The Once and Future Dollar
Barry Eichengreen at the American Interest:
The week between Christmas and the New Year is normally a quiet time for economic news. On December 25, 2011, however, headlines were ablaze with the news: China and Japan had reached an agreement to use their own currencies in trade and financial transactions. Their governments would establish a market for direct exchange of yuan and yen, avoiding the convoluted process in which a bank or firm in one country must first sell its national currency for dollars and then use them to buy the currency of the other. As part of the same agreement, Japan’s central bank agreed to hold more of its foreign currency reserves, most of which are in dollars, in yuan instead.
This historic accord was widely seen as a rebuke to the dominance of the dollar in international transactions. The dollar is involved in 85 percent of global foreign exchange trades. Fully 80 percent of all over-the-counter foreign exchange transactions involving the yuan and the yen are trades of those currencies for dollars. While neither China nor Japan divulges the share of its foreign exchange reserves held in dollars, educated guesses put that figure at more than 60 percent in both cases—even higher than the share of dollars in central bank reserves worldwide.
It is far from clear why the world’s second and third largest economies, both in Asia, should continue to utilize the dollar so heavily. The situation is probably best understood as a holdover from the past, when the two countries did little business with one another but traded extensively with the United States. Not so long ago, the United States was the world’s leading exporter and dominant foreign investor. The United States was the only country of economic consequence whose financial markets were fully open to investors, both private and official, from around the world. New York was the leading center for international financial transactions of all kinds. All this made it logical that firms, banks and governments should become habituated to a world in which the vast majority of international transactions were in dollars. And such habits, once formed, die hard.
This habit, however, in the view of the Chinese and Japanese governments, has outlived its usefulness. Holding such a large share of their foreign reserves, and private investments on top of that, in U.S. treasury bonds puts both countries at the mercy of the United States, which could erode the value of their assets by pushing down the dollar. Because so many transactions within Asia use the greenback, banks and firms depend on their ability to get their hands on dollars when they need them. Given America’s less than admirable record of financial stability, this is not always something that can be taken for granted. In several recent credit crunches, when the private availability of dollars dried up, the Federal Reserve made emergency dollar credits available to the Bank of Japan and Bank of Korea. These arrangements, known as swap agreements, allowed the two Asian central banks in turn to make dollars available to their firms and markets. But Asian governments are aware that the Fed is a political animal and that some members of the U.S. Congress are not exactly fans of dollar swaps. They fear that a U.S. central bank that has been a reliable provider of emergency dollar liquidity in the past may not be an equally reliable provider in the future—hence the desire of Asian countries to shed their dollar dependence.
So should the Sino-Japanese accord be seen as a lump of coal in America’s Christmas stocking? Should we worry that our living standards, economic policy freedom and geopolitical leverage are being eroded by the dollar’s loss of dominance? Or are the economic and political benefits of the dollar’s singular status—and, equally, the ability of other countries to diminish it—prone to exaggeration?
Still the One
A first thing to say is that the dollar, like the United States, isn’t going anywhere. The United States still accounts for nearly a quarter of global GDP when the output of other countries is valued at market exchange rates (which is the appropriate metric when one is concerned with international transactions). By this measure, the United States is still nearly three times the economic size of both China and Japan. Its financial markets are deep and liquid. The market in U.S. Treasury bonds—the principal instrument that foreign central banks hold as reserves—is the single largest financial market in the world. The fact that there exists a huge volume of currency transactions involving dollars allows investors to buy them in substantial quantities without driving up their price and to sell them without driving that price down. In the competition with other currencies, in other words, the dollar enjoys the advantages of incumbency.
To be sure, the yuan, the yen and other alternatives may acquire larger global roles over time. In particular, a situation in which the yuan is involved in less than 1 percent of all foreign exchange transactions, and where central banks hold it not at all as foreign exchange reserves (aside from token amounts held by the central banks of Malaysia and Nigeria) hardly seems destined to last. The explanation for this peculiar state of affairs is that China maintains tight restrictions preventing foreign investors from getting their hands on the yuan and, more generally, from moving money in and out of the country. As China now loosens those restrictions, more of its cross-border business will be conducted in yuan. As it builds markets in which its currency can be exchanged directly for other non-dollar currencies, like the market it intends to build with Japan, that trend will accelerate. No doubt some of the yuan’s gains will come at the expense of the dollar.
