In the background of three significant international events occurring simultaneously-the US dollar is depreciating against the Euro, the price of oil is soaring in the international circuit, the gold price has reached its highest peak in almost five years-there seems a vigorous competition among currencies to emerge supreme.
The recent issue of The Economist questions the dominance of th mighty U.S. dollar as reserve currency:
Once a decade or so, economists ask whether the dollar's reign as the world's number one reserve currency might be at the start of a slow decline....
...In the past 30 years, the dollar has had four bouts of marked depreciation. During the most recent, which began in 2002, it has fallen by 28% against the euro and by 14% against a broad basket of currencies. .... 66% of the world's official foreign-exchange holdings are still in dollars, compared with 25% in euros, 4% in yen and 3% in pounds.....yet dollar sceptics note that this time the dollar's crown is, if not wobbly, at least skewed.
America's current-account deficit, at 6% of GDP, is its highest on record; its net foreign liabilities, at 22% of GDP, are also close to an all-time high. Foreign central banks seem to have reduced their purchases of American Treasuries: official holdings of these rose by only $2 billion in the first seven months of 2005, against $295 billion in (the whole of) 2004 and $175 billion in 2003. If this trend continues, other currencies could one day challenge the dollar's dominance. History offers perhaps only one true example of a reserve-currency shift, from the British pound to the dollar. The pound was king during the era of the gold standard. But in the years after 1914, Britain switched from net creditor to net debtor, and by the 1920s the dollar was the only currency convertible to gold.... Two costly wars and two episodes of currency devaluation in Britain later, the dollar was unchallenged as the world's chief reserve currency.
The likeliest pretender to the dollar's crown is the euro. Reserve currencies need to have a home economy with a large share of global output, trade and finance. America's economy still dominates, but the euro area is not much smaller. The euro area's total trade with the rest of the world is about as big as America's; about half of this trade is invoiced in euros. The financial market of the reserve currency country must also be deep, open and well developed...
Confidence in the value of the currency is also an important requirement, and this is where critics of the dollar have mostly taken aim. Barry Eichengreen, of the University of California at Berkeley, argues in a recent paper* that whether the dollar retains its reserve-currency role depends mostly on America's own policies. If America allows its large current-account deficit to persist and its net foreign liabilities to rise, foreigners will become less willing to hold more dollars. The dollar would depreciate, creating inflationary pressure in America and making dollar reserves less attractive still—perhaps even if the Federal Reserve raised interest rates.
In another recent study†, Menzie Chinn, of the University of Wisconsin, and Jeffrey Frankel, of Harvard, estimate the importance of these factors in determining the shares of different currencies in the world's total reserves. They also take “network externalities� into account: the tendency of each monetary authority to favour the dominant currency because all others do. They use these estimates to predict whether the euro could overtake the dollar as the world's main reserve currency.
It could, but not soon. Suppose, say the authors, that the dollar loses 3.6% a year against a basket of other currencies, while the euro gains 4.6% a year—the same rates as in 2001-04....it is impossible to forecast such a change with any precision. The dollar, after all, took decades to displace the British pound....the euro zone has obvious economic weaknesses....the stability and growth... and the EU constitution rejected by France and the Netherlands, some even wonder whether the single currency will be around in 20 years...
Another view, offered by Mr Eichengreen, is that the world might eventually have more than one main reserve currency. The dollar could share its status if other currencies become more attractive. The preference to stick with the dominant currency might secure the greenback's position for a long time. However, as financial markets in other countries become more liquid, this effect is weakened and other currencies become more trusted as a store of value. Reserve-currency competition will then cease to be a game in which the winner takes all. This process... favours the euro. Whether the dollar ever loses or is forced to share its pre-eminence among reserve currencies depends mostly on whether America continues to run the economic policies that will eventually undermine its position...
†“Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency?� NBER Working Paper No. 11510:
In the end, I think, we are witnessing a period of transition, with the US dollar on one side and the Euro on the other. It is very difficult to predict a clear winner between these currencies.
2 comments:
Reserve Currency- Dollar
Very intresting and relevant thought.Euro is just a pretender to the crown and will take some strong internal reforms to get its own house in order before it even thinks of the crown.
