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Thursday, September 29, 2005

Will the Dollar Lose Its Position as the Dominant Reserve Currency?

The Economist asks whether the U.S. dollar is losing, or about to lose, its position as the dominant reserve currency:

How the dollar might lose its status as the world's main reserve currency, The Economist:  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. ... Even so, 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... And 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 ... 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. ... 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. America leads the euro area by most measures, but the creation of the single currency has helped to integrate Europe's financial markets.

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. ... In another recent study, Menzie Chinn, of the University of Wisconsin, and Jeffrey Frankel, of Harvard, ... use ... estimates to predict whether the euro could overtake the dollar as the world's main reserve currency. It could, but not soon. ... they reckon, the euro could become the top currency by 2024. If in addition Britain, Sweden, Denmark and all the central and eastern European countries that joined the European Union last year adopted the euro, it would supersede the dollar by 2019...

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. ... This process, thinks Mr Eichengreen, favours the euro. He is doubtful about other candidates, notably the yuan. He argues that both Europe and America “have strong institutions, respect for property rights, and sound macroeconomic policies relative to the rest of the world.” In China, by contrast, capital controls, financial markets that are neither very liquid nor transparent, and uncertainty about property rights make the yuan an unlikely contender for decades to come...

*“Sterling's Past, Dollar's Future: Historical Perspectives on Reserve Currency Competition”. NBER Working Paper No. 11336: www.nber.org/papers/w11336
“Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency?” NBER Working Paper No. 11510: www.nber.org/papers/w11510

    Posted by on Thursday, September 29, 2005 at 04:08 PM in Economics, International Finance | Permalink  TrackBack (0)  Comments (1)


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