But China has a long way to go before the yuan becomes an attractive alternative to the dollar for banks and firms trading and investing anywhere other than in China itself. Chinese regulations, as noted, make it hard to acquire the currency. Firms can obtain it by exporting to China and accepting payment from their customers in that form. Many of the companies in question then deposit those payments in accounts in Hong Kong, where they can be borrowed by other investors. At latest report, about $100 billion worth of yuan deposits, a modest pool, has accumulated there. But for the yuan to play a more significant international role, it would be necessary for the Chinese authorities to permit foreign investors to purchase their securities on China’s own market, much as foreign investors are free to purchase Treasury bonds in the United States.
That, however, would require wholesale changes in Chinese economic policy and, indeed, in the country’s very successful development model. The system of capital controls limiting foreign financial investment would have to be dismantled. Larger capital inflows and outflows would make it harder for Chinese policymakers to keep the exchange rate at artificially competitive levels; any attempt to do so would be met with capital inflows that would push the rate up or else cause runaway inflation. China would thus have to abandon its tried-and-true development model based on export-led growth fueled by a hyper-competitive exchange rate. Chinese leaders now acknowledge that the country will soon outgrow the current development model. They foresee a time when China will depend less on exports and more on domestic consumption, and when it will have abandoned its dollar peg in favor of a more flexible exchange rate. But no one thinks that this process will be easy or that it will be completed overnight.
Simply declaring that the market is open, in any case, may not be enough to make the customers come. The liquidity of Chinese financial markets is limited: Most government and corporate bonds are held to maturity by Chinese banks and credit cooperatives. As a result, the volume of trading is a tiny fraction, barely 1 percent, of that in the United States. China’s banks are run by civil servants; their top managers are not selected on the basis of a global search. Not enough is known about their exposures, for example, to the property market.
Then there is the minor matter of rule of law. The Chinese authorities may hesitate to tamper with the deposits of foreigners precisely for fear of killing the golden goose. But they have not hesitated to look the other way in the face of abuses of international property rights protections for fear of killing off foreign direct investment. And it is far from clear what they would do in the event of a serious economic or diplomatic dispute with another country. Let’s say the United States slapped a tariff on imports from China: How might China alter its treatment of the deposits of American companies in return?
Japan may be more advanced than China both economically and financially, but it too faces significant obstacles if it seeks to unseat the dollar. The yen accounts for less than 4 percent of the foreign exchange reserves of central banks and governments, and its share has been trending downward for twenty years. That Japan was mired in an economic slump and had an unresolved banking crisis for much of that period does not help. Low birth rates and nonexistent immigration mean that the Japanese labor force, defined as those aged 23 to 69, is projected to decline significantly in coming decades. These dismal demographic prospects suggest that the country and its currency will play even smaller roles going forward.
To be sure, there are economic powers and internationally traded currencies beyond East Asia. The fact that the most widely used of these, the euro, has serious problems will not come as news to readers. Doubts about the credit-worthiness of European governments and about the stability of the continent’s banks leave foreign authorities understandably reluctant to boost their holdings of euro-denominated bonds and bank deposits. Indeed, some Asian central banks, concerned about the possibility of a eurozone breakup, are reported to have actively drawn them down.
Other European issuers of internationally recognized currencies like the United Kingdom and Switzerland are simply too small to make a dent in the dollar’s market share. In Latin America, at least one country, Brazil, possesses the requisite size. But much as Brazil has long been regarded as “the country of the future”, its currency, the real, remains a currency of the future, and its economy and financial markets are volatile by international standards. To insulate Brazil’s markets from large inflows and outflows of foreign funds, the authorities levy a heavy tax on foreign purchases of domestic securities. In South Asia, India is an obvious candidate for one day possessing a global currency, but it has even further to go than Brazil in terms of building the kind of deep and liquid financial markets that make a currency attractive to foreign users.
