The Dollar Dilemmas

The Dilemmas of the Dollar

by Barry Eichengreen

Legions of pundits have argued that the dollar's status as a reserve currency has been damaged by the credit crisis of 2007-9. The crisis has not exactly enhanced the attractions of the United States as a supplier of high-quality financial assets. It would be no surprise if the disfunctionality of U.S. financial markets diminished the appetite of foreign central banks for U.S. debt securities.

Meanwhile the federal government is emitting vast quantities of public debt. Together these trends in supply and demand are a recipe for a significantly weaker dollar. Capital losses on their outstanding dollar reserves will in due course cause central banks to consider alternatives. The dollar's status as the dominant international currency will then be history.

There is only one problem with these arguments. It is that there has been no actual diminution of the dollar's international role. The dollar in fact strengthened following the outbreak of the crisis. With the spread of illiquidity, investors sought refuge in the most liquid market, that for U.S. government debt securities. Since then the dollar exchange rate has fluctuated, but there has been no dollar crash.

The same is true of the composition of the foreign reserves of central banks. International Monetary Fund figures show the share of dollars in total identified official foreign exchange holdings as of the end of 2007 to have been 64 percent, down only marginally from the 66 percent of 2002-3. U.S. Treasury data similarly show that ongoing accumulation by foreign authorities has if anything accelerated in recent months. All that has changed is that foreign central banks are accumulating Treasury rather than agency securities and that they are favoring short-term bills over long-term bonds.

The explanation is that the alternatives all have equally severe problems. The euro is the leading rival to the dollar, but Europe's banking crisis and recession are at least as serious as those of the United States. In addition, different euro-area government bonds vary in their risk, returns and liquidity. German bunds have a reputation for stability, but since they tend to be held to maturity by institutional investors, the market in them lacks liquidity. Certain other euro area countries with plenty of bonds have deep financial problems as a result of past policies and the crisis. Italian government bonds are in fact the most important euro-area debt securities in value, but Italy's economic and financial problems render them unattractive as reserve assets.

For the renminbi to become attractive as a reserve unit, China would have to build deep and liquid financial markets so that renminbi-denominated assets could be freely bought and sold when a central bank needed to intervene in the markets. A necessary precondition is full capital account convertibility. China has been moving in that direction for ten years and may need another ten years to get there. Chinese officials have targeted 2020 as the date by which Shanghai should be transformed into an international financial center, meaning that its markets are open to foreign investors. Until then, talk of the renminbi as a serious rival to the dollar will be premature.

A final alternative is to issue non-national reserve assets like the Special Drawing Rights of the IMF. SDRs are a synthetic currency unit currently made up of the dollar, euro, yen, and pound sterling. Creative thinkers in China, Russia, and Brazil have suggested that more SDRs might be issued to meet central banks' growing need for foreign reserves. The problem here is the same as with the renminbi, only more extreme. SDRs can be used only for transactions with the IMF and among consenting governments. Unlike national currencies, they cannot be used for foreign exchange market intervention. For central banks and governments that see reserves as insurance - and anticipate having to actually use them - this illiquidity renders SDRs unattractive.

Making SDRs attractive would require making them liquid. This would mean developing private markets on which SDR claims can be bought and sold. It would be necessary to build a broad and liquid market on which governments and, for that matter, financial and nonfinancial firms could issue SDR bonds at competitive cost. Banks would have to find it attractive to accept SDR-denominated deposits and extend SDR-denominated loans. The pension funds and insurance companies that are the dominant sources of private demand for bonds would have to be attracted to holding bonds denominated in a basket of currencies despite the fact that their liabilities tend to be dominated in a single national currency. All this is possible, but it will not be easy. It is worth recalling that there was a previous attempt to commercialize the SDR in the 1970s that never really got off the ground. Succeeding this time would take decades rather than years.

It is as Winston Churchill said of democracy: it is the worst political system except for all the other. The dollar, analogously, will remain for worst reserve currency except for all the others for a considerable period to come.