International Currency Competition: Are There Alternatives to the US Dollar?

Policy Brief Series Issue 3, Nov 2011

International Currency Competition: Are There Alternatives to the US Dollar?

Ramkishen S. Rajan and Sasidaran Gopalan1

Key Points • The US dollar has remained a centrepiece of the international monetary system due to a lack of credible substitutes.

• The downgrade of US debt by Standard and Poor’s in August 2011 has further fuelled speculation of the demise of the dollar as the undisputed global reserve currency.

• This brief argues that despite persistent structural weaknesses in the US, the lack of credible alternatives, coupled with the significant depth of the US financial markets, is likely to result in preserving the ‘exorbitant privilege’ of the dollar in the near future.

• However, over time, the international monetary system will witness the gradual rise of other international currencies such as the Chinese renminbi. Asian central banks and sovereign funds with an abundance of external assets should actively support the development of such alternatives.

1

Ramkishen Rajan is currently a Visiting Professor at the Lee Kuan Yew School of Public Policy, National University of Singapore and Professor of International Economic Policy and Public Policy, George Mason University, USA. E-mail: rrajan1@gmu.edu. Sasidaran Gopalan is a Research Scholar at the School of Public Policy, George Mason University, USA. E-mail: sasi.daran@gmail.com. All errors are our own.

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Introduction The current international monetary system centred on the United States dollar appears to be at a crossroad. Notably, the supremacy of the dollar as a global reserve currency has been questioned following the August 2011 downgrade of the government debt held by the United States (US) from a top investment grade rating of ‘AAA’ to ‘AA+’ by Standard and Poor’s, and a warning of a possible further cut to ‘AA’ within two years. While the downgrade was unprecedented, the predictions of the dollar’s demise are neither new nor credible.

Since 1971, when the Bretton Woods system of pegged exchange rates (centred on the dollar) broke down, the sustainability of the de facto dollar standard has been questioned at various times – in the 1980s when Japan was a rising star, in the late 1990s when the euro came into existence, and currently, in the aftermath of the global financial crisis of 2008-09. Each time, the dollar proved resilient as the global reserve currency for at least two reasons: its ‘safe haven’ status, and its role as the most preferred currency in international trade invoicing and cross-border financial/foreign exchange transactions (Figure 1). The choice of a reserve currency also tends to be highly influenced by the peg that a particular central bank chooses to maintain. Here too, the dollar remains hugely important as it still acts an exchange-rate anchor for more than 60 countries, accounting for nearly 14 per cent of the world economy (Figure 2).

Figure 1: Global Importance of the US Dollar in Percentage Terms (as of November 2010)

Source: Adapted from The Economist, November 2010, available at www.economist.com/node/17414511

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Figure 2: Number of Economies Managing their Exchange Rates against USD/Euro

Source: Adapted from The Economist, August 2011, available at www.economist.com/node/21525923

On a structural basis, the dollar’s share of global central banks’ foreign exchange reserve holdings peaked at almost 85 per cent in the early 1970s shortly after it abandoned the convertibility of the dollar to gold. Since 1971, the dollar has remained the dominant reserve currency, although its share has been declining gradually, reaching 70 per cent of the global reserves of central banks by 2000, dropping further to 60 per cent by 2010 (Figure 3). Many observers contend that this declining share signals the beginning of the end of the dollar supremacy. The structural weakness of the US economy and the long-term decline of the dollar over the last decade (Figure 4) have only fuelled the anxiety of central banks holding large dollar assets, particularly those of China and the rest of emerging Asia which constitute about three-fifths of the total foreign holdings of US Treasury securities (around US$ 2.5 trillion; See Table-1) 2. This has led to an intensified search for an alternative to the dollar.

2

China alone constitutes about a quarter of the total foreign holdings of US Treasury securities (Table 1).

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Figure 3: Share of Major Currencies in Identified Foreign Exchange Reserves of Central Banks: 1973 – 2011 (%)

Notes: 1) Data for 1973 and 1987 reproduced from Eichengreen, B. (2005), ‘Sterling’s Past, Dollar’s Future: Historical Perspectives on Reserve Currency Competition’, Working Paper No.11336, NBER. Data for 2011 is for the First Quarter. 2) The Deutsche Mark had shares of 6.7 per cent, 13.4 per cent, 15.9 per cent and 14.7 per cent respectively for 1973, 1987, 1991 and 1995. 3) The reported shares pertain to allocated reserves only. Unallocated reserves refer to reserves whose currency composition has not been identified.

