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.

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."