, International Economics, International Finance | , , , , ,

20 Comments »

  1. ici, il faut une traduction!

    Comment by Arnaud P | April 12, 2009 | Reply

  2. Hi Lambert! love your blog, economy made (almost) simple… thanks a lot!
    Hope you’re all right since Wolves!

    Estelle

    Comment by Anonymous | April 13, 2009 | Reply

  3. Thanks Estelle. I am not longer in Wolverhampton, I moved to Preston (North West) long time ago!

    Comment by Anonymous | April 13, 2009 | Reply

  4. Hello Lambert, have not heard from you in ages. How are you doing?

    The world is currently dependent on USD for trade, no matter where you go. However, there was an idea about of using the ‘dinar’ as a replacement for USD for trade. It was suggested that Islamic countries use dinar. The idea never take off i guess.

    Here’s a link to the article. http://findarticles.com/p/articles/mi_m0WDQ/is_2002_April_1/ai_84531883/

    Comment by Anonymous | April 13, 2009 | Reply

  5. Why not the British Pound?

    Matt

    Comment by Anonymous | May 24, 2009 | Reply

  6. Response to Matt:

    I guess you are suggesting the British Pound because it is the strongest currency in the world. Well, the “reserve currency” is not only a matter of the strength of that currency. If this was the case, the British pound would have since been the de “facto” reserve currency as it has always been stronger than the US Dollar, the Euro and the Yen.
    Rather, a reserve currency is more about the trust placed in that currency by international investors, treasuries, central banks and financial institutions around the world; the percentage & the Power of that currency in the IMF main currencies basket; the availability of that currency in the four points of the globe, etc etc…
    Criteria after criteria, you can judge for yourself that, the British pound does not challenge either the Euro, far less the US dollar. In terms of availability for example, can you tell me how many treasuries around the world have the British pound as their main reserve currency? And how quick can you get the British pounds in places such as the Southeast Asia or Central Africa as compared to the US Dollar or the Euro?
    The last thing I would like to point out is that, the reserve currency would never be based on the strength of a currency only as long as the exchange rate regime is a floating exchange rate system where the strongest currency today will not necessary be the strongest just the minute after (appreciation, depreciation).
    Finally, as I said in my analysis, the US Dollar is not and has never been the official reserve currency. Banks and institutions keep their reserves in US Dollar because others do the same. Consequently, the US Dollar became the reserve currency de facto.

    Thanks for raising the question!

    Comment by Lambert A Mbela | May 24, 2009 | Reply

  7. will china overtake the u.s.a in economicgrowth,and why china is getting more market than u.s

    Comment by allan | August 11, 2009 | Reply

  8. Super-Duper site! I am loving it!! Will come back again – taking your feeds too now, Thanks.

    I’m Out! 🙂

    Comment by online stock trading guru | January 11, 2010 | Reply

  9. Hi Lambert,

    How much money did the US print in 2009? Do you know how to find that out?
    Just found your blog today. Love your style. Keep writing!

    Comment by SarahJayne | August 13, 2010 | Reply

    • Sarah,

      Thanks for your comment.

      With regards to your question: “How much money did the US print in 2009? Do you know how to find that out?”

      Can I first ask which type of money are you referring to?

      If you are referring to the MB known as the monetary base or total currency (this is the base from which other forms of money (like checking deposits) are created and it is traditionally the most liquid measure of the money supply); if you are referring to this, on 4 November 2009, the Federal Reserve reported that the U.S. dollar monetary base was $1,999,897,000,000. This was an increase of 142% in 2 years.
      But the monetary base is only one component of money supply. M2, the broadest measure of money supply, has increased from approximately $7.41 trillion to $8.36 trillion from November 2007 to October 2009, the latest month-data available.

      Data source: http://www.federalreserve.gov/econresdata/releases/statisticsdata.htm

      Hope this helps!

      Lambert

      Comment by Lambert Anoke Mbela | August 13, 2010 | Reply

  10. Dear Lambert!
    While you really well explained why the whole world is so exposed to dollar, you didn’t prove that diluting this currency has no limits at all. Trees don’t grow up to the sky..
    What you’ve written about the dollar’s future seems to me too optimistic. It’s true that the yen or the today so attractive CHF will never become a world money because of their amounts but others, like, the Euro or a basket-type currency could just as well do that (a great luck for the US today is that Euro is so weak because it was introduced in countries where it shouldn’t have been).
    The oil trading business in USD is an unnatural monopoly and there’s no serious reason to be maintained. There are already some, yet weak, attempts to change it.
    The only intrinsic reason of keeping dollar as money reserve is that the big loaners like China, Japan and the great banks do the same and would suffer too much (never the banks, always the people) if it turned out one day that the tremendous amount of dollars they have (or would like to get back) is worth much-much less as if it where circulating in the real economies of the world. This is the reason why they buy US bonds and go into the very dangerous play by irresponsively lending, knowing well that actually their money will never be returned.
    And I’m sure you know much better than I how can it happen that a country with a 400 percent Debts to GDP ratio is still an AAA. Oh, yes, in God we trust.
    Today 9/10 of the whole money in the world is virtual much resembling to the cigarette end thrown off by John Lennon. It may be worth a few hundred pounds today. But what happens if people didn’t believe that the music of the band is worthy?
    Otherwise, I enjoyed your article very much.
    Best wishes for Christmas,
    Robert Mistula
    Budapest, Hungary

    Comment by Robert Mistula | December 13, 2011 | Reply

    • Hello Robert,

      Thank you very much for your comment. Really enjoyed reading you!

      I agree with you in relation to the virtual aspect of our today economy and the fact that the USA is living on debts (well beyond their means with no counterpart in the real economy) disturbing ultimately the entire world economy!

      On the other hand, I am not too optimistic but simply realistic. As you, yourself mentioning it, like the way I explained it in my article, there is no official rules or reasons of keeping dollar as money reserve (The dollar’s “primary reserve currency” status is more de facto than official). Financial Institutions, Central Banks and international investors are holding their reserve in US Dollar because others do the same full stop! With everyone doing likewise, the market in dollars is deep, liquid and likely to last for long time ahead.
      Also, currency and business is all about trust and confidence, and the US dollar is still considered by most investors as the more stable currency (considering its stability and availability around the world) compared to others such as the Euro or the Yen.
      Thus with all these, do you seriously think that shifting over to any other reserve system or currency will happen overnight?

      Lambert

      Comment by Lambert Anoke Mbela | December 20, 2011 | Reply

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      Comment by Lambert Anoke Mbela | March 26, 2013 | Reply

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