Source: IMF Currency Composition of Official Foreign Exchange Reserves Database, www.imf.org/external/np/sta/cofer/eng/index.htm .

Figure 4: Real and Nominal Effective Exchange Rates of the US Dollar (1982-2011)

Note: REER/NEER Narrow indices – 27 countries.

Source: Compiled from Bank for International Settlements effective exchange rate database.

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Table 1: Foreign Holdings of US Treasury Securities - Asia (Millions of US Dollars; as of June 2010) Long Term Treasury

Short Term Treasury

Total Treasury

Share of Total World (%)

China Hong Kong

1,108,128 60,451

3,997 76,542

1,112,125 136,993

27.22 3.35

India

21,373

14,067

35,440

0.87

Indonesia

8,218

18,882

27,100

0.66

Japan

737,309

62,549

799,858

19.58

South Korea

34,445

2,519

36,964

0.90

Malaysia

10,247

838

11,085

0.27

Philippines

19,012

933

19,945

0.49

Singapore

46,648

6,673

53,321

1.31

Taiwan

149,029

2,855

151,884

3.72

Thailand

11,501

24,223

35,724

0.87

Emerging Asia

2,206,361

214,078

2,420,439

59.24

TOTAL WORLD

3,343,156

742,624

4,085,780

100

Source: Compiled from US Treasury Securities Database.

Are There Credible Alternatives?

The US no longer dominates the world economy, with its share of global GDP declining to around 25 per cent (measured in 2005 prices). 3 In economics, the world has become much more multi-polar.

Many argue that this multipolarity will – and should – be reflected in the international monetary system. What are the alternatives to the dollar?

The Euro With about a quarter of allocated central bank reserves parked in euros, it seemed a logical competitor to the dollar up until a year ago, when the complex sovereign debt crisis that has engulfed the region raised concerns about the viability of the Eurozone. The threat of the

3

In contrast, the share of emerging markets (from Asia and Latin America) in global GDP exceeds 30 per cent in 2010.

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‘disintegration’ of the euro currency bloc – exaggerated or not – has brought the Eurozone to a crisis of confidence.

The crisis notwithstanding, observers also note that the euro has seen a dramatic expansion only in debt issuance, while the dollar dominates in cross-border foreign exchange or banking transactions. The internationalisation of the euro has also been concentrated within the Eurozone region, which reflects the limited and regional nature of its influence. Even though Europe’s financial markets may have the required depth and liquidity, a number of ‘structural’ factors have held back the rise of the euro as a dominant reserve currency. 4 For instance, even prior to the Eurozone crisis, the euro’s attractiveness was limited by the comparatively higher transaction costs, which stem primarily from the inability of the European Monetary Union (EMU) to supply an instrument on par with the US Treasury bill that ensures both liquidity and convenience. 5 Second, the euro has functioned as a ‘currency without a state’, founded as a result of an inter-state treaty. The uncertainty associated with this governance arrangement has handicapped the euro, and thrown the Eurozone into a debate on the weak governance framework. Thus, absent significant structural and institutional changes within the Eurozone, it is rather unlikely that the euro will be a credible competitor to the dollar - and will at most remain a regional currency, albeit a significant one.

Japanese Yen In Japan’s heyday in the 1970s and 1980s, the yen seemed a promising candidate with the requisites to emerge as a globally important currency. Its share of global reserves peaked at almost 9 per cent in 1991 and there was even a concomitant decline of the dollar’s share from more than 65 per cent in 1987 to about 50 per cent in 1991. However, Japan’s under-developed financial markets hindered the global use of the yen. While Japan was keen to promote the international use of their currency 4

For elaboration, see Cohen, B. (2011), ‘Paradise Lost? The Euro after the Crisis,’ mimeo, University of California, Santa Barbara, April. The euro’s share in global central bank reserves was still ranging between 25 per cent and 30 per cent even before the crisis began, which is no more that the aggregate share of the legacy currencies (Deutsche mark, French franc, Netherlands guilder etc). This suggests that the euro had not made significant inroads as a competitor currency to the dollar even before the debt crisis.

5 Paradoxically, the idea of issuing Eurobonds – where all the 17 Eurozone member economies would be able to borrow in bonds issued by a common European debt agency - seems to be in the discussions as one of the potential solutions to the prolonged Eurozone crisis. For a more detailed analysis on Eurobonds, see, The Economist (2011), ‘Unpalatable Solution’, accessible at http://www.economist.com/node/21526325.

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in the mid- and late- 1990s, the economy stagnated and its financial sector became burdened by inefficiencies and non-performing loans. In addition, Japan’s bank-based financial system precluded the development of deep and liquid financial and capital markets as in the US and Western Europe.

