Reserve Currency

The inadvertent quid pro quo

The Times summarizes the state of the US dollar's valuation, reserve currency status, and the accidental arrangement with Asian central banks that makes the system work:

Over a decade, the proportion of US government debt held overseas has more than doubled from 20 per cent to about 45 per cent. Underpinning this massive expansion of overseas borrowing has been an inadvertent and undeclared currency pact between America and Asian economies.

Desperate to prevent their currencies rising against the dollar and undercutting their booming exports to the US, Asian nations have bought up billions of dollars and US Treasury bonds to shore up America’s greenback and keep their exchange rates pegged against it. The accidental quid pro quo has been that Asia has been able to continue to keep selling its goods to Americans at highly competitive exchange rates, while America has been able to run up ever-increasing debts to pay for them — helpfully financed by the Asian central banks.

Early indicators of change are seen in Japan and China:

No one can predict with certainty if or when the edifice will crumble, but it seems more and more inevitable that, sooner or later, it will. Already, a reviving Japan has abandoned efforts to restrain a rise in the yen, removing one key prop for the system. Perversely, Washington seems intent on kicking away another, persisting in its efforts to persuade Beijing to scrap its currency’s dollar peg and revalue the yuan.

Could the Chinese yuan overtake the US dollar as a reserve currency of choice in Asia? The necessary political stability in China seems like a longshot.

Euro diversification

It's starting to happen. At the Bank for International Settlements meeting in Basel recently, Asian central bank officials have started talking about diversifying their currency reserves from dollars only to euros and dollars. China, Korea, Malaysia, and the Phillipines have made such comments recently, according to The Business Times (Singapore). Since the 1997 Asian financial crisis, Asian central banks have been accumulating larger foreign currency reserves as a hedge against speculative attacks on their own currencies. Spending has been at an all-time high level in the last 18 months, when Asian central bank reserves rose 57%, to US$2.156 trillion, mostly to curb strength in their own currencies. Asian central banks now hold the majority of the world's currency reserves as a result, it is said.

The key thing I will be looking for is a gradual process of diversification and not a precipitous sell-off of dollars.

T-bills

In Wanna Buy a T-Bill, Sucker? The foreign fools who are buying American bonds in Slate, Daniel Gross notes large debt purchases (US Treasury bonds) by Asian central banks in recent months. Such purchases have increased more than 12-fold over 3 years ago.

The massive foreign purchases of U.S. government bonds have helped keep interest rates at or near historic lows, even as federal surpluses have turned into massive deficits.

He sees the current approach as being one that ultimately encourages more investment in Asia by US companies:

The Asian central banks aren't buying U.S. government bonds for investment purposes; they're buying for mercantilist purposes. By buying dollars and dollar-denominated assets like Treasury bonds, they help keep their currencies relatively weaker and the dollar relatively stronger. And by providing a ready market for our government's chief product, they've helped keep U.S. interest rates low. That keeps politicians happy and enables American companies and consumers to do what they do best: borrow tons of money at favorable rates and spend it.

If correct, the situation is a virtuous circle of cross-investment, and not, as some seem to say, a sinister plot by which the US takes advantage of the rest of the world.

De facto dollar standard

In a recent study of international business practices regarding currency exchange rate fluctuations, it is a surprise that most businesses engaged in international trade do not in fact take any extraordinary measures to isolate themselves from the negative effects of exchange rate changes. The number one ordinary measure taken? Use of the US dollar to denominate all transactions, whether US firms are involved or not, whether the transactions have any connection to the US or not. This is true of 50% of non-US firms! This widespread practice increases demand for dollars for purely private (and licit) transactional purposes, and may in fact be part of the reason that there could be a strong dollar in the 90s while the US ran a significant trade deficit.

Says the co-author of the study report:

"To the extent that the U.S. dollar becomes the preferred global currency for international transactions, changes in the value of the dollar will have little direct effect on prices," added Fosler. "This result calls into question the conventional wisdom that a decline in the dollar is the solution to the U.S. trade deficit or that the revaluation of another currency like the Chinese RMB will have real effects. Businesses can simply re-denominate their transactions in U.S. dollars."

