Over the past several decades, the U.S. dollar has enjoyed its status as the world’s most important and dominant reserve currency. Every major government and financial institution in the world now holds significant quantities of U.S. dollars as part of their foreign exchange reserves. However, are we seeing that the dollar’s role as the world’s dominant reserve currency may be coming to an end? But before getting into the details of Reserve currency and its evolution, let us take a walk into the fact that might draw the end of period of the dominance of US dollar. In 1965, the United States of America was the largest creditor nation in the world. Today, it is the world’s largest debtor nation. Figure 1: Brother, can you spare a couple billion? The most widely quoted figure for the debt of the United States is called the national public debt. U.S National Debt Clock in Manhattan quotes the figure currently at $12.311 trillion  . It has increased from $2.6 Billion to $12.311 trillion in the past 100 years. We will start analyzing this first by understanding what exactly is a reserve currency, its evolution and why does it matter?
In the foreign exchange market and international finance, a world currency, supranational currency, or global currency refers to a currency in which the vast majority of international transactions take place and which serves as the world’s primary reserve currency  .
A reserve currency, or anchor currency, is a currency which is held in significant quantities by many governments and institutions as part of their foreign exchange reserves. It also tends to be the international pricing currency for products traded on a global market, such as oil, gold, etc  . It is held by central banks and other major financial institutions of different countries enabling them to pay off international debt obligations and influence their domestic exchange rate. Adding to this is the fact that Reserve currency allows the issuing country to purchase the commodities at a marginally lower rate than other nations. For major currencies, this transaction cost embedded in currency change is negligible with respect to the price of the commodity. The government issuing the currency will be able to borrow money at a better rate, as there will always be more liquid market for that currency than others.
Evolution of Reserve Currency
Spanish dollar: 17th-19th centuries
The Spanish dollar (also known as the piece of eight, the real de a ocho or the eight-real coin) is a silver coin, worth eight reales, that was minted in the Spanish Empire after a Spanish currency reform in 1497. Because it was widely used in Europe, the Americas, and the Far East, it became the first world currency by the late 18th century. Many existing currencies, such as the Canadian dollar, United States dollar, and the Chinese yuan, as well as currencies in Latin America and the Philippine peso, were initially based on the Spanish dollar and other 8-reales coins  . Figure 2: Source: https://en.wikipedia.org/wiki/File:Philip_V_Coin.jpg In the 17th and 18th century, the use of silver Spanish dollars or “pieces of eight” spread from the Spanish territories in the Americas westwards to Asia and eastwards to Europe forming the first ever worldwide currency  . There were 3 major reason that helped Spanish dollars entroute to being the World currency  : Spain’s political supremacy on the world stage The importance of Spanish commercial routes across the Atlantic and the Pacific The coin’s quality and purity of silver.
19th – 20th centuries
Before 1800s and during the same, most domestic currencies were dimensioned against Gold weights and International trade was designated in terms of these currencies which in turn stood for the weights of gold. The economic unit of account is a fixed weight of Gold. Hence, we can say that world’s first global currency was gold  . Three distinct kind of Gold standard prevails: Gold specie standard: System in which monetary unit is associated with circulating gold coins Gold exchange standard: Involve the circulation of silver coins, or coins made of other metals, but the authorities have guaranteed a fixed exchange rate with another country on the gold standard, creating a de facto gold standard Gold bullion standard: System in which instead of circulation of gold coins the authorities have agreed to sell gold bullion on demand at a fixed price Governments, especially during the War times, faced with the need to fund high levels of expenditure especially the military expenditures, but with limited sources of tax revenue, suspended convertibility of currency into gold on a number of occasions. This lead to the collapse of International Gold standard and the emerging collapse around the time of World War I had substantial significances on global trade. After the Second World War, a system similar to a Gold Standard was established by the “Bretton Woods Agreements”  . Under this system, many countries fixed their exchange rates relative to the U.S. dollar. The U.S. promised to fix the price of gold at $35 per ounce and the exchange rates around the world were nailed against the United States dollar. United States Dollar became the dominant Global Currency and was characterized by the fact that it can be exchanged for a fixed amount of gold. But by 1970, with the repeal of Dollar reserves by French Government and by the tight Fiscal strain of federal expenditures for the Vietnam War, President Richard Nixon ended the direct convertibility of the dollar to gold in 1971, resulting in the system’s breakdown, commonly known as the “Nixon Shock”  . Espousing the collapse of the fixed exchange rate regime, repeal of the gold standard and the institution of floating exchange rates as per the Smithsonian Agreement in 1971, most currencies around the world no longer are benchmarked against the United States dollar. Even then United States dollar got increasingly used as the main currency medium for conducting Global Trade.