The dollar thus has the dubious distinction of being the least unattractive contestant at the beauty pageant. It will not dominate international finance forever, for the same reasons that the United States will not dominate the world economy indefinitely. Emerging markets starting out behind us have scope for growing faster—for narrowing the per capita income gap as they figure out their problems. It will take time for them to build deeper and more liquid financial markets and allow foreign investors to access them more readily. Any diminution of the dollar’s international role is still a ways off—even if there is no question that this change is coming.
Should we be worried that our children or grandchildren will be significantly worse off as a result of the dollar’s diminished international role?
Consider what the United States stands to lose: The fact that so much international business is conducted in dollars is a considerable convenience for U.S. banks and firms. The fact that they can engage in transactions with foreign customers using their local currency allows them to avoid the cost of changing money each time they sell merchandise or invest across borders. By contrast, exporters and investors in other countries who are compensated in dollars must pay to convert their receipts back into local currency. This additional cost is a competitive disadvantage for them.
Firms in other countries also bear the risk that the exchange rate will move against them while the transaction is underway. While they buy materials and hire workers to produce their goods using local currency, they set their export prices and receive payment in dollars. If the dollar unexpectedly depreciates, what they receive may not cover their costs. They can insure against this risk by purchasing a forward contract, but this hedge constitutes yet another cost. This, too, is something that a typical American firm is able to avoid.
Similarly, a U.S. bank that takes deposits in dollars and also extends loans to foreign customers in that currency does not have to worry about exchange rate risk. In contrast, a foreign bank that funds itself by borrowing dollars on the interbank market but denominates its loans in the local currency has what is known as a currency mismatch on its balance sheet. It must either bear the risk of insolvency if the dollar unexpectedly appreciates or insure itself by buying a hedge.
Yet these advantages of the dollar’s international status are fairly minor. Credit card holders may see a 2 percent charge each time they use their card in a foreign country, but banks and firms undertaking large foreign currency transactions can do so at a small fraction of that cost. Those costs have not prevented firms in a variety of countries whose currencies are not used internationally from becoming successful exporters. Other determinants of export competitiveness loom larger, in other words. Similarly, there are more important determinants of the competitiveness of a bank than whether or not the currency of the country in which it is chartered is used internationally. The fact that Britain is outside the eurozone has not prevented London from retaining its mantle as Europe’s leading financial center.
More important is the impact of the dollar’s international status on the U.S. Treasury’s cost of borrowing. To the extent that foreign central banks and governments use U.S. Treasury bonds as a store of wealth, reflecting their stability, liquidity and wide acceptability, the demand for them is stronger. Treasury is therefore able to place its bonds with investors at lower interest rates. This effect will be most pronounced when other countries are growing strongly—when their economies, exports and international financial transactions are all expanding and their central banks therefore seek to accumulate additional reserves as insurance against shocks to that growing volume of transactions. Thus, toward the middle of the last decade, when the world economy was growing as rapidly as any time since the early 1970s, yields on ten-year Treasury bonds were depressed by as much as a full percentage point by foreign purchases, according to some estimates. This represented a considerable savings to the U.S. government.
And to the extent that yields on government and private securities are linked, lower Treasury yields also mean lower corporate borrowing costs and lower mortgage interest rates. Since a stronger demand for dollar-denominated securities internationally also means a stronger dollar exchange rate, there are, in addition, benefits for American consumers. A stronger exchange rate means a lower dollar price for that favorite bottle of French Bordeaux, those Chilean blueberries and that Korean flat-screen television.
Indeed, it is not only for foreigners that the dollar, by virtue of its special status, serves as a form of insurance. The fact that U.S. financial markets are so liquid, and that dollars are widely accepted, gives them a kind of special safe-haven status. Whenever there is a shock to the global economy, there tends to be a rush into dollars by international investors seeking safety. Ironically, this rush into dollars is evident even when the United States itself is the source of the disturbance. Witness how the dollar strengthened when the subprime mortgage crisis erupted in the autumn of 2007 and again following the chaotic debate over whether to raise the debt ceiling in summer 2011. In a sense, the dollar’s special status affords the United States protection against the economic consequences of even its own misbehavior.
