Ratings

(Editor's Note: Ping Chew is Managing Director, Head Of Greater China.)

People's Bank of China Governor Zhou Xiaochuan recently sparked a new round of debate regarding the international monetary regime with his call for a new international reserve currency. While the U.S. dollar was not specifically mentioned, it is clear that the proposed new international currency is meant to replace the role that the U.S. currency currently plays. When a senior official of a government that holds about 10% of the U.S. government's marketable debt makes such a statement, people take notice. There appears to be some international support for Governor Zhou's idea although the U.S. is understandably less enthusiastic. So will we see the U.S. dollar losing its international pre-eminence anytime soon?

An evaluation of this question must begin with an understanding of why the U.S. dollar is so well regarded globally in the first place. There are four main reasons for this. One is that it has--at least up until now--been a reliable store of value. Two, it is the most-widely accepted means of international payment for goods and services. Third, large, deep, and liquid U.S. dollar financial markets exist for savers to invest their money in. Finally, a long period of dominance has allowed the currency to become a part of the international financial trading infrastructure.

The U.S. dollar is the most frequently used currency in international trade today. The fact that the U.S. is the world's largest trading nation is only part of the reason. The value of international trade that is invoiced in the U.S. dollar is much larger than total trade conducted by the U.S. and countries with currencies linked to the greenback. This is particularly true in Asia, where many countries bill more than 80% of their exports in the currency.

Large international savers such as the Persian Gulf states and East Asian exporters also find U.S. financial markets most attractive. Partly, this is because Gulf oil exports are paid for in the U.S. dollar and it is also the most convenient currency for Asian central banks to intervene in foreign exchange markets. More importantly, it is because the U.S. financial markets remain the most efficient places to intermediate global funds. In these markets, particularly the U.S. Treasury securities market, large amounts of financial assets can be bought and sold without causing large movements in market price. Moreover, due to the narrow differences between buying and selling prices, the costs of transacting in these assets are lower than in any other markets. Investing in U.S. financial markets, and also through the U.S. dollar in other financial markets, therefore, lowers costs and increases the flexibility of portfolio decisions.

The previous two reasons also give rise to a third factor that keeps the U.S. dollar as the world's currency. The currency has become an integral part of international financial and commodity markets because it is so frequently used in international trade and investment. In quoting exchange rates, the value of a currency is most frequently stated in terms of the U.S. dollar. Even in actual exchange, the U.S. dollar's role is important. A company wishing to exchange Thai baht for New Zealand dollar typically buys the U.S. dollar first before converting it into New Zealand dollar. This is why the U.S. dollar is involved in one leg in close to 90% of all foreign exchange transactions, compared with less than 40% for the euro and 16% for the Japanese yen. Similarly, commodities, such as oil and copper, usually have their quotes and their trade executed in U.S. dollar. This prevalence also means that derivative markets are most developed for anyone wishing to hedge currency and commodity price risks.

The common factor crucial for the continued validity of the above support for the U.S. dollar's international status is confidence in the stability of its purchasing power and the government to honor its debts. Whether one is a trader or an investor, there is a need to hold the currency on an ongoing basis. People have to believe that it is a good store of value, in that the real effective exchange rate of the U.S. dollar is not expected to see large declines over the short to medium term. This belief rests on the strength of the U.S. economy, the independence and checks inherent in key institutions, as well as the prudence and coherence of its policies. If even a significant minority of external creditors has doubts that these factors are no longer true, then markets in U.S. dollar money and capital markets will become unstable. The real interest rates and equity premiums will rise sharply and the dollar will fall precipitously against other major currencies.

The reason for Governor Zhou's proposal is that recent developments have the potential to weaken confidence in the U.S. dollar. As the U.S. has the largest trade deficit in dollar terms, its vibrant economy as well as responsible fiscal and monetary policies have supported the value of its currency. These conditions make investments in U.S.-based companies attractive and the government's debt a safe asset to hold. Given these factors, the U.S. has managed to attract international capital to help maintain its international balance of payments.