Factors influencing the decision of Central Bank of a country to hold a particular currency as Reserve Currency (Lim 2006 and Cohen 2000)
Amount of World Output and trade: The larger the more likely it is that other countries will use it Macroeconomic and political stability, leading to stability in currency’s value High degree of financial market development Network externalities emulating a self-generating demand for the currency
Economic Reasons for United States Dollar becoming the Reserve Currency
United Stated being the preeminent Economic superpower United States Dollar was stable in value and freely convertible. Convertible currency is any type of currency that can be quickly purchased or sold without the need to obtain permission from some sort of central bank. The convertible currency may be used to obtain other forms of currency, or utilized to purchase gold United States Dollar was less subject to exchange depreciation or exchange controls than other currencies New York offered a broad range of financial facilities for the short-term investment of reserve funds Because of the depth in the market, large purchases and sales of liquid financial assets in New York could be effected without sizable change in their prices No other financial market, except possibly that in London, offered comparable facilities. But Sterling appeared subject to the risks of both depreciation and of inconvertibility to a greater extent than the United States dollar Above all, the ability of United States financial facilities and capital market to meet the needs of other countries in a satisfactory way in which they can hold the reserve currency
Benefits associated with United States Reserve Currency role
A country, here in our case United States benefit immensely because United States dollar is the predominant reserve currency. The benefits associated are: United States benefits from the increased demand for the dollar that the reserve currency status creates. This increased demand in turn adds significantly to the value of United States Dollar Other countries give goods and services to United States in exchange for United States Dollars issued by the Federal Reserve Other Countries also lend the Dollars they have accumulated back to United States at low interest rates United States benefits from importing these goods and exporting its inflation to other countries in the form of depreciating dollars Improved efficiency of New York financial markets due to immense complexity arising of the opening up of financial markets across the word in tandem with globalization United States enjoy the luxury of having increased flexibility in financing United States payment deficits
Costs associated with United States Reserve Currency role
Restrain on Independent domestic monetary policies. Being the Reserve currency country United states have reduced ability to pursue an independent monetary policy, especially when the United States is in a recession Ineffectual intentional devaluation of United States Dollar. Even if United States wants to devalue their currency it is not possible as other countries also will devalue their domestic currency in the same proportion. United States is so important in Word trade that if there is a devaluation done by United States, other countries in order to preserve their international competition are succumbed to domestic currency devaluation Burden of supplying reserves to other countries and also the burden of maintaining a complex financial market system Last but not the least is the immense risk associated with a full flush out of United States Dollars by the countries having Dollars as currency reserve. This effects out as a sudden devaluation of the United States Dollar coupled with loosing the benefits and status associated with the Stature of International Reserve currency
Whether a Single Reserve Currency: An Economic Viability
Figure 3: Source: https://en.wikipedia.org/wiki/Reserve_currency In practice we can see that United States Dollar account for 64% of the Currency composition of official foreign exchange reserves. But on a theoretical front, economists have two opposing views on viability of a single reserve currency always dominate the global economy. YES View: Due to the presence of Network Externalities one currency will almost always dominate. Network externalities arise from the field of invoicing trade and denominating foreign debt securities. This means that there are strong incentives to conform to the choice that dominates the marketplace  NO View: Economists such as Barry Eichengreen  differs from the view of existence of Network externalities since they are not substantial. As far as the currency’s market is liquid, there is strong scope for reverse diversification and capital losses can be hedged against. The implication is that the world may soon move away from United States Dollar. Hartmann (1998) and Eichengreen (2005) point out that although some theoretical analyses based on network externalities in the use of money for transactions suggest that there will be only one international currency, this argument does not apply to the currency of denomination of reserves
Is the World moving away from United States Dollar?
More than 60% of the World’s reserve currency is held in United States Dollars. Then why would Mr. Greenspan think that the euro might replace the dollar as the world’s predominant reserve currency?
As the world moved on with Globalization as one of the main drives, United States Dollar started facing serious challengers as a world currency. During the latter half of 1980s, the Japanese yen started appreciating from 225 Yen per Dollar in 1985 to 128 Yen in 1988. Also Yen started became increasingly used as an international currency. This period coined as the “Japanese Asset Price Bubble” lasted for a decade and after which as expected the world saw the Japanese Recession in 1990s. Thus we can see that Japanese Yen never posed real threat to the stature of United States Dollar as World Currency. More recently, the Euro has been gaining ground as reserve currency since it was introduced in 2002. Now, only seven years later, approximately more than one-fourth of the world’s reserve currency is held in Euros.
