The US Dollar as the World’s Reserve Currency

By: Kyle J. Shimek

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Abstract

This knol looks at the role of the US Dollar as the primary reserve currency in the world and what is likely to happen in the future.

      In the contemporary age of globalisation, two currencies have served as the world’s primary reserve currencies – the US dollar (USD) and the British Pound Sterling (GBP). The USD took over from the GBP in the twentieth century, particularly accompanying American political and economic dominance following World War II. The USD has remained dominant to this day, although there is much speculation about its decline. However, despite the US debt crisis, the Global Financial Crisis, and the economic rise of China, the USD represents 85% of foreign exchange transactions.1 The US benefits in many ways from this dynamic, but is it likely to remain in this position?

      Having the USD as the world’s primary reserve currency gives the US a primary role in world trade and finance. The USD has historically been quite stable and is often seen as a way to avoid currency exchange loss. This role as the global currency gives the US, already the world’s largest economy, an even more important role.

      Having the position as the world’s currency gives a country more hard power as well as soft power. Benjamin Cohen points out that this situation makes a country capable to “pursue diplomatic or military initiatives outside its borders,” and gives it geopolitical power. In terms of soft power, a country has the “enhanced prestige and status that is associated with international money.”2 It can be argued that it is in other countries’ interests to keep the US dollar a strong currency because it provides a safe, stable means to deal in international transactions. A change in the USD’s role can be seen as instability in the global financial market.

      The USD’s role also allows the United States to borrow money at a better rate due to the large demand for USD. The US can issue debts in its own currency allowing the US to pass on its inflation its creditors. Additionally, commodities are typically priced in USD. For example, OPEC sets the price of oil in US dollars, and gold is also priced in USD. As pointed out by Nouriel Roubini, having commodities priced in USD means “that a fall in the dollar’s value doesn’t lead to a rise in the price of imports [for the US].”3

      There is much speculation about how long the USD can retain its dominance, particularly with the downgrading of the US’s credit rating by Standard & Poor’s. There are many who have proposed alternatives for the world’s reserve currency. Many have suggested using the IMF’s Special Drawing Rights (SDRs). In 1940, economist John Maynard Keynes originally proposed an idea for a supranational currency called the bancor. Zhou Xiaochuan, Governor of the People’s Bank of China, has praised Keynes’ idea and called for the use of the SDR as a world reserve currency. Kazakhstan’s president, Nursultan Nazarbayev, has proposed a universal world currency called akmetal.4 Meanwhile, many are speculating about the rise of the Chinese renminbi (also known as the yuan). Despite the current situation, however, it is likely that the USD will remain in its position in the short run, though it is likely that the dynamic will change in the future.

      Currently, there are no viable alternatives to the USD. The second most widely-held currency is the Euro, at just over 26% of foreign exchange reserves. However, with the European Sovereign Debt Crisis, it is unlikely that the young currency of the Euro is ready to replace the USD. The Japanese yen is similarly not a feasible replacement as the Japanese government is currently facing massive government debt – 212% of its GDP according to OECD5 – and its credit rating was recently downgraded by Moody’s. The British pound sterling (GBP), formerly the primary reserve currency before the USD took over, is the third largest held reserve currency. Today, though, the GBP only accounts for 4.1% of reserves and there is speculation that it may soon lose its place as third in currency reserves.6 The Chinese renminbi faces even more shortcomings – the Chinese banking sector is still very young, the renminbi has nearly no international use (especially outside of Southeast Asia), its government keeps the renminbi under a fixed exchange rate (which is widely considered undervalued), and its authoritarian government lacks transparency.

      In February 2011, the IMF released a report stating that the use of its Special Drawing Rights (SDRs) as a reserve currency in place of the USD could help stabilise the world financial system. Dominique Strauss-Kahn, head of the IMF at the time, said that there are “technical hurdles” with using SDRs but they could provide stability.7 Former Chief Economist at the World Bank, Joseph Stiglitz, has endorsed this idea. However, as Benjamin Cohen points out, total SDRs now could only account for less than 5 percent of global reserves and without a government to back it, it is unlikely that SDRs would have much integrity.8 Helmut Reisen, Head of Development at the OECD Development Centre, suggests that if SDRs were to be used, the IMF would need to include more global currencies in its value, such as the Australian dollar, Canadian dollar, the Norwegian krone, and the Chilean peso, to give the SDR a “link to the raw materials cycles.”9 The SDR is unlikely to work in the near-term due to limits on its role and lack of perceived credibility of the IMF.

   With the US dollar still strongly in the lead and a lack of viable alternatives for the immediate future, it will likely be some time before the USD loses its role as the primary reserve currency. As The Economist mentions, 66 countries (other the US itself), either “adopt the dollar as legal tender, peg their currency to it or manage their exchange rate against it.”10 The primary force preserving the USD’s dominance, as noted by many analysts,11 12 is inertia – once a currency is established as a global reserve, it becomes entrenched and difficult to replace. However, with criticism of US dominance, the increasing power of other nations and more proposals for an alternative, it is likely that the USD will lose its role, possibly as soon as the middle of this century. After reaching its peak in 1999 (at about 71% of global reserves), the USD’s use as a reserve currency has been in steady decline until today. It now accounts for about 61% of reserves and is still declining. It will happen gradually, but it is quite conceivable that the USD will lose its status as primary reserve currency by the end of the twenty-first century.



Bibliography

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