Thus, despite Japan’s size and rapid rate of growth pre-1990s, the yen has failed to evolve as a significant dollar rival. The yen’s share in global reserves of central banks has in fact rapidly declined since the 1990s, falling to less than 4 per cent in 2010. In addition, the economic stagnation, large domestic debts and the unfavourable demographics that plague Japan make the yen an extremely unlikely competitor to the dollar. Simply, the yen’s time may have come and gone.

Special Drawing Rights (SDR) After the G20 summit in April 2009, China’s central bank Governor Zhou Xiaochuan called for a ‘super-sovereign reserve currency’ based on the Special Drawing Rights (SDR) floated by the International Monetary Fund (IMF). The SDR is ‘an international reserve asset, created in 1969 to supplement countries' official reserves. Its value is based on a basket of four key international currencies, and SDRs can be exchanged for freely usable currencies.’ 6 The SDR proposal is not new.

It dates back to the 1940s when Keynes proposed the creation of an International Clearing Union that would issue a supranational reserve currency named ‘Bancor’ - a currency based on the value of 30 commodities including gold. However, there are serious concerns about the viability of SDRs as a global reserve currency. First, the SDR currently constitutes less than 5 per cent of global reserves. Second, the SDR is not a conventional currency in that it can be used only in transactions between central banks and the IMF, and not between the government and the private sector. Third, without changes in its composition, the SDR will always be limited in attractiveness because 80 per cent of the basket of currencies that constitute the SDR is represented by the combined share of the dollar and euro, defeating the use of a SDR as an alternative currency for diversification purposes (Table 2).7 6

See IMF Factsheet on the SDR, accessible at http://www.imf.org/external/np/exr/facts/sdr.htm The table also points out that the weights for dollar in the SDR basket have largely remained constant (with minor variations) over time whereas the euro has gained more weight primarily at the expense of the yen. It is also important to take note of a few proposals that are being discussed to make the SDR more attractive, meaningful and acceptable.

One of them is to expand the SDR to include the currencies of emerging markets such as the Chinese renminbi, which if done is believed to make the use of SDR more attractive for private users. For discussions on how to enhance the role of

7

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Table 2: Share of SDR: 1981-2015

US Dollar

Jan 1981 Dec 1985 42%

Jan 1986 Dec 1990 42%

Jan 1991 Dec 1995 40%

Jan 1996 Dec 1998 39%

Jan 1999 Dec 2000 39%

Jan 2001 Dec 2005 44%

Jan 2006 Dec 2010 44%

Jan 2011 Dec 2015 41.9%

Euro

NA

NA

NA

NA

32%

31%

34%

37.4%

Japanese Yen British Pound German Mark French Franc

13%

15%

17%

18%

18%

14%

11%

9.4%

13%

12%

11%

11%

11%

11%

11%

11.3%

19%

19%

21%

21%

NA

NA

NA

NA

13%

12%

11%

11%

NA

NA

NA

NA

Source: Adapted from Pacific Exchange Rates Database, accessible at http://fx.sauder.ubc.ca/SDR.html .

Gold The demand for gold surged after the global financial crisis. Several central banks including the People’s Bank of China, the Reserve Bank of India (RBI) and other Asian central banks diversified their reserves by purchasing the metal. Given that most emerging economies hold a very small percentage of their total reserves in gold (Figure 5), it remains unclear whether the motivation to purchase gold is a one-off stock adjustment or part of a serious diversification strategy. 8 Given also the lack of adequate supply/availability of gold (one of the problems inherent in the Gold and Gold Exchange Standards pre-World War II), it is unlikely to pose any meaningful threat to the dollar even as a quasi-currency. 9 As with the SDR, there may be minor portfolio reallocations towards gold from time to time but neither is expected to be anything more than peripheral reserve assets.

the SDR as a global currency, see the following paper by the IMF’s Strategy, Policy and Review Department: Moghadam, R. (2011), ‘Enhancing International Monetary Stability: - A Role for the SDR’, January 7, accessible at http://www.imf.org/external/np/pp/eng/2011/010711.pdf .

8 The share of India’s reserves invested in gold stood at around 7 per cent of total reserves in October 2010 after its one-off purchase of gold in late 2009. See, Rajan, R.S. and S. Gopalan (2010), ‘India’s International Reserves: How Large and How Diversified?’, Global Economy Journal, Vol.10 (3), Article 6.

9 However, the demand for gold as a private store of value might continue to rise as long as the global economy remains in a state of flux.

