USD as the International Reserve Currency:

Past, Present and Future

For

Macro Economics: Principles and Policies

Submitted to, Submitted By Group 4:

Prof. Vijay Prakash Ojha Lokesh Narang (09FT-076)

Mohd Afroze Ali (09FT-085)

Mohd Asif (09FT-086)

Parinit Agarwal (09FT-103)

Prateek Maheshwari (09FT-107)

Praveen Chavali (09FT-108)

c
c
Introduction
One can hardly pick up a financial newspaper these days without seeing a story on the
dollar¶s impending loss of international pre-eminence. But reports of the dollar¶s death have
been greatly exaggerated. The dollar is still the dominant reserve currency for central banks
and governments. The share of international reserves in dollars has actually been rising, not
falling. The market in U.S. treasury securities is still the single most liquid financial market in
the world, which makes it attractive for central banks to hold their reserves in this form. The
dollar is still the dominant invoicing and vehicle currency in international trade. Petroleum
and other commodities are still invoiced in dollars.

There are, of course, good reasons for questioning whether this will remain the case. The
dollar has fallen by 16 percent on a trade weighted basis from its peak at the beginning of the
decade. More importantly, never before have we seen the extraordinary situation where the
country issuing the leading international currency is running a current account deficit of 6
percent of GDP. Never before have we seen the reserve currency country in debt to the rest of
the world to the extent of 25 percent of GDP. The connections between U.S. budget deficits,
themselves partly a reflection of the country¶s overseas military commitments, and the
weakness of the currency suggest parallels with the trials of the dollar in the 1960s and the
tribulations of sterling after World War II. All this is bound to raise questions in the minds of
foreign holders of U.S. treasury securities that may lead them to search for alternative forms
in which to hold their claims. And for the first time in living memory there exists another
currency with a deep and liquid market issued by an economy as large as the United States.
That currency, obviously, is the euro. Looking forward there is also the renminbi, the
currency of an economy that 50 years from now may be even larger economically and trade
more extensively than the United States.

Over the past two and a half thousand years there have been over a dozen reserve currencies
that no longer exist. Sterling lost its status in the first half of the 20th century, the dollar
might lose its status in the first half of this century.

USD as International Reserve Currency Page 2c

Xow dollar became the international reserve currency

Now days, foreign deposits and purchases of foreign bills and bonds are nothing new, large-
scale holdings in foreign financial centres by central banks and governments are a relatively
recent development. The spread of this practice coincided with the emergence of the
international gold standard in the decades prior to World War I. With a few important
exceptions, the standard in question was a gold bullion standard, not a gold coin standard. A
significant share of the monetary circulation of countries on the gold standard was not gold
coin, in other words, but token coins and paper convertible into gold bullion under certain
circumstances. The gold bullion standard was a 19th century innovation. Once gold was
concentrated in the vaults of central banks (or in treasuries and other note issuing banks
where there existed no central bank), there was an incentive to substitute or at least augment
it with bills and deposit claims which bore interest but were convertible into gold.

Why London should have been the place where many such reserves were maintained and
why sterling bills and deposits should have been their single most important form are easy
enough to understand. Britain was the world¶s preeminent trading nation, absorbing more
than 30 percent of the exports of the rest of the world in 1860 and 20 percent in 1890.It was a
leading exporter of manufactures and services and also a voracious consumer of imported
foodstuffs and raw materials. Between 1860 and 1914 probably about 60 percent of world
trade was invoiced and settled in sterling. For foreign suppliers seeking to sell, say, cotton,
quoting prices in sterling was helpful for breaking into the British market. With the growth of
imports and re-exports of these materials came the development of commodity exchanges
where both spot and forward prices were similarly quoted in sterling. Britain¶s position as the
single most important source of long-term overseas investment worked in the same direction.
Foreign governments seeking to borrow abroad came to London, making sterling the logical
unit of account for debt securities, since then as now there was a limited appetite for bonds
denominated in their own currencies, the markets in which were less liquid and whose value
was more easily manipulated by the issuer. When funds became available, it was natural to
park them temporarily in deposit accounts in London, generally in the same bank that had
underwritten the loan. Lenders encouraged the practice on the view that the maintenance of
deposits in London was a bonding device that might promote good behaviour on the part of
the borrower.