This foundation is looking shaky now that the economy has suffered serious damage, budget deficits are expected to rise sharply, and the Federal Reserve is pursuing quantitative easing. Not only have growth prospects dimmed but inflation risk over the medium term has risen. U.S. policymakers pursuing measures that deal with domestic problems, however, have affected confidence over the longer-term attractiveness of the U.S. dollar. But it is still too early to call the end of the pole position of the U.S. dollar. And even if it isn't, it is not clear that Governor Zhou's proposed use of the Standard Drawing Rights (SDR) is the right answer anytime in the next few years.

The SDR is currently an accounting unit that represents a basket of currencies: U.S. dollar (44%), euro (34%), yen, and sterling (both 11%). It is neither used in physical or financial trading, only in the internal accounting of the International Monetary Fund. There is no economic need and, therefore, demand for the currency. It will be difficult to persuade major financial institutions to make expensive investments to change their systems for such trading. It will also be of little use to international savers since it will be a long time, if at all, for SDR financial markets to grow to a reasonable size. Finally, companies involved in international trade will find it difficult to hedge the SDR against the domestic currencies that determine their costs of production.

A more natural alternative to the U.S. dollar is a currency that is already widely used today. Perhaps this is the reason why China has signed currency swap agreements with a number of countries recently. However, the renminbi (RMB) is hardly ready for a major international role anytime soon. Strict capital controls, including currency convertibility, in China currently prevent such a development. And in the next few years, it is unlikely that policy makers will feel sufficiently confident in the Chinese banks to subject them to the large international currency flows that come with an internationalized renminbi.

The most likely candidates for an alternative international currency are the euro and Japanese yen. In recent years, however, the growth in the use of the euro has slowed significantly. In terms of use in international trade and international debt issuance, the share of the euro has stabilized in recent years. While its use in Europe is naturally widespread, the currency's influence outside of the region has remained small. The Japanese government's push to internationalize its currency in the late 1990s has also met with no success. Importantly, while the U.S. economy has weakened recently, the European and Japanese economies hardly seem in better shape.

Moreover, more so than the U.S., both regions face serious demographic challenges that are likely to bring down their medium- to long-term growth. Over a longer horizon, as long as fundamental U.S. economic policies are not changed, the country will continue to have better growth prospects. The truth is that, in the near term, there appears to be no good alternative to the U.S. dollar as an international currency.

It's also far from certain that conditions in the U.S. economy are sufficiently serious for the world to doubt the stability of the worth of its currency. Even counting a few years of exceptionally large fiscal deficits, it is unlikely that the U.S. government debt will reach that of the Japanese government in relation to their respective GDP. Yet, domestic confidence in the Japanese government's creditworthiness is so strong that it can continue to borrow long term at among the lowest interest rates in the world. These rates are attained despite maintaining an open capital account that has enabled the Japanese private sector to become one of the world's largest external creditors. Even the U.S. government itself had experienced a far higher debt burden than currently just after the Second World War. Yet, the U.S. dollar continued to grow in international importance at that time.

The U.S. dollar had survived serious tests before. In the early 1970s, there was a significant loss of confidence in the U.S. currency, which eventually led to the dollar floating freely against gold. Stagflation in the 1970s also called into question the pre-eminence of the U.S. economy and the role of the U.S. dollar. In both episodes, however, the innovation and flexibility of the country's open economy helped it to return to strong growth. Confidence in the U.S. dollar also returned as a result.

What could prevent a similar revival are policy mistakes by the U.S. government. The economic position of the U.S. will not emerge unscathed from this financial turmoil. In the near to medium term, we believe some weakening of the dollar's dominance is likely. Only a permanently less-vibrant U.S. economy, however, will ensure a trend decline in the U.S. dollar's international importance. If it happens, it will most likely come from a structural shift in the U.S. economic policy--for example, if we see a much more protectionist international trade regime or excessive regulation of businesses.

These risks could materialize. The rise of unemployment in the country, coupled with the government's weakened finances, has led to rising pressures to put American firms and workers first. The recent U.S. stimulus package, for instance, came with a "Buy American" clause. Meanwhile, public discontent with executive compensation and increased state control over the economy could lead to restrictive policies that could ultimately introduce excessive risk-averseness in firms. Policy mistakes could lead to a period of price instability. Such factors as these could diminish America's growth prospects and the long-term international status of the U.S. dollar. But if this day arrives, we believe it will likely stem from developments in the U.S. rather than efforts abroad.

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