The dollar dilemma

Detailed opinion editorial by Niall Ferguson in Australian Financial Review quotes De Gaulle's 1965 warning about the use of the US dollar as an international reserve currency and proceeds to describe how current US economic policies are primarily underwritten by central banks (especially in Asia) holding US dollars as reserve. Substantial increases in US interest rates combined with increased use of the euro as a reserve currency could result in significant hardships to un-hedged debtors in the US, primarily the US government and private homeowners. This is not necessarily a calamity, but it would have serious effects, most notably a slowdown in the US economic recovery.

This rapid role reversal - from world's banker to world's biggest debtor - has had two advantages for Americans. First, it has allowed US business to invest substantially (notably in information technology) without requiring Americans to reduce their consumption. Between 10 and 20 per cent of all investment in the US economy in the past decade has been financed out of the savings of foreigners, allowing Americans to spend and spend. The personal savings rate is less than half of what it was in the 1980s.

The second pay-off, however, has taken the form of tax cuts rather than private sector investment. The dramatic shift in the finances of the federal government from surplus to deficit since 2000 - a deterioration unprecedented in peacetime, according to the IMF - has been substantially funded from abroad. Had that not been the case, the combination of tax cuts, increased spending and reduced revenue that has characterised George Bush's fiscal policy would have led to much more severe increases in long-term US interest rates. Veterans of the Nixon and Reagan years can only shake their heads enviously at the way the present Republican administration has escaped punishment for its profligacy. To run deficits on this scale while enjoying long-term bond yields of under 5 per cent looks like the biggest free lunch in modern economic history. The cost of servicing the federal debt has actually fallen under Bush, even as the total debt itself has risen.

The reason is simply that foreigners are willing to buy the new bonds issued by the US treasury at remarkably high prices. In the past 10 years, the share of the privately held federal debt in foreign hands has risen from 20 to nearly 45 per cent. Just who is buying all these dollar-denominated bonds, apparently oblivious to the possibility that, if past performance is any indication, their value could quite suddenly drop?

The answer is that the purchases are being made not by private investors but by public institutions - the central banks of Asia.

Between January 2002 and December 2003, the Bank of Japan's foreign exchange reserves increased by $US266 billion. Those of China, Hong Kong and Malaysia rose by $US224 billion. Taiwan acquired more than $US80 billion. Nearly all of this increase took the form of purchases of US dollars and dollar-denominated bonds. In the first three months of this year alone, the Japanese bought another $US142 billion. The Asian central banks' motivation for doing so is simple: to prevent their own currencies from appreciating relative to the dollar - because a weak dollar would hurt their own exports to the mighty American market. Were it not for these interventions, the dollar would certainly have depreciated relative to the Asian currencies, as it has against the euro. But the Asian authorities are willing to spend whatever it takes of their own currency to keep the dollar exchange rate steady.

Cheap dollar "overshooting"

Washington Post columnist David Ignatius spells out in "Fiddling while the dollar drops" a scenario where the dropping value of the dollar against other currencies (particularly the euro) could drive Asian central banks to hedge by diversifying their reserves, which in turn could further weaken the dollar on exchange markets, which could drive the Fed to boost interest rates to protect the currency, which in turn could drive down the stock market. Ignatius' thesis is that the cheap dollar is politically expedient at present, and thus there is concern by a number of experts that the market value of the dollar could "overshoot" as it declines, triggering these undesirable consequences.

EC President on Euro Strength

European Commission President Romano Prodi, speaking yesterday to the Economic Club of New York, describes some of the euro's success in its first 18 months:

At the end of 1998, money-market instruments denominated in the euro's predecessor currencies accounted for just over 17% of world issues, compared to 58% for dollar-denominated instruments. By mid-2003, the share of issues in dollars had fallen to 30%, while the share of euro issues had climbed to almost 46%.

