Does the world need another reserve currency?

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We are back…

There has been nothing short of good news regarding the recovery of America’s economy since the 2008 financial crisis. The Standard and Poor’s 500 (S&P500) has been reaching record highs and Non-farm Payroll (NFP) has also increased with 288,000 jobs added in the month of June. With Janet Yellen’s Federal Reserve continuing to taper quantitative easing, consumers and investors alike believe that there will be an imminent recovery. Before long, we may return to the good old days. Or so it may seem.

… Or so it may seem

The US recovery from the Great Recession has been the weakest since the post-war era. Previously dubbed as the “New Economy”, due to its big economy with a relatively free capital flow, reliable banking system and a huge export clout, the United States Dollar became the de facto currency of the world and the choice of foreign currency asset, which countries hold in reserves. This “New Economy” is no more, and along with it, the USD’s reliability as the World reserve currency. The United States may lose its exorbitant advantage it has been enjoying as the World’s reserve currency.

Losing steam for the long haul

During the mid-90s, economists predicted that America’s potential rate of growth to be about 3.5%. Merely two decades later, the IMF has cut its estimates to a mere 2%. Some financial institutions and economists put the figure even lower. Despite the seemingly great display of recovery by the United States in the recent months, Investment Bank J.P Morgan estimates that America’s potential growth to be 1.75% - half the rate two decades ago. Such figures speak a great deal regarding United States’ future as an economic powerhouse. Failure to increase United States’ long run productivity growth rate will result in loss in competitiveness from other economics powerhouses. Bearing in mind that the issuer of the world reserve currency needs to have sufficient economic clout, losing its long run productivity growth rate and having a weak economy will erode United States’ ability to project power and dominance to the rest of the world, causing the USD to inevitably lose its status as the world reserve currency.

Not-so-risk-free afterall

Most, if not all, business and economics students are taught that US Treasury Bills and Bonds are considered as risk-free. The fiscal cliff and the United States federal government shutdown of 2013 proved otherwise, challenging traditional “wisdom”. With the Federal Reserves narrowly avoiding a default, we can hardly call Treasury Bills and Bonds as risk-free assets. The failure of the United States government to reach a bipartisan agreement in their political brinksmanship, while holding the world economy “hostage”, has resulted in countries having doubts in the United States government’s commitment in ensuring a stable global financial market. The implications in the event of a United States default will be unthinkable. Who is to say that such fiscal brinksmanship will never happen again? Countries will prefer not to have the fates of their domestic economies tied to the outcomes of domestic bickering in the United States.

Every man for himself

Governments are self-interested parties that prioritise the needs of their own country before others. Therefore, it is understandable that the United States government put the interest of their people first before others as they have an obligation and the need to account to their electorate. As such, there exist a conflict of interest between choosing appropriate macroeconomics policies to fuel growth in the United States domestic economy and its implications to holders of United States Treasury Securities. Leading up to the sub-prime mortgage crisis in 2008, loose monetary policy and easy access to credit in the hopes of fuelling consumption and demand in the United States eventually resulted in the greatest bailouts which the world has ever witnessed. The result was catastropic to say the least, with the United States taxpayers and the rest of the world having the pay the price. Countries all over the world holding United States Treasury Securities as reserves faces increased risk as these assets value are tied to United States’ choice of macroeconomic policies, which they have little or no control over.

No way out?

By this point, people may be starting to wonder, “what makes the dollar so attractive?” or “ why then is the world still using the dollar as the choice reserve currency?” The answer: There simply are no good alternatives. There exist several other alternatives that come to mind when the topic of world currency reserve is being discussed. However, none of them seem to be “good enough”. While the Euro is one of the popular reserve choices, the Eurozone is still undergoing economic and political instability. With plenty of countries still in denial of overspending and under-taxing, it is an unlikely candidate to completely take over the status from the USD. The Japanese Yen, another currency used in reserves, is also an unlikely contender for the status with Japan’s mounting public debt and uncertainty revolving around the effectiveness of Abenomics. The China Renminbi is the closest sovereign currency contender for the reserve status. However, the Chinese government is known for its heavy hands in manipulating foreign exchange rates and capital controls. For the Renminbi to take over the status, the Chinese government needs to be willing to liberalise capital flows as well as to undergo significant political and institutional reforms. This is highly unlikely given China’s cautionary stance towards their economic policies.

While there seems to be no clear choice in a sovereign currency that can take over the global reserve status, there have been calls by numerous parties (most notably China, Russia and the Gulf States) for a supra-sovereign currency in the form of the IMF’s Special Drawing Rights (SDR). The United Nations Conference on Trade and Development (UNCTAD) and the International Monetary Funds (IMF) have also issued reports in support of the use of a new reserve currency, based on the SDR, which will be managed by a new global reserve bank. This new supra-sovereign currency is said to be safer and provide better stability for the global financial market. It also allows countries to be insulated from large shocks resulting from other Central Banks’ decisions to use macroeconomic policies as tools for promoting growth in their own economies. Some countries have already begun using SDR in the foreign exchange markets.

The inevitable

Economist Avinash Persaud once stated, “…reserve currencies come and go. They don't last forever. International currencies in the past have included the Chinese Liang and Greek drachma, coined in the fifth century B.C., the silver punch-marked coins of fourth century India, the Roman denari, the Byzantine solidus and Islamic dinar of the middle-ages, the Venetian ducato of the Renaissance, the seventeenth century Dutch guilder and of course, more recently, sterling and the dollar.” A push for a world maket dominated by the dollar is nothing new. The recent financial crisis has exposed the United States’ inability to handle the pressure on the dollar. Countries also fear that their own economies are held “hostage” by macroeconomics policies and poltical brinksmanship in the United States, which are exogenous. It is apparent that the world needs a new alternative reserve currency, which may provide greater global financial stability. However, the key question should be what alternative should the World use. The answer to the question is much more sophisticated. There is currently no currency that seems to be able to handle the reserve currency status. While we will eventually witness a deviation from the dollar-denominated world, the adoption of a new reserve currency typically takes a long time. Since 1450 till 1920, Portugal, Spain, Netherlands, France, and then Britain, succeeded each other’s currency to gain global reserve currency status. Each currency held on to the status on average for 94 years during this period. Coincidentally, this year marks the 94th year in which USD became the global reserve currency since 1921.

The Bottom Line

The global economy is dynamic and reserves currency status changes as market shares (in the form of proportion of global output) changes. The USD is already beginning to lose status, most notably to the Renminbi. However, due to the shortfalls of the use of Renminbi as a global reserve currency (as discussed earlier) we may eventually observe a change in reserve status from the USD to a supra-sovereign currency, based on IMF’s SDR, in the next ten to fifteen years.

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