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Figure 5: Leading Countries with Major Gold Reserves, August 2011 (Gold as a % of Total Reserves of the Country)

Source: Compiled from World Gold Council data, http://www.gold.org/government_affairs/gold_reserves/

The Chinese Renminbi and the Indian Rupee With the above options showing limited effectiveness as alternatives to the dollar, the burden of speculation has fallen on the Chinese renminbi as China’s economic prowess has grown in the past three decades both in terms of scope and trade openness. China stands out as the world’s largest merchandise exporter today, the second largest merchandise importer and third in commercial services trade.

Notably, China’s trade prowess has provided a basis to accelerate the use of the renminbi in settlements for international trade transactions. By the first quarter of 2011, 7 per cent of China’s total trade was settled in renminbi. To boost renminbi liquidity, the People's Bank of China has signed currency swap agreements worth more than US$130 billion with many countries in Asia and beyond. Some central banks have also started to hold renminbi deposits and bonds as part of their reserves (e.g. Malaysia, Nigeria). Notably, since 2004, China has developed the Hong Kong Special Administrative Region as an offshore renminbi trading hub. 10 10

Islam, M.S., ‘The Rise of China’s Currency’, mimeo, National University of Singapore, September (and references cited within). Also see Chen, X. and C. Yin-Wong (2011), ‘Renminbi Going Global,’ Hong Kong Institute of Monetary Research Working Paper, 08/2011, March and references cited within, accessible at http://www.hkimr.org/cms/upload/publication_app/pub_full_0_2_272_WP%20No.08_2011%20(Final).pdf.

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While China is taking a piecemeal approach to capital account deregulation (in line with its approach of gradual experimentation towards economic reforms in general), the greater issue that stands in the way of the renminbi’s emergence as the global reserve currency is China’s weak banking system and the concurrent lack of sufficiently ‘deep, liquid and open capital markets’.11 China’s financial markets are still ‘immature’ by several measures, with equity and bond markets under-developed. For instance, China’s equity markets represent about 6 per cent of the capitalisation of the world’s equity markets and its bond market represents just 2.4 per cent of the world’s bond markets.12 Concerns similar to that of the renminbi rule out the ascendancy of the Indian rupee to challenge the dollar, at least for the time being. 13 .Further, given the risk-averse nature of India’s central bank and the potential susceptibility of India’s balance of payments to volatile capital movements (India runs a current account deficit in contrast to China’s burgeoning current account surplus), the Indian authorities do not appear to harbour any obvious ambitions regarding currency internationalisation on a global scale anytime soon.

Conclusion Talk of the imminent demise of the dollar is premature and exaggerated. Even if there were viable immediate alternatives, it is important to recognise the natural ‘inertial bias’ associated with the dominant currency. As Hal Varian, the chief economist of Google points out, ‘(f)ormally, a good exhibits network effects if the demand for the good depends on how many other people purchase it… . If no one adopts a network good, then it has no value, so no one wants it. If there are enough

11

Frankel J. (2011), ‘Historical Precedents for the Internationalization of the RMB’, mimeo, Council of Foreign Relations and China Development Research Foundation, November 1.

12 Smithstreet Solutions (2009), ‘The Future of the Renminbi’, China, accessible at http://www.smithstreet.cn/en/publication.

13 While India’s financial system is no doubt stronger than that of China and arguably has better respect for property rights, India lags China in terms of trade and investment linkages with Asia and the rest of the world. India’s capital account is also relatively closed and does not allow its currency to be used for international transactions (with Nepal and Bhutan being the only exceptions), and there remain severe restrictions for non-residents to hold rupee denominated assets as well. India’s capital account is also still relatively closed. See Ranjan, R. and A. Prakash (2010),.

‘Internationalisation of the Currency: The Case of the Indian Rupee and Chinese Renminbi’, accessible at http://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/RRSS180510F.pdf .