Finally, the dollar’s role as the currency on which so much international financial business is based gives the U.S. government a little bit of additional diplomatic leverage. In 2008, following the failure of Lehman Brothers, foreign central banks desperate for dollar liquidity turned to the Fed for loans, as noted above. In response, the U.S. central bank negotiated four $30 billion currency swaps with Mexico, Brazil, Singapore and South Korea. The Korean swap in particular is credited with quieting that country’s financial crisis. Seoul may be a staunch U.S. ally, but it is also keenly aware of its economic and political dependence on China. In South Korea and beyond, America’s unique ability to provide dollars in unlimited quantities, but also to withhold them, provides U.S. foreign policymakers with another pressure point to push.
On the other hand, the fact that foreign central banks and governments hold so many dollars also gives them a pressure point in conflicts with the United States. By U.S. Treasury estimates, China holds some $1.1 trillion in U.S. government bonds. Total official foreign holdings exceed $3.2 trillion, nearly a third of the $10 trillion of U.S. Treasury debt held by the public. It is worth noting that these official figures are almost certainly underestimates. In addition to purchases in the United States, which are tracked by the U.S. Treasury, governments and central banks can purchase U.S. Treasury bonds through intermediaries in foreign centers like London, where they are harder to detect. Foreign central banks also hold the securities of government-sponsored agencies like Freddie Mac and Fannie Mae, although they have trimmed those holdings since the subprime crisis.
If by purchasing U.S. Treasury bonds foreign central banks can lower U.S. interest rates by as much as a full percentage point, then they could, by curtailing those purchases, presumably raise U.S. rates by a corresponding amount. The U.S. housing market and construction sector would feel the pain. This would be a not-so-subtle way for China to make known its displeasure with U.S. policy toward North Korea or Iran, or with a U.S. Treasury decision to label China a currency manipulator. The benefits that America derives from Chinese purchases of U.S. debt are a factor in the State Department’s reluctance to push Beijing harder on human rights issues and the Treasury Department’s reluctance to push it harder on the exchange rate issue.
In principle, China could go further and sell its previous purchases. Given the magnitude of its holdings, this would cause bond prices to crater and U.S. interest rates to spike. Smaller bond market shocks than that have caused financial mayhem in the United States. Consider the 1.5 percent rise in thirty-year Treasury yields that occurred in 1994 when Japanese investors faced with a financial crisis at home sold off their U.S. holdings. The result was serious losses and fears of insolvency of major financial companies and hedge funds. If the Chinese wished to wreak havoc in U.S. financial markets, this would be the way.
The deterrent to China’s doing so is that it might also be wreaking havoc in its own markets. When institutional investors in Japan sold off some of their U.S. treasuries in 1994, driving down the price, they suffered losses on their remaining holdings. This heightened concern about the solvency of not just U.S. financial firms but Japanese financial institutions as well. China would face an analogous problem.
Beijing would be in a stronger position, admittedly, to the extent that most of its U.S. Treasuries are held by its central bank and government. Unlike the managers of a highly leveraged Japanese bank, Chinese public officials can simply grit their teeth and take losses on their residual holdings of U.S. Treasuries, if such is the price of exerting leverage over the United States without jeopardizing their own financial stability. But the Chinese government is already under fire from its public for having taken losses on its investments in U.S. Treasury bonds as a result of the dollar’s depreciation against the yuan. That public would not respond happily to more losses.
In addition, extensive sales would cause the dollar exchange rate to plunge. Chinese exporters would feel the effects in the pocket book. Transactions that were seen as the overt use of financial means to exert political leverage over the United States would undoubtedly provoke U.S. retaliation. Congress would be quick to slap a tariff on Chinese exports, hitting China right where it hurts. Lawrence Summers, the former U.S. Treasury Secretary, has colorfully referred to the bind in which this places the two countries as a situation of “mutually assured economic destruction.” This is not to deny that it is better to be a foreign creditor than a foreign debtor when international conflicts arise. Nor is it to say that the Chinese would never, under any circumstances, use their financial weapon. But, in order for them to do so, the stakes would have to be very high.
