The Fall of the Dollar as the World’s Primary Reserve Currency
By Ed Moy
The efforts to bump the United States dollar off its pedestal as the world’s primary reserve currency have gained significant momentum this year. Should that happen, the consequences to Americans could be substantial: mediocre economic growth, higher interest rates, and less global prestige.
A reserve currency is a foreign currency held by a central bank. They are acquired through trade or purchase of bonds. These reserves help countries and their businesses make international transactions easier by avoiding the complications and costs of exchange rates.
The British pound sterling was the world’s primary reserve currency until 1944. With the defeat of Germany and Japan in sight, central bankers from 44 countries met in Bretton Woods, New Hampshire, to forge a new monetary regulatory system for the post-war world. The gold standard had fallen out of favor because the enormous amounts of currency needed to finance global war far exceeded the gold available. The substitute would have to be a stable currency from a sovereign nation that was a commercial powerhouse.
The United States was the only country that met that criterion. Its industrial capacity was huge and undamaged by the war, its global leadership was undisputed, and rebuilding nations would need what the United States was selling. It was agreed that the U.S. dollar would become the world’s primary reserve currency.
And for 70 years, the U.S. dollar has dominated the global economy. The benefits to the United States have been huge. It has ensured that the American economy is the largest in the world by making international transactions like exports much easier. It has kept interest rates low because of high demand for the dollar. And it has maintained the United States as the preeminent world leader and the unquestionable supremacy of the dollar, until now.
A number of factors have converged to challenge the U.S. dollar’s status.
The catalyst has been the 2008 financial crisis. The contagion was started by credit default swaps and questionable mortgage-backed securities, courtesy of American financial institutions. Then the United States had to bail out their own institutions as well as many foreign institutions with more U.S. dollars. To finance this, America has borrowed recklessly to fund huge deficits. Finally, three rounds of massive quantitative easing by the Federal Reserve have flooded the world with U.S. dollars. Foreign central banks have become uneasy over this risk, particularly on the questionable prospects of the successful unwinding of this untested experiment.
This has opened a 70-year-old wound. While the world agreed on making the U.S. dollar the world’s primary reserve currency, there was not much choice. No other nation was in such a great position.
In addition, emerging economies like China and India have questioned why the dollar (and the euro) continue to have favored status in reserve currencies. Their position is that reserve currencies are biased to the West when the East has risen. After all, U.S. GDP is $16.8 trillion while China’s GDP is $16.2 trillion. The balance of global economic power has shifted.
A weak U.S. economic recovery is contributing to a weak hand in foreign policy, which has created opportunism by the rest of the world. This has resulted in increased momentum to depose the U.S. dollar and America’s influence from its pedestal.
The Chinese pushed the first domino last fall, calling for a “de-Americanized world” and the tool to usher in that new era is “the introduction of a new international reserve currency that is to be created to replace the dominant U.S. dollar.”
Since then, the world has jumped on this bandwagon.
China alone has recently set up yuan clearing banks in Hong Kong, London, Macau, Singapore, and Taiwan and more are planned for Frankfurt, Luxembourg, and Paris. They are near completion of the China International Payments System to rival CHIPS and the Federal Reserve’s Fedwire.
And the Chinese have found willing partners all over the world. Russia and China recently agreed to create a joint rating agency in addition to increasing trade between each other.
And most significantly, the BRICS countries (Brazil, Russia, India, China, South Africa) announced the formation of a New Development Bank to directly compete with the International Monetary Fund and the World Bank. Initially capitalized with $100 billion, it will soon be joined by other countries that may include Mexico and South Korea. Notably, the NDB will be headquartered in Shanghai, but the first president will be Indian.
While the U.S. dollar is not in imminent danger of being deposed soon, these efforts are clearly laying the groundwork for a post-American world as well as actively working to take America down a notch or two. There is a very realistic scenario of the U.S. dollar gradually being reduced as a proportion of reserve currency to where using a market basket of currencies becomes viable. According to the IMF, the U.S. dollar as a percentage of all foreign exchange holdings has dropped from 55 percent in 2001 to 33 percent in 2013.
The alarm bells are ringing but is anyone listening?
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