Since World War II, the U.S. Dollar has held the status as the worlds “most popular” reserve currency, accounting for more than 60% of total global reserves. A reserve currency serves as a global currency in that many international transactions and commodity prices are denominated in it. Many countries (other than the issuing country) generally hold the currency in large quantities.
Since currency reserves are held by nations in the form of government debt, interest rates tend to be lower for reserve currency nations. Much attention has been given in the media to the large amount of U.S. debt that China holds in the form of U.S. Treasury bonds (more on this later…). Their massive purchases of these bonds has, in essence, had the effect of pushing interest rates in the U.S. down. This allows the U.S. to run large scale trade deficits (importing significantly more than they export). In other words, without foreign countries funding our trade deficit via the purchase of treasury bonds, the U.S. standard of living would likely be reduced substantially.
The financial crisis of 2008-09, and subsequent increase in the national debt to unprecedented levels have caused some to question the dollar’s status as the world’s primary reserve currency. Of course this begs the question: What global economy is of suffcient size and depth to replace the dollar as primary reserve currency? The two most realistic challengers are the Euro and Chinese Yuan, both of which suffer from their own special set of challenges.
The Yuan
While China is the worlds largest exporter and second largest economy, it does not maintain a free floating currency (a precondition to reserve status). Simply allowing their currency to float freely isn’t as easy as it sounds. Were the Yuan to immediately float, it would likely strengthen dramatically vs the dollar thus making Chinese exports to the U.S. consumer more expensive. This would have the effect of dampening Chinese growth (which is heavily reliant on foreign consumption). At the same time, U.S. exports would look much more attractive (perhaps sparking a manufacturing renaissance here in the USA) thereby causing our trade deficit to shrink. Effectively, a free floating currency relationship between $ and Yuan could help to correct the trade imbalance between the world’s two largest economies. However, in the short run this would likely come at the cost of lower Chinese growth (less attractive export market) and a lower standard of living (higher rates due to less treasury bond demand) in the U.S.
The Euro
Approximately one quarter of global reserves are already held in Euro, and the Euro zone economy as a whole is massive. While Euro zone economies may share a common currency, there is no unified fiscal union to support it. This is highlighted by the significant uncertainty surrounding the slow Greek train wreck. It’s been a year since the 110 Billion Euro “bailout” of Greece by the IMF and EU, and they are still rioting in the streets of Athens. Basically, one gets the sense that no one knows what to do. Contrast this to the U.S. during our recent financial crisis. Regardless of how one feels about bailouts, stimulus packages and quantitative easing, the U.S. decisively used every tool available via unified fiscal and monetary policy to pull the country out of the greatest economic meltdown since the great depression. The words “backed by the full faith and credit of the U.S. Government” continue to carry real weight. Until Europe has a true fiscal union, it seems unlikely that they will be a true challenger to the dollar’s reserve prominence.
The reality is there are no real contenders to quickly fill the dollar’s role as primary global reserve currency. Over time, as China’s economy develops and liberalizes (i.e. opens) it may find itself a viable reserve currency candidate. But history suggests this happens over a period of decades not years, and would be far from catastrophic for the United States. In fact, in the long-run a triumvirate ($, Euro, Yuan) of reserve currencies may help to smooth global trade imbalances. U.S. investors have much to worry about, but the dollar’s status shouldn’t be high on the list.
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