Anand Bhal
The picture behind the picture is after World War II, most of Europe and Japan lay economically prostrate, their industries in shambles and production, in general, at a minimum level. The U.S. was the only major power to escape the destruction of war, its industries thriving with a high level of productivity. In addition, prior to and during WWII, due to extreme political and economic upheaval, a considerable amount of gold from European countries was transferred to the U.S. Thus, after WWII the U.S. had accumulated 80 percent of the world's gold and 40 percent of the world's production. At the founding of the World Bank (WB) and the International Monetary Fund (IMF) in 1944-45, U.S. predominance was absolute. A fixed exchange currency was established based on gold, the gold-dollar standard, wherein the value of the dollar was pegged to the price of gold-U.S. $35 per ounce of gold. Because gold was combined with U.S. bank notes, the dollar note and gold became equivalent, which then became the international reserve currency.
Initially, the U.S. had $30 billion in gold reserves. But the United States spent more than $500 billion on the Vietnam War alone, from 1967-1972. During these years, the U.S. had over 110 military bases across the globe, each costing hundreds of millions of dollars a year. These expenses were paid in paper dollars and the total number given out far exceeded the gold reserve of the U.S treasury. By then (1971-72), the U.S. Treasury was running out of gold and had only $10 billion in gold left. On August 17, 1971, Nixon suspended the U.S. dollar conversion into gold. Thus, the dollar was "floated" in the international monetary market.
In the early 1970s, U.S. oil production peaked and its energy resources began to deplete. Its own oil production could not keep pace with growing home consumption. Since then, U.S. demand for oil continually increased, and by 2002-2003 the U.S. imported approximately 60 percent of its oil-OPEC (primarily Saudi Arabia) being the main exporter. The U.S. sought to protect its dollar strength and hegemony by ensuring that Saudi Arabia price its oil only in dollars. To achieve this, the U.S. made a deal, some say a secret one, that it would protect the Saudi regime in exchange for their selling oil only in dollars.
Saudi Arabia, the largest oil producer with the largest known oil reserves, is the leader of OPEC. It is the only member of the OPEC cartel that does not have an allotted production quota. It is the "swing producer," i.e., it can increase or decrease oil production to bring oil draught or glut in the world market. This enables it more or less to determine prices.
Oil can be bought from OPEC only if you have dollars at that time . Non-oil producing countries, such as most underdeveloped countries and Japan, first have to sell their goods to earn dollars with which they can purchase oil. If they cannot earn enough dollars, then they have to borrow dollars from the WB/IMF, which have to be paid back, with interest, in dollars. This creates a great demand for dollars outside the U.S. In contrast, the U.S. only has to print dollar bills in exchange for goods. Even for its own oil imports, the U.S. can print dollar bills without exporting or selling its goods. For instance, in 2003 the current U.S. account deficit and external debt has been running at more than $500 billion. Put in simple terms, the U.S. will receive $500 billion more in goods and services from other countries than it will provide them. The imported goods are paid by printing dollar bills, i.e., "fiat" dollars.
Fiat dollars are invested or deposited in U.S. banks or the U.S. Treasury by most non-oil producing, underdeveloped countries to protect their currencies and generate oil credit. Today foreigners hold 48 percent of the U.S. Treasury bond market and own 24 percent of the U.S. corporate bond market and 20 percent of all U.S. corporations. In total, foreigners hold $8 trillion of U.S. assets. Nevertheless, the foreign deposited dollars strengthen the U.S. dollar and give the United States enormous power to manipulate the world economy, set rules, and prevail in the international market.
Thus, the U. S. effectively controls the world oil-market as the dollar has become the "fiat" international trading currency. Today U.S. currency accounts for approximately two-thirds of all official exchange reserves. More than four-fifths of all foreign exchange transactions and half of all the world exports are denominated in dollars and U.S. currency accounts for about two-thirds of all official exchange reserves. The fact that billions of dollars worth of oil is priced in dollars ensures the world domination of the dollar. It allows the U.S. to act as the world's central bank, printing currency acceptable everywhere. The dollar has become an oil-backed, not gold-backed, currency.
But now the situation seems to be changing .The US in involved in wars and is having large trade deficits the capital account is saving the dollar from a sharp depreciation because as earlier said it the foreigners who subscribe to bill and bonds in the US.Now the dominance of Euro is bound to increase because comfortable trade position and simple economics its profitable to hold or to invest in the appreciating currency. If dollar continues to deprecate like it did in the near past I think the it will lose the dominance in the world market but the US will not let it happen the invasion of Iraq was a step in this regard . Now it control oil there which will be traded in dollar and similar kind of steps will be taken by the US to protect dollar .US clearly under stand if Euro becomes reserve currency it will be too difficult for Us to survive
So point what I want to make is its not simply the economics which will decide the fate of Euro Or dollar rather it is politics which will decide who will rule. I think its too difficult to make a prediction but it will defiantly an interesting thing to watch.
Rajesh Kumar
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