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Dollar Reserve Status Is Tale of Fading Glory: Michael R. Sesit
Commentary by Michael R. Sesit
May 2 (Bloomberg) -- Reserve currency status is like your health: Abuse it, and you risk losing it.
With the dollar's 45 percent decline against the euro during the past six years and its 37 percent drop on a trade-weighted basis, there is a growing concern that the greenback's six-decade reign as the world's most important currency may be ending.
It's not. The dollar is the world's reserve currency, and absent some unexpected exogenous shock, will probably remain so for some time.
Nonetheless, the dollar's premier status is under threat, especially as a store of wealth, by both foreign governments and private investors. Also, companies are using it less as a currency in which to invoice and settle international trade transactions.
Why care? Reserve currency status allows the U.S. government to borrow in its own currency, lets the U.S. run large trade deficits, and helps the government and American companies to fund themselves at low interest rates. It makes it easier for U.S. companies to do business and increases the international demand for U.S. assets.
Moreover, as the specie of choice, the dollar is blessed with seigniorage, the interest-free loan America receives from the hundreds of billions of dollars held overseas and hoarded as misfortune insurance.
Although the composition of official central-bank foreign- exchange holdings receives the lion's share of attention when people talk about reserves, it is the private sector's trade in goods and services that plays a dominant role in determining a currency's international status.
Cash Reserves
Official reserves equal 33 percent of global imports, according to UBS AG. If a company in country A trades with a company in country B and the transaction is invoiced and settled in the currency of country C, that third currency will have reserve status. That's because both companies are likely to keep cash balances in that currency.
``The dollar is the most important reserve currency in the world, but it is no longer the only reserve currency, nor even the overwhelmingly dominant choice as a reserve currency,'' says Paul Donovan, a London-based economist at UBS.
When the Bretton Woods system collapsed in 1971, almost all Japanese exports were priced in dollars. Now less than half are. About 40 percent of Japan's total exports are invoiced in yen, up from 34 percent in 2001.
Raw Materials
Seventy percent of Australia's exports are denominated in U.S. dollars, reflecting the dominance of raw materials in their makeup. Apart from commodities, the dollar plays a smaller role. For instance, 59 percent of beverage shipments to other countries are denominated in Australian dollars, 19 percent in pounds and 16 percent in U.S. currency.
Data on country invoicing patterns are hard to come by. Still, the decline in dollars held outside the U.S. from 1.83 percent of world trade in 2002 to 1.22 percent in 2006 reflects the U.S. currency's shrinking role as a medium of exchange.
Anecdotal evidence also suggests a trend. In November, India's Taj Mahal said it would no longer accept dollars and take only rupees. International drug dealers are said to prefer euros to dollars.
Ditto, Copenhagen-based A.P. Moeller-Maersk A/S, whose container-shipping line, the world's biggest, on April 1 began invoicing in euros for transporting containers from Europe and North Africa to Australia, New Zealand and the South Pacific. The shipping industry historically billed in dollars.
$4.9 Trillion
On the official side, developing countries have been steadily inching away from the dollar. Their foreign-exchange reserves surged to $4.9 trillion in 2007 from $1.2 trillion in 2000. Emerging-market countries accounted for 76 percent of total global reserves in 2007, up from 56 percent in 1997, according to the International Monetary Fund. Yet during that period, their dollar holdings shrank to 61 percent from 73 percent.
The euro has been the beneficiary, rising to 28 percent of developing-country reserves in the fourth quarter from 19 percent when the decade began.
Behind this dollar downgrade lies the U.S.'s rising debtor profile, an unpopular war in Iraq, the growing threat of trade protectionism, apprehension over the greenback's decline and the subprime crisis.
``These factors have all conspired to weaken investor confidence in the buck and undermine the dollar's position as the world's top currency,'' says Joseph Quinlan, New York-based chief market strategist at Bank of America Capital Management.
Asian and oil-exporting central banks also hold more dollars than they prudently need and are seeking to diversify their portfolios away from their traditional preference for highly liquid, relatively low-yielding Treasuries.
No Allegiance Owed
Many countries -- including China, Russia, Kuwait, Singapore and Norway -- are transferring tens of billions of dollars to sovereign wealth funds. Long-term investors with mandates to maximize returns, these entities owe no allegiance to the U.S. currency and over time their investments will probably result in their governments' holding fewer dollars.
The durability of the dollar's reserve-currency status owes more to the absence of a challenger than sound U.S. policies. The euro is hobbled by the lack of a single, pan-European capital market and its being a hybrid currency used by a mix of countries yet owned by none.
China's yuan is a potential contender, but not until that currency becomes fully convertible, the nation's financial markets more developed and internationally recognized laws more established -- which is years away. Japan, meanwhile, has always resisted the yen being a reserve currency.
It isn't ordained that the dollar surrender its position as the world's go-to currency. Yet if Americans insist on living beyond their means, eschew sound fiscal policies, ignore the greenback's weakness and remain tempted by protectionism, the dollar will in small bites begin to mimic the British pound -- the currency of a once proud but spent imperial power.
