Ruminations on USD as International Reserve Currency

The governor of China’s central bank recently made a speech, in which he argued that the ongoing global financial crisis was made more severe because of central banks’ use of US dollars as international reserve currency. Others, notably French leaders, have raised this issue in the past. Governor Zhou’s speech is considered a significant signal of possible change in Chinese policy stance as it was made about ten days before G20 summit scheduled in London, where the world leaders are meeting to decide on further necessary actions to stabilize the international financial system.

This concern was first voiced in 1960s by the then French finance minister Valéry d'Estaing, who asserted that United States had exorbitant benefits in the US Dollar being the international reserve currency. French President Sarkozy, recently reaffirmed it in November 2008 saying that dollar could not claim to be the only currency in the world…, that what was true in 1945 was no longer true.

What are the benefits the US is enjoying because its domestic currency is the international reserve currency? Why do France and China appear to be fed up with this arrangement? And for that matter, what the heck is an international reserve currency?

International reserve currency is defined as "a foreign currency held by a central bank or monetary authority for the purposes of exchange intervention and the settlement of intergovernmental claims." In other words it is the currency in which central banks of different countries keep their “reserves”. Central banks have sovereign will to choose the currency in which to park their foreign exchange assets, still US dollar has become the international reserve currency because dollar happens to be the currency in which prices of products traded on a global market, such as oil, gold, etc are denominated.

Because these commodities are traded in dollars, US traders do not have to worry about costs / risks arising from fluctuations in foreign currency. They buy at a little cheaper rate as they do not have to change currencies. They also raise debts at a cheaper rate because everyone is holding dollars and can lend. But these will at best amount to a few basis points (one basis point is 1% of 1%) and cannot be called exorbitant benefits.

To understand that we must realize that even if USD is overvalued United States will never suffer a crisis like Asian Tigers suffered in 1997 or the Latin Americans suffer rather periodically because the USA has all its debts in its domestic currency. It does not need to issue debts in foreign currency as all commodities it needs are priced in US dollars and the US pays for its imports in its domestic currency. In a world of fluctuating currencies the United States with its dollar denominated debts is fairly insulated. If the foreign currency crashes, foreign borrowers take the hit and if the dollar crashes, foreign lenders take the hit! (Devalued dollar will certainly reduce American’s wealth a little bit but will make their exports very competitive and will help increase the output and employment of their economy.)

Chinese concern is understandable as they are the biggest lenders to the US. The expansionary policies being followed by Obama administration has them worried about the likely depreciation of their almost 1.5 trillion USD denominated assets! This concern has always been in minds of the producers / exporters of primary commodities like oil. In June 2003 the Malaysian Prime Minister Mahathir Mohammed had observed that three years ago the euro was worth slightly over 80 cents but it was then worth US$1.20. As oil was priced in US dollars, producing countries were actually getting much less in 2003 than what they got in 2000. He added that perhaps it would be better if payment for the sale of oil was made with the euro equivalent of the US dollar.

The importance of the currency of crude trade can be guessed from the whispers floating in 2001 that Iraq was invaded at least partly because in November 2000, it began selling its oil in euros. The invasion forced Iraq back to the dollar and dissuaded Iran from switching to the euro for its oil sales.

Governor Zhou’s speech extensively refers to the dilemma faced by the issuer of the international reserve currency i.e. the US central bank. It needs to issue adequate volumes of dollars to provide liquidity to the world and in the process it cannot maintain the value of dollars. Though the dilemma of value vs volume is faced by all central banks, the issuer of international reserve currency has two constituencies to bother about – domestic and international. Often their needs will be clashing.

Consider today. Americans’ need recapitalized banks and high liquidity to ensure flow of abundant credit at low costs to stimulate growth. This calls for large-scale printing of green backs and that naturally worries Zhou sitting on a heap of 1.5 trillion dollars.

Noted currency economist Avinash Persaud had observed a few years back that in coming decades USD will be replaced as the international reserve currency by Yuan. For the time being Zhou is less ambitious and is only demanding revitalization of SDR – an international currency issued by IMF, the value of which is determined with reference to a basket of four currencies – USD, euro, GBP and Yuan. The mechanism is already in place but there is no liquidity in SDR. Total issued SDR’s amount to less than $30 billion. There is a proposal for increased issuance of SDRs, but it has not yet mustered the required 75% votes in IMF because US (with over 17% voting rights) is playing coy.

It is interesting to note that China has come to own trillions of dollars of US treasury papers out of its own free will, indeed eagerness to ensure that Yuan does not appreciate against dollars and Chinese imports enjoy continued competitiveness in the incomparably vast US markets. In the process the US deficit has climbed up in excess of 6% of its GDP. If USD gets devalued Chinese will suffer double whammy. Their pile of USD will be worth less and the consequent upward rise in Yuan will make their exports that much less acceptable in the US.

Now let me put across an unthinkable question. With faltering economy and mounting debts can US choose to default on its obligations?

Unthinkable though it does appear today, it has precedents! Till 1933 the US government was bound to pay to a bearer of its currency notes the value of the note in gold. In 1933 it resolved to pay the bearer the value in the very same kind of notes! The absurdity of it was challenged in courts that recognized it as a repudiation of the government’s undertaking, even deplored this refusal to fulfill a solemn promise but concluded that the government through the exercise of its sovereign power had rendered itself immune from any liability for this action.

In a similar exercise of sovereign power Nixon administration in 1971 had "closed the gold window" repudiating the pledge (which was a cornerstone of the Bretton Woods arrangement) to convert dollar in gold at $35 per ounce official price. Dollar henceforth became convertible into gold at open market prices and just before the Bretton Woods system officially closed in 1973 dollar was worth $44 per ounce of gold.

Many of us still may be viewing default by the US, even a partial one where the US commits to pay only half the amount of its IOU’s (that is what treasury notes are, in fact) too bizarre an idea. I will request them to think in terms of official devaluation of dollar. This after all does not appear all that outlandish. Suppose Obama and Bernanke decide to devalue dollar by half. The impact for foreigner holders of US treasury notes (China, Japan, India among the larger ones) will be that they will be receiving half the value of their dollar assets in other currencies. Exactly the same as if US had decided to repudiate half of the external claims on its treasury! Devaluation does seem far more plausible than default on treasury papers though it has the same impact for external lenders.

The situation today eerily reminisces the late 1960s and early 70s. Vietnam War had accelerated inflation in the US and the country was running, for the first time in the 20th century, a trade deficit. The inflection point was reached when nations believed that the US was not capable of cutting its budget or its trade deficit. Dose it ring familiar today?