A sharp plunge in the dollar that caught institutional investors wrong footed would be devastating to all concerned. But can’t it be argued that a very gradual curtailment of purchases of dollars by China and other countries, which resulted in a gradually weakening U.S. exchange rate, would be just the tonic the U.S. economy needs? With the eventual emergence of rivals to the dollar in the international sphere, foreign central banks and other investors, seeking additional safe assets, will be able to buy more of those other currencies and correspondingly fewer dollars. Given that the Obama Administration seeks to double U.S. exports in the next five years, a gentle decline in the dollar could be just what the doctor ordered. John Bryson, the newly confirmed head of the Commerce Department, the agency most directly concerned with growing U.S. exports, emphasized once again the need for yuan appreciation (read: “dollar depreciation”) when he met with Chinese Vice Premier Wang Qishan in Chengdu this past November.
Purchases of dollar securities have in fact been the main way that China has kept the yuan from rising more rapidly against the dollar. For China, it can be argued, it is mainly the desire to keep its exchange rate down and its exports as competitive as possible—not the need for more insurance against shocks—that has led to the accumulation of such an immense stockpile of dollar reserves.
But China exports more to the European Union and to the rest of the world than to the United States. The question, then, is why it attempts to keep the yuan down against the dollar rather than keeping it down against a basket of currencies that includes not just the dollar but also the euro and perhaps others. Part of the answer, again, is habit. The country’s exporters have grown accustomed to a stable dollar exchange rate and to pricing their merchandise in dollars. Their policymakers want to keep them comfortable. But another part of the answer is that the alternative, keeping the yuan stable against the euro, requires taking risky positions in European government bonds. Keeping it stable against still other currencies would require intervening in even smaller, less liquid markets. Until other currencies acquire the stability, liquidity and international status of the dollar, it will remain the exchange rate anchor and intervention currency of choice for central banks and governments around the world. And from the point of view of U.S. exporters, that status quo is a very mixed blessing.
Beyond that, the dollar’s status as the only true global currency may not have entirely favorable implications for financial stability in the United States. U.S. households have a well-developed appetite for debt, and government policies that drive down U.S. interest rates effectively subsidize their borrowing. In boom times, when Americans have been known to indulge in a borrowing binge, anything that makes it cheap to borrow reinforces this reckless predisposition. The housing bubble that burst in 2006 had multiple causes, as bubbles and crises always do. But along with lax regulation, the incentive problems of mortgage securitizers and rating agencies, and loose monetary policies, the appetite of foreign governments for dollar assets undoubtedly played a role. In periods of frenzied excess in financial markets, speculative investments are financed with borrowed money. Normally, however, incessant demands for borrowed funds drive up interest rates, putting a damper on the speculative boom. But in the United States—in 2003–05 for example—the ready availability of funding from foreign central banks neutralized this stabilizing tendency. With American investors anxious to hang themselves, foreign central banks gave them more rope.
In a world where there are also other reserve currencies and other sources of international liquidity, foreign central banks would have alternatives. If they saw the United States again blowing a housing bubble or otherwise engaging in irresponsible financial behavior, they could cut their accumulation of dollars in favor of other currencies. Reckless U.S. investors would be confronted by higher interest rates, forcing them to curtail their excesses and mitigating risks to financial stability.
The debate over the dollar’s reserve-currency status is confused and confusing. Different U.S. government officials and agencies stake out different positions. Even a single government agency like the Treasury Department simultaneously reiterates its intention to defend and preserve the dollar’s position as the leading international currency and, at the same time, welcomes the transition to a safer and more balanced monetary and financial world. This reflects the reality that the dollar’s singular status is both a benefit and a burden to the United States. When, someday, that status is less singular, the dollar will have to share the international stage with other currencies, and both the burden and benefit will be tempered. But not any time soon.
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