‘The dollar is our currency, but your problem’ warned US President Richard Nixon’s Treasury Secretary, John Connally. His warning came more than five decades ago, but for many emerging economies it rings as true today as it did back then.
After the global financial crisis, many emerging economies scrambled to get access to US dollars to save their economies. A few months later, the US Federal Reserve started quantitative easing and they had the opposite problem as a huge inflow of US dollars pushed up their currencies and inflated their asset prices. Years later, it started tapering its quantitative easing program and an appreciating dollar led to a sharp tightening in global financial conditions, pushing many countries into difficulty or, in Argentina’s case, into a full-blown currency crisis.
Things have not improved much since then. US President Donald Trump now threatens to weaponise the US dollar, demonstrating a willingness to deploy financial sanctions that far surpasses his predecessors. He has repeatedly called for a weaker dollar to claw-back trade demand from other countries and continues to place unprecedented pressure on the politically-independent US Federal Reserve to bring down the dollar and push down interest rates, tweeting as recently as this week that: ‘Jay Powell and the Federal Reserve fail again’.
Given this track record, it is little surprise there is growing dissatisfaction with the US dollar’s dominance in the global economy, a dissatisfaction which Trump is worsening. This is not an unforeseen problem. Called the Triffin Dilemma, Robert Triffin warned back in 1960 that having the US dollar act as the global reserve currency creates a conflict of interest between short-term domestic and long-term international objectives for countries which issue global reserve currencies. Keynes made similar warnings in his advocacy for a global reserve currency — the bancor — instead of relying on the US dollar.
The reserve status of the dollar means that the United States must be willing to supply the world with an extra supply of its currency to fulfil global demand for foreign exchange reserves. The upshot for the United States is that it enjoys lower interest rates, increased investment and cheaper consumption, allowing it to borrow and spend well beyond what other countries could get away with. But as the inverse of this inflow of investment, it must also be willing to run a large trade deficit — the very thing Trump laments. Unfortunately for Trump, he cannot have it both ways.
While some things can be blamed on the dominance of the US dollar, it cannot be blamed for everything. Countries which commit the ‘original sin’ of borrowing in a foreign currency do so because it is cheap and their financial regulations are lax, not because of the US dollar’s dominance. The requirement that countries stockpile foreign exchange reserves to preserve financial stability similarly has more to do with an inadequate global financial safety net than it does with the US dollar’s dominance. Around 50 per cent of global trade and current account imbalances are the result of domestic policy distortions, according to the IMF, such as inadequate social safety nets that fuel excessive savings.
Nevertheless, the serious problems with the dollar’s dominance in the global economy have led to a renewed interest in possible alternatives.
The most commonly cited alternative is the hope that another currency, or set of currencies, could take the place of the dollar. Such proposals are quickly defeated by reality. The euro area has no united fiscal authority to back its currency, China’s currency is too inflexible and heavily controlled and non-US currency markets are woefully inadequate in terms of depth and liquidity. The US dollar, as Adam Posen puts it, wins ‘the least ugly’ contest.
This has led many, most notably Bank of England Governor Mark Carney, to propose more innovative solutions. At Jackson Hole in Wyoming, Carney proposed that a new virtual reserve currency be created, not dissimilar to Facebook’s Libra, in which the value of the digital currency is based on a basket of global currencies. Unlike Libra, this digital currency would be regulated by central banks who would work together to ensure the currency is well governed. Not everyone is convinced. Synthetic baskets of currencies have not been successful in the past, argues Posen, and developing a new digital reserve currency would take time and significant international cooperation.
Others believe that we need not bother with new currencies at all. They argue that an existing framework already exists: the IMF’s special drawing rights (SDRs). In this week’s lead essay, Matthew Harrison and Geng Xiao argue that the dollar should no longer be the reserve currency, but neither should the renminbi. Instead, introducing wider systematic use of the SDR would help solve the challenges of the current system.
‘The SDR represents a basket of the world’s leading currencies, with its value based 42 per cent on the dollar, 31 per cent on the euro, 11 per cent renminbi, 8 per cent sterling and 8 per cent yen — a weighted combination of the world’s major currencies’. If the SDR could be used for trade settlements, reserve holdings and investments, Harrison and Geng argue that the stresses and imbalances of the international monetary system would be reduced dramatically. The question is how this could be achieved.
Harrison and Geng think that China could play a lead role too. They propose that China should make the SDRs integral to its capital account liberalisation. Via Hong Kong, core infrastructure around SDR pricing, settlement and daily interest rate-setting should be established where China-based issuers seeking foreign currency would get preferential approval for SDR bond issuance. For China, they see an SDR initiative providing a mechanism for financial market opening in a controlled manner. And ‘since the SDR is around 11 per cent renminbi, further renminbi internationalisation would be achieved at a stroke and China would gain kudos as initiator’.
Harrison and Geng write that a flourishing SDR market would be a valuable asset for the world and would help contribute to a more stable international monetary system, and perhaps greater understanding between countries. Time will tell which proposals may ultimately unseat the US dollar, and if any manage to do so. There is as much uncertainty around the future of the US dollar as there was with the pound sterling before the world wars.
Ultimately, it seems that only two things are certain: unseating the US dollar will be a slow process, but it is a process which is being sped-up by President Trump.