Recent developments in international financial markets add pressure on the dollar. First, the emergence of the euro offers a serious alternative placement for foreign assets. Moreover, after a brief initial period, transaction costs in the euro currency markets have fallen drastically. Second, several other industrial countries’ currencies have also enhanced their liquidity and thus also offer attractive alternative assets for further diversification (Optimal Currency shares in International Reserves: The impact of Euro and the prospects for the Dollars by Elias Papaioannou, Richard Por tes and Gregorios Siourounis; European Central Bank, Working Paper series, Nov 2009) For determining the determinants of reserve composition researchers have done regression on actual currency shares on Macroeconomic, monetary and financial factors. Chinn and Frankel (2005) used aggregate IMF data to investigate determinants of the global composition of international reserves. Their projections suggest that it will take at least 25 years for the euro to challenge the dominance of the dollar as a major reserve currency, unless there is a major deterioration in the stability of the dollar (depreciation, inflation) Dooley, Lizondo and Mathieson (1989) and more recently Eichengreen and Mathieson (2000) utilized confidential IMF data to investigate the high persistence. Both studies found that currency pegs, the direction of trade, and the currency of foreign debt can explain the high inertia in reserve composition The U.S. supply of liquidity to the world must be matched by comparable demand on the part of foreign investors (Stiglitz, 2006). United States need the cooperation of other nations. In effect other nations must realize trade surpluses and thus lend to the United States to finance its trade deficits. Because the United States is an important supplier of both reserve currency and assets for international reserves, it must issue monetary liabilities that are sufficiently attractive for acquisition by other nations. However United States Dollar does not fulfill all the prophesies for the stature of Reserve currency. The root cause for the same is the existence of huge debt burden. America’s $54 trillion financial obligation is almost 400% higher than estimates for 2008 U.S. GDP. In fact, the sum of these obligations is nearly the equivalent of estimates for 2008 world GDP. The sheer size of this financial responsibility is fair grounds to even question the solvency of the United States. Another important reason which can give immense pressure on the status is the fact that United States Dollar’s value is getting depreciated. Against major currencies, the dollar depreciated by about 33 percent during 2002-2009. The economic crisis of 2007-09 has created doubts about the stability of the structure of economy, capital market and United States Financial system. Aggravating this is the financial stimulus packages offered to overcome the crisis, which in turn pushed up the inflation further debasing the United States Dollar value. China, which holds about 60 percent of its $2.273 trillion  foreign-exchange reserves in dollars, is especially vulnerable. China would like to diversify out of dollars, as seen in its decreased purchases of U.S. Treasury securities in 2009. Same is the case with Russia who criticizes United States of digging a hole with an economy based on huge deficits and massive borrowing, creating a cloud on Dollar’s future. Critics claim that claim that a credit-based reserve currency such as the dollar is inherently risky, facilitates global imbalances, and promotes the spread of financial crises. As a result, they argue that the dollar should no longer serve as the world’s reserve currency (Robert J. Carbaugh and David W. Hedrick, 2009). If the United States Dollar needs to be dethroned, who can be the next contender? – EURO, YUAN or A new single Global Currency.
Can Euro Supplant Dollar?
IMF estimates suggest that since 2001 developing countries have reduced the share of dollar-denominated assets in their foreign-exchange reserves from 70 percent to 60 percent. Also at the same time they have increased the share of euro-denominated assets in their portfolio by nearly an equal amount. However, according to the IMF survey Developing countries are not dumping dollars. They continued to add dollars to their portfolios, but they have acquired Euros and British pounds at a faster rate. Figure 4: Source: International Monetary Fund, COFER data Money reduces the cost associated while economic exchange. The more widespread the currency is more valuable and more acceptable it will be for the country holding it. Thus the whole point of a currency capable of becoming a reserve currency stems from having a large domestic base. Euro has all the potential for this. United States has a population of 308 Million  and renders a GDP of around $14.4 trillion  . European Union encompasses of 27 nations, population of 501 million and renders a GDP of around $18 trillion  . Of the 27 nations, 14 have adopted Euro as the currency. Thus as more nations start adopting Euro the domestic base of Euro is going to increase. This makes Euro most attractive to peg against. Adding to this is the fact that the European financial market is deep and broad. Hence as seen in the trend and as we move ahead, foreign companies and governments will denominate more of their securities in Euros and foreign banks will give and make more loans in Euros. If European Union countries not currently using Euros (especially UK) accept Euros then by 2020 United States Dollar will loose dominance (Menzie Chinn & Jeffrey Frankel, 2008).
