Dollar's volatility leaves battle for reserve currency open
June 18, 2009
By Brian Kantor
A much discussed topic lately is the role of the US dollar as a reserve currency. Such a unit is held as a reserve of international purchasing power or liquidity by governments, banks and firms.
The greenback is mostly nominated as the unit for transacting and accounting purposes for cross-border transactions that do not involve US parties directly.
The US unit became the reserve currency of choice in the 20th century. It was because of the increasingly dominant role played by US firms in global trade and finance that the dollar replaced the pound sterling, which had served this role in the 19th century.
Reserve currencies are not declared by some international agency. They emerge in response to the global needs of trade and finance. The possibility of one reserve currency increasingly replacing another is clearly always open, given the freedom that contracting parties have to nominate the unit of account in which to conclude a contract. Governments and banks also have the freedom to choose the most helpful currencies in which to hold their reserves of international purchasing power.
The advantage to the issuer of a reserve currency, and to the issuer of the bonds or bills held by foreign banks and governments, is that these holdings obviously reduce the issuing government's costs of finance.
What makes issuing notes a particularly cheap source of finance for the government is that foreign holders are prepared to forgo interest on the dollars they hold. A significant proportion of greenbacks in issue are held outside the US.
The fact that the dollar is nominated as a unit of account by trading parties outside the US, or when the US government currency or bonds is used as a reserve of buying power by foreign investors, tells us that there is something unsuitable about a domestic currency that might have been used in this way. This unsuitability presumably arises out of the relative unpredictability of the exchange value of one or the other domestic currency.
It is surely this lack of predictability of the exchange value of the dollar that calls into question its continued role as the predominant reserve currency. Even the unpredictable strengthening of the reserve currency, while highly acceptable to its holders, will make the currency less useful for the purposes of facilitating trade or finance.
The US dollar was very strong in the mid-1980s. It weakened sharply in the late 1980s and traded at these weaker levels more or less stably until the mid-1990s, when a further period of pronounced strength emerged. This was then reversed over much of the past decade. This is not a very impressive track record.
The US, however, is extremely reluctant to commit itself to policies that would stabilise the US dollar if it might mean a less stable domestic economy.
Official comment on the direction of the dollar is never made. But unless the dollar becomes more predictable than it has been recently, the suitability of the greenback and other US government liabilities to serve as a reserve will remain a live issue.
Yet no other currency has presented itself as more predictable than the dollar for this purpose. No other country, or bloc of countries like the euro zone members, seems willing to commit to currency stability as a serious goal of their policies.
The Chinese yuan may offer predictability of exchange value, but it does not offer easy convertibility of yuan assets into other currencies. Most other governments also judge that any commitment to exchange rate predictability, even should such a commitment be regarded as credible, will make it more difficult to stabilise their domestic economies. This is also true of the governments that make up the euro zone.
The contest for global currency supremacy therefore can be regarded as ongoing, because of the reluctance of governments to facilitate such a status.
With the outcomes of this competition for reserve currency status as uncertain as they are now, gold is likely to retain its appeal as protection against the unpredictability of other stores of value.
Brian Kantor is an economist and strategist at Investec Private Client Securities.
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