Overall, therefore, euro-denominated debt issuance has increased enormously in a very short span of time.

And specifically about the euro as a reserve currency relative to the dollar:

As a reserve currency, the euro accounted for almost 15% of official reserves in 2002. Admittedly it still played a much smaller role than the US dollar, whose share amounted to 65%. By holding large amounts of US dollars, the European Central Bank itself contributes to the prevailing role of the US currency as an official reserve currency.

Krugman: no big deal

Princeton Economics professor and New York Times columnist Paul Krugman says there's not really anything to be concerned about in changes to the use of the US dollar as an international reserve currency. His opinion is that the dollar's reserve currency status doesn't really have much effect on the US. The number of dollars going into central bank coffers as reserves is tiny compared to GDP:

Well, then, you may say, surely the international role of the dollar forces people out there to hold dollars for transaction purposes. Yes, but not so you'd notice. When Daewoo repays a dollar loan from Sanwa, it writes a check on its account with some international bank. True, that bank itself surely maintains an account in New York, backed in part by non-interest-bearing reserves held at the Fed. So the U.S. does in effect get a zero-interest loan out of the dollar's international role--but it probably amounts to only a few billion dollars, small change for an $8 trillion economy.

More significant than currency reserves, Krugman says, is the use of US cash worldwide as a medium for illegal transactions:

Where the U.S. does get a significant free ride is from the willingness of foreigners to accept our currency--actual bills. Foreigners hold more than $200 billion of American money. Guess what kind of business requires payments of large sums in cash, by people unconstrained by official restrictions on possession of foreign exchange? That's right: the dollar is the world's premier medium of illicit exchange. Every year the U.S. ships foreigners $15 billion in cash (about 0.2% of GDP), and gets real goods and services in return. Better not ask what kind.

But still, he says this is a tiny proportion of GDP.

Is he right that the small proportion of GDP of these transactions means that there is naught to worry about?

I wonder, what is the total value of US dollar currency reserves worldwide, and what is the total value of US currency in circulation abroad? What proportion of GDP are we talking about then? What proportion of the total amount of US dollars worldwide are we talking about?

No answers yet, just lots of questions.

The Dollar Bubble

Arnold Kling on the overvaluation of the US dollar:

Even though the dollar is overvalued, it is impossible for the United States to suffer a currency crisis of the sort experienced by Asian countries in the late 1990's or Latin American countries seemingly once a decade. The reason is that the United States has the luxury of having its debts denominated in its own currency....

The beauty of having dollar-denominated debts in a world of currency fluctuations is that the United States is fairly insulated. If the foreign currency crashes, foreign borrowers take the hit. If the dollar crashes, foreign lenders take the hit. Foreigners are screwed either way....

If you are waiting for a financial-market disaster to come crashing down on the evil Americans and their evil Republican administration, I would not hold your breath. If the dollar bubble bursts, it will reduce our wealth a bit (because of the rise in the cost of foreign goods), but the improvement in our trade competitiveness will help to increase output and employment.

Definitions

Now for some definitions:

A reserve currency is "a foreign currency held by a central bank or monetary authority for the purposes of exchange intervention and the settlement of intergovernmental claims."

Special Drawing Rights (SDRs): "Created in 1969 by the International Monetary Fund (IMF) as a supplemental international monetary reserve asset, SDRs are available to governments through the IMF and may be used in transactions between the IMF and member governments. IMF member countries have agreed to regard SDRs as complementary to gold and reserve currencies in settling their international accounts. The unit value of an SDR reflects the foreign exchange value of a "basket" of currencies of several major trading countries (the U.S. dollar, the German mark, the French franc, the Japanese yen, and the British pound). The SDR has become the unit of account used by the IMF and several national currencies are pegged to it. Some commercial banks accept deposits denominated in SDRs."

Seignorage is "the difference between the value of money and the cost of its production."