Arguments that goes against Euro taking dethroning United States Dollar as reserve currency
United States Dollar enjoys the network externalities. It has got the inertia from being the mostly used currency in the International market United States Dollar market enjoys the advantage of being larger in size, credit quality and liquidity over the Euro market As seen with the Ups and Downs in the value of United States Dollar, even Euro’s value has fluctuated from $1.6 per Euro in 2008 to $1.3 per Euro in mid 2009 If United States if able to unwind its current macro-economic imbalances then United States Dollar value will increase and it will be difficult to dethrone the same from its stature
Can the World accept “Supranational” currency (Single Global Currency)?
International Monetary Fund Managing Director Dominique Strauss-Kahn’s vision of “an IMF of 21st century” is envisaging on the call to provide a globally issued reserve asset, similar to-but in important respects different from-the SDR (Address at the Annual Meeting of the Bretton Woods Committee in Washington, DC, Friday February 2010)  . A single global currency refers to a hypothetical single global currency or supercurrency, as the proposed terra or the Dey (acronym for Dollar Euro Yen)  , produced and supported by a central bank which is used for all transactions around the world, regardless of the nationality of the entities (individuals, corporations, governments, or other organizations) involved in the transaction. No such official currency currently exist  .The major push for the Single Global Currency came from Russia and China in March 2009, when the Kremlin  called for a supranational currency as part of the reform of the Global Financial system. Later in the same month, Zhou Xiaochuan, President of the People’s Bank of China, called for “creative reform of the existing international monetary system towards an international reserve currency,” conceiving it would “significantly reduce the risks of a future crisis and enhance crisis management capability  . However there are both costs and benefits associated with the implementation of a Single Global Currency. The advantages of going for a single global economy are analyzed by Ratnam Alagiah in the paper “Writing the Future: A theoretical Justification for a uniform and universal system of currency in accounting for inflation”, Journal of Modern Accounting and Auditing, July 2009. He compares the benefits associated with signal world currency as with having a single domestic currency. The advantages gained are: Reduction of the inflation rate to one common rate (if required) among all states Possible reduced Interest rates Expansion in investment Increase in development and trade due to the removal of uncertainty Reduction in transaction cost Reduction in cost of capital (Moshirian, 2004, Page 306) Apart from the benefits, one positive factor which can drive the confidence in the emergence of the Single Global currency is the evolution of Euro. In the past, in the absence of the Euro, with the diverse currency regimes across Europe, financial institutions in Europe were more exposed to fluctuation from foreign exchange and foreign exchange risk than now. Thus, emergence of the Euro has been a step in the right direction. This step forward can be seen as a crusade of emergence of Single currency in the 21st century, creating right environment for all key stakeholders and players in an increasingly integrated global environment. While introduction of a Single Global Currency has lots of positive effects, the implementation of the same poses serious challenges and threats. The vast diversity in the existing national political and economic system will create a stop block in the introduction meeting all the ends up. Other reasons impeding the evolutions are the loss of National monetary policy and religious difficulties. For Single Global Currency adoption to take place, as pointed by the theory of Optimum Currency  is the existence of Capital and Currency mobility. But Fariborz Moshirian in his paper, ” Global Financial Services and a Global single currency”, Journal of Banking and Finance, August 2006, analyses that “that a number of assumptions made as part of an optimum currency theorem are no longer relevant to the financial and economic forces that are in operation in the 21st century. It appears that labor immobility may not inhibit the process of financial integration amongst various developed and emerging countries, as capital mobility is ensuring that nations that are the recipients of foreign capital could develop their economies and increase their level of integration with the global economy”. Denotations are that one hand while banks may loose some income due to less trading in foreign exchange, lower interest rates, lower inflation and more business predictability, banks will benefit from better investment opportunities, more dynamic growth, demanding more credit but at lesser credit risk.
Will YUAN be the next reserve currency?
TBD: To be completed in the Main Final Project report. Here I will be giving insights about whether Chinese Yuan has the potential of being the next world currency and if not what are the reasons. Also I will provide facts about whether it can fulfill the prophesies for the stature in the near future. TBD: If the World can accept a single Global Currency, How will be the International Market articulate the phasing out scheme of the current Reserve currency, United States Dollar. By taking inputs from the Research Paper, “Can SDRs and a Reserve Currency Coexist?” by Henry N. Goldstein, I will try to analyze the possibility of an exist phase where there is diminishing amounts of United States Dollars, Euro, YEN, YUAN and other currencies, while at the same time increasing amounts of “Single Global Currency”.