USD as International Reserve Currency Page 3c

That Britain was imperial power reinforced sterling¶s role. From the early 18th century a
conscious effort was made to encourage the use of the pound throughout the empire as a way
of simplifying and regularizing transactions. These practices further enhanced the liquidity of
the London market, which was probably the single most important fundamental making it
attractive for foreign central banks and governments to hold interest-bearing assets there in
the first place. At the end of 1913, sterling balances accounted for less than half of the total
official foreign exchange holdings while French francs accounted for perhaps a third and
German marks a sixth. In the 1920s and 1930s three currencies again shared this role,
although now the dollar supplanted the German mark. The establishment of the Federal
Reserve System in 1914 had enhanced the liquidity of the New York market and heightened
its attractions as an international financial centre.

Before World War I the dollar was scarcely used in international transactions. There existed
no central bank to rediscount those acceptances, purchase bills on the open market, and
otherwise ensure the liquidity of the market. This changed of course with the founding of the
Fed. World War I had a reinforcing effect. Germany suspended convertibility in the opening
week of the war. The Bank of France, which had never been legally obliged to convert notes
into gold, did so only under exceptional circumstances before an official gold embargo was
imposed in 1915. Britain restricted the export and melting of gold. The United States, in
contrast, preserved gold convertibility even after it entered World War I, in 1917. Its shares
of global trade and foreign lending were then markedly higher in the 1920s than they had
been before World War I, leading to a considerable expansion in the dollar¶s role as a unit of
account and means of payment for international transactions between private parties.
Germany and France suffered financial turmoil in the first half of the 1920s. In the second
half of the decade the Bank of England was continuously under the pressure. And yet, despite
all this, sterling, the dollar, and the franc shared the reserve currency role in the 1920s and
1930s. But sterling was probably still first, followed by the dollar and the franc. In part, the
post-World War II dominance of the dollar reflected the exceptional dominance by the
United States of global trade and payments in a period when Europe and Japan had not yet
fully recovered from the war and modern economic growth had yet to spread to what we now
refer to as emerging markets. In addition it reflected the fact that the governments of other
potential reserve centers actively discouraged international use of their currencies. Germany
saw the internationalization of the deutschemark as a threat to its control of inflation. Japan
saw the internationalization of its currency as incompatible with their systems of directed

USD as International Reserve Currency Page 4c

credit. France had seen more than once how allowing private foreign funds to move in also
allowed them to move out if investors concluded that the government¶s macroeconomic
policy aspirations were incompatible with its putative commitment to currency stability.
These and other considerations led the countries whose currencies were potential alternatives
to the dollar to maintain significant capital controls well into the post-World War II period, in
some cases until the end of the 1980s. Controls limited the liquidity of their securities
markets. Thus, it was not simply the unusually large size of the U.S. in the world economy or
the admirable liquidity of U.S. financial markets but the maintenance of controls by other
potential reserve centers that explains why the dollar was so dominant in reserves for so long
after World War II. While most of these controls were relaxed or removed by the 1990s, that
decade was marked by a slump in Japan and the uncertain transition to the euro, making it an
unpropitious time for radical portfolio reallocation. In addition the rapid growth of the
American economy, especially in the second half of the 1990s, meant that the dominance of
the dollar troubled few reserve managers. The question now is whether this might change.

The Present Times

The United States¶ status as the unrivalled global superpower has rested on two
unchallengeable pillars - the overwhelming US military superiority over all other rivals; and
the control of global economic markets with the dominant role of the US dollar as reserve
currency. However the scenario has changed drastically in the last few years; the US trade
deficit, federal budget deficit, low interest rate, and low GDP growth compared to the high ±
GDP growth rest±of-the-world has caused the dollar to decline against the world¶s major
currencies. Though the fall in currencies¶ value maybe dismissed as cyclical occurrences,
what makes the situation unique is that most countries¶ currency reserves are crammed with
depreciating dollar assets.

Why the USD still occupies the cult status can be argued on the basis of the following
factors:
2c The U.S. economy is still the world's largest in terms of output and trade.
Consequently, the USD has a large share in international output, trade and finance
giving it a big advantage.

USD as International Reserve Currency Page 5c

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the world. In other words, complete capital account convertibility. This would entail a
fundamental change in Chinese growth model. Accomplishing this might take decades
together, if at all it. Hence, an immediate replacement of the USD by Chinese Renminbi can
be ruled out.

The Special Drawing Rights (SDRs)

In April 2009, China¶s Central Bank Governor Zhou Xiaochuan proposed replacing the US
dollar as the international reserve currency with a new global system controlled by the IMF.
The proposal found an immediate backing by Russia's President Medvedev. China suggests
the shift on two grounds:

1.c As Zhou states, that the outbreak of the crisis and its spill-over to the entire reflects
the inherent vulnerabilities and systemic risks in the existing international monetary
system.

2.c The country issuing the reserve currency (in this case dollar) finds it difficult to
pursue both the domestic goals of price stability and its international responsibilities
of a stