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Mar 29, 2017 | 09:00 GMT

Not Much Stands in the Dollar's Way

Not Much Stands in the Dollar's Way
(TEH ENG KOON/AFP/Getty Images)
Forecast Highlights

  • Even though potential U.S. policy moves could undermine the dollar, its days as the world's reserve currency are unlikely to end any time soon.
  • There are no strong candidates to supplant the dollar, since other leading national currencies have drawbacks that limit their appeal to investors.
  • Alternative currencies such as the Special Drawing Right or bitcoin face stability issues because their functioning relies on cooperation among parties that might not be sustained.

In the 19th century, during the glory days of the British Empire, the pound sterling reigned supreme in a world that accepted it as the universal medium of global exchange. But as the wars of the 20th century took their toll on the fading United Kingdom, the U.S. dollar became ever more important, officially supplanting the pound as the world's dominant currency at the 1944 Bretton Woods Conference. It has been the global reserve currency ever since. But how long it can maintain that lofty status depends both on the continued strength of the United States and the status of any potential successor currencies. 

Being the issuer of the global reserve currency can be a mixed blessing. A guaranteed international demand for a national currency means that the country's central bank has much more freedom than its counterparts to print money, since the wider world — rather than just the home state — will absorb the ensuing inflation. This was famously referred to as an "exorbitant privilege" by Valery Giscard d'Estaing, France's finance minister in the 1960s. The exorbitant privilege means the host country could consistently run deficits that in other countries would engender debt repayment concerns. On the downside, a financial bloodstream shared with the entire globe makes the host country vulnerable to forces outside its borders. The choice has thus been characterized as wielding currency either as a sword — an instrument of international influence — by promoting it abroad or as a shield against external pressures by keeping it domestically focused.

Global reserve currency status rests on two pillars: faith and inertia. Because the reserve currency should be the world's safest asset, if global investors begin to lose faith in its underlying safety, its status could slip. Inertia comes into play because countries hold vast stocks of the reserve currency in their central bank reserves, making it difficult to divest, and global trade infrastructure is set up to maintain the status quo. Disrupting this picture would require a mighty force (like two world wars) or a change that unfolds over a long period of time.

Since the recent change of leadership in the White House, questions have arisen about the sustainability of the dollar's role as the global reserve currency. Some of U.S. President Donald Trump's previously stated positions, if they come into being, would likely undermine faith in the currency. While campaigning in May 2016, Trump suggested that if he became president, he might tackle the national debt (currently around 104 percent of annual gross domestic product) by buying it back at a discount, a mechanism he was familiar with from his days in the private sector.

But in this case, his business experience does not transfer to the national level. Creditors of a private company might be persuaded to accept a loss on their investment if they think they are in danger of losing everything in a corporate default. In the United States' case, however, that risk is mitigated by the 14th Amendment to the U.S. Constitution. After the Civil War, southerners threatened to enter Congress and default on the national debt that had been accrued during the conflict. To head off that possibility, the Constitution was amended to say that "the validity of the public debt of the United States … shall not be questioned." This should make a default impossible, barring a further constitutional amendment, which would be extremely hard to bring about for this purpose.

There is a second way to diminish debt, though: inflation. The U.S. debt is denominated in dollars, meaning that in theory the Federal Reserve could print enough money to simply devalue it. While Trump has not made mention of this particular path to debt reduction, it is technically possible, especially as the administration's influence over the Federal Reserve Board deepens through appointments made over the next two years. Investors should therefore take seriously the possibility that the dollar could become a less secure asset in the years to come.

What Could Replace the Dollar?

Of course, focusing on the dollar alone doesn't tell the whole story. Investors considering a move away from the greenback would also have to consider what alternative to move into. And at the moment, there are few contenders that could be considered reliable successors to the dollar.

Euro

The euro is the second reserve currency after the dollar. When the eurozone was created in 1999, some experts predicted that the euro would overtake the dollar by 2015. Since then, however, the divisions among European countries have become ever clearer. Unless the monetary union also becomes a fiscal union with risk-sharing  — an unlikely proposition — investors will be reluctant to put their faith in the euro for fear that the currency bloc could collapse at any moment.

Yen

The Japanese yen would be third in line in its suitability to assume global reserve status. During Japan's period of rapid growth in the 1970s and 1980s, its leaders chose to adopt the shield strategy and did not promote the yen's internationalization, even though many in the United States regarded it as a threat. Today, with the country in a prolonged economic slump and the demographics of its aging population working against it, it is hard to see the yen mounting a challenge for the top spot any time soon.

