Whither the US dollar?

Nov 27, 2008 Editorial

The travails in the financial systems of the US and Europe, which have unfortunately – but unavoidably in the light of the financial liberalisation pushed over the last three decades – infected the rest of the world, have once again raised the issue of the role of the US dollar as the main reserve currency in the world today.

At the Bretton Woods meeting of 1945, the victorious powers of WWII had bowed to the realities of economic, political and military power and conceded the displacement of the sterling which had played that role up to then, by the dollar.

All currencies were pegged to the dollar, which had a fixed rate of exchange to gold. In the following decade, however, the inevitable differing economic development of the major countries placed tremendous strains on the system as currencies were forced to be revaluated to match the economic realities on the ground.
By 1971, even the US was forced to devalue the dollar and abandon the fixed rate of exchange system.

Theoretically, in the new floating rate system that evolved, any of the major currencies could have replaced the dollar as the main reserve currency, but none did because of several factors, which persist to this day – even though they are beginning to be questioned.

There was first and foremost the size of the US economy but even more importantly its position as the major market for the production of countries that hoped to emulate its development.

As these countries, first Europe, then Japan and the Eastern Tigers, and finally China, India and the other Asian economies accepted payment in dollars for the goods they exported, they accumulated huge surpluses of dollars. In effect they were funding the trade deficit of the US by accepting those dollars.

But as was pointed out back in the fifties, in the early days of the dollar as a reserve currency, by the economist Robert Triffin, any national currency used as a reserve currency by other nations was going to face a dilemma without solution. The deficits it had to run to supply the demand for its money would eventually force the devaluation of that money.

One little known foreign demand that the US has to satisfy is from those organisations that use cash only for their transactions – it ships out US$15 billion in greenbacks annually to satisfy this dark “market”.

Just as Europe with it excess dollars had forced the US to devalue the dollar in 1971, most analysts expect that with the record trade deficits that it has been running in the last decade – at least US$1 billion every day – the dollar is punching way beyond its real weight.

This situation has been allowed to continue because the surplus countries – especially China with its almost US$2 trillion and Japan with its US$1 trillion reserves – do not want to allow their currencies to appreciate too much against the dollar so as to make their goods uncompetitively priced.

In the present crisis, the dollar has even appreciated against many currencies because of the second reason that maintains the dollar as a reserve currency: the US is still viewed as a safe haven for liquid assets.

China, especially in view of its historic conservative approach, at this point would not want to sink the boat that holds so many of its apples, by dumping its dollars.

What Guyana, as well as the rest of the world, has to project is what will be the posture of the surplus countries towards keeping the dollar as the major reserve currency after they ride out the present crisis?

Japan has already begun to allow the yen to appreciate against the dollar. Last week, in atypically harsh language, the People’s Daily — a newspaper of China’s ruling Communist Party — said that Asian and European countries should banish the U.S. dollar from their direct trade relations for a start, relying only on their own currencies.

We believe that announcements that the Yuan or the Euro could become the new reserve currencies are premature.

What is more likely in the short term is that while the dollar will continue to dominate, its present 65 percent share will decline and it will definitely be devalued. A basket of leading currencies may be the best hedge.

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