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adopters, then the good becomes valuable, so more adopt it—making it even more valuable.’ 14 Thus, a currency becomes more useful if more people use it and the resultant larger network of users of the dollar make the use of dollar even more attractive. This ‘inertial bias’ was what helped sustain the sterling as a significant reserve currency even decades after the decline of the UK as an economic and military power. 15 It is also useful to recall that following the Lehman Brothers bankruptcy in 2008 and even the most recent S&P downgrade, dollar demand actually increased quite sharply as several investors flocked to US treasury bills in a flight to safety. A day after the S&P downgrade, the 10year yield on treasuries surprised the markets by dropping 25 basis points to an all-time low. Thus the role of the dollar as a safe haven may only be strengthened in the near-term given the sharp run up in gold prices recently and the active intervention by the Swiss National Bank to drive down the value of the other haven currency – the Swiss franc - to ward off sharp capital flows as investors fled the Eurozone.16 While the lack of a single alternative national currency might continue to preserve the dollar’s ‘exorbitant privilege’ for the near future, the global international monetary system is likely to get more fragmented and multipolar gradually. Assuming current trajectories continue, however, the real ‘game changer’ could be the renminbi – with much hanging upon how effectively China handles its efforts at currency internationalisation. While the immediate rise of the renminbi as the alternative reserve currency will be limited by a number of constraints, such as China’s underdeveloped financial sector, weak banking system and limited capital account convertibility, its growing trade and economic might suggests it has the potential to overcome those constraints.

Interestingly, what differentiates China today from Japan in its heyday is its active promotion of its currency’s internationalisation. In one of the most optimistic predictions to date, Arvind Subramanian, a senior fellow of the Peterson G. Peterson Institute for International Economics, 14

Varian, H.R. (2003). “ ‘Economics of Information Technology’,” in “ ‘Academic Papers and Books, 2004 and Earlier Non-technical papers,”’, mimeo, accessible at http://people.ischool.berkeley.edu/~hal/Papers/mattioli/mattioli.pdf .

15 There remains some debate about the lag between the date the US economy passed the UK economy in terms of size and the time the dollar passed the Sterling in terms of central bank holdings of reserves. For more see Frankel, J. (2011), ‘The Rise of Renminbi as International Currency: Historical Precedents’, Voxeu, http://voxeu.org/index.php?q=node/7075, October 10. The sterling was also boosted for a prolonged period post UK’s economic decline because of Commonwealth ties.

16 See ‘Francs for Nothing,’ accessible at http://www.economist.com/node/21528631, September 10 2011.

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notes that the renminbi could become the premier reserve currency ‘by the end of this decade, or early next decade’ (2022 to be precise). However, he likely overstates the case given his emphasis on the net creditor position of China as one of the determinants of reserve currency status in his empirical specification.17 In addition, he appears to downplay serious questions about the political and institutional system in China and whether that might remain a hindrance to the renminbi becoming a bone fide rival to the dollar.

As far as smaller countries in Asia are concerned, they should welcome and promote the development of alternative reserve currencies. There is clearly demand by some Asian central banks for more renminbi-denominated government bonds, and China has begun to gradually accommodate this demand by opening up its domestic interbank bond market to foreign central banks. 18 The emergence of credible reserve currency alternatives presents the Asian central banks with the opportunity to diversify their considerable foreign exchange reserves without compromising their primary liquidity considerations. Thus Asian central banks and sovereign funds with an abundance of external assets should actively support the development of such alternatives as a means of enhancing global stability in their own self-interest. A multi-polar global currency system may also impose more policy discipline on major powers to adopt more disciplined domestic economic policies, failing which they are likely to lose their shares as preferred currencies in central bank holdings. 19 However, the key challenge for Asia and the international community would be to ensure that this move to a more diverse reserve currency composition is gradual so as to minimise the potential volatility that could arise from rapid portfolio rebalancing

17

The author calculates this variable in the following way, ‘For any given time period, the cumulative current account balance of a country (over the preceding 10 years) is measured. The cumulative net flow of capital for the world as a whole is calculated by adding up the current account surpluses for all countries running surpluses. The country’s cumulative balance as a share of the world’s cumulative balance is the measure that (is) use (d) in the regressions.’ See Subramanian, A. (2011), ‘Renminbi Rules: The Conditional Imminence of the Reserve Currency Transition’, Peterson Institute for International Economics Working Paper, 11-14, September.

18 Anderlini, J. (2010), ‘Beijing Looks to Broaden Renminbi Use’, Financial Times, August 17: http://www.ft.com/intl/cms/s/0/81500cea-a9fc-11df-8eb1-00144feabdc0.html#axzz1d5b09rfE .

19 There are, however, risks to a country that has a global currency – exchange rate volatility, greater vulnerability to speculative attacks (due to wide-spread availability of its currency offshore, etc). China, India and other emerging markets are aware of such concerns and therefore are treading cautiously along currency internationalisation as did Singapore (which restricted currency internationalisation until the late 1990s).

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The Lee Kuan Yew School’s Briefing Room Series is edited by Toby Carroll, Senior Research Fellow at the Centre on Asia and Globalisation, and Claire Leow, Senior Manager for Research and Dissemination at the Research Support Unit.

Feedback should be sent to: research.lkyschool@nus.edu.sg