Yuan

Much has been written in recent years about the rise of China and its currency, the yuan. In some ways, China has made great strides in internationalizing its currency, having made the decision to adopt the sword strategy during the past decade. Currency swap lines and entry into the International Monetary Fund's Special Drawing Right (SDR) basket show that the Chinese have been creating the infrastructure of a reserve currency for the yuan. But so far, few investors or traders have embraced it. In the foreign exchange market, the yuan appears in only 4 percent of transactions (versus the dollar's 88 percent), while accounting for only 1.7 percent of international payments in January 2017 (compared with 40.7 percent for the U.S. dollar). China faces problems largely connected with its political system: Investors are unlikely to allow the yuan to become the global reserve currency as long as China remains an autocracy, since the risk of political interference in its value would be high. With China unlikely to introduce rapid political reforms in the coming years, the yuan will struggle to supersede the dollar.

A Role for Nontraditional Currencies?

While national currencies have served as global reserve assets until this point, some people have argued that the likeliest successor to the dollar could be an entirely new type of currency. Two developing trends, in particular, have the potential to produce nonnational international currencies: the SDR, and cryptocurrencies such as bitcoin.

The SDR functions as the internal money of the IMF. It derives its value from a basket of five major currencies: the dollar, yuan, euro, yen and pound sterling. Countries have SDR accounts at the IMF, and they can credit and debit one another using the SDR if they wish to. The fund makes decisions around the basket, such as which currencies are included and what measures to use to calculate its value. In recent years, a proposal emerged to develop the SDR into a currency that could be used by individuals and companies (at the moment, only countries can use it). With its multinational underpinning, the argument goes, the SDR could be a solution that would prevent any one country from monopolizing the exorbitant privilege.

Bitcoin, meanwhile, is at the leading edge of a wave of cryptocurrencies. These currencies use a distributed ledger mechanism in which users share the burden of the currency's functioning by offering up their computer power, creating a democratic currency that does not need a central bank to oversee it. A 2015 report showed that bitcoin insiders expected it to become the sixth-largest reserve currency by 2030. But at less than $20 billion, the currency's current market cap is still very small on the global scale.

Both the SDR and bitcoin face a similar issue: a lack of agency. What they each purport to offer, in comparison with the usual currencies, is a way to democratize their administration away from any one country. The problem is that neither provides the solid basis and backing that can be afforded by the world's superpower.

In the case of the SDR, it would need an active agent controlling it to become a tradable currency. That "central bank" role would probably be filled by the IMF itself or by a subsidiary. This would likely require the formation of something akin to today's European monetary union, where a central bank exists with a sizable amount of autonomy and without the backing (or supervision) of a single powerful government. This solution would likely face international resistance, especially if the SDR came to be seen as a vehicle only for larger countries with the most influence in the IMF. In addition, such a venture would rely on the continuing cooperation of the world's biggest countries; after all, the IMF itself is the product of nations' willingness to work together. The further empowerment of the IMF needed to develop the SDR would therefore require deeper international cooperation, an evolution that would run against today's political currents. The IMF and the world's international organizations are a product of the Bretton Woods agreement, and any success they have had has largely been due to U.S. support and influence. So, with the United States now turning away from multilateralism, the SDR's prospects of greater prominence appear to be limited.

By their nature, bitcoin and other cryptocurrencies defeat the question of control, since they function without a central bank. But a closer look reveals that in some ways this is a false benefit. Not having an institution to administer it has contributed to bitcoin's rapid price fluctuations. Bitcoin started 2017 with a value of $998. That figure sank to $776 in early January before reaching a peak of $1,291 in early March. While frequent price shifts can be good for speculators, they are not appreciated in a transactional currency where stability is key. Bitcoin's aspirations of developing a better infrastructure, moreover, were dealt a heavy blow in March when the U.S. Securities and Exchange Commission, citing bitcoin's lack of regulation, rejected a proposal to create an exchange-traded fund that would derive its price from the digital currency. One of the SEC's concerns was the large proportion of bitcoins held overseas (particularly in China) in less regulated markets outside U.S. jurisdiction. This is a sign of the difficulties awaiting any nonnational currency attempting to grow within the current system.

Finally, and most detrimentally, bitcoin may be approaching a "hard fork." Two influential sets of bitcoin users are locked in an argument about how the currency should function. There is a chance the groups will go their separate ways, splitting bitcoin in two in the process. This could cause both the original and splinter versions of the currency to diminish in value and importance. These episodes reveal the inherent danger in the democratic nature of bitcoin and its peers. While a democratic system eliminates the agency problem, it also results in a flimsiness that would not exist in a national currency. The U.S. dollar is backed by the land, wealth, infrastructure, culture, institutions, population and military might of the United States, so an investment into the currency is an investment into the whole country. By contrast, the continuing and aligned commitment of a cryptocurrency's community has little to underpin it, which creates a great deal of risk for prospective investors.

The world's financial systems are entering a new period of uncertainty. Some of the truths investors had taken for granted with regard to the dollar may no longer be relied upon, and the currency could become less secure in the future. Nevertheless, a look at the dollar's potential replacements shows that none are close to being ready to assume its mantle as the reserve currency, and in fact many are headed in the wrong direction. For now, then, it seems that the dollar will remain the world's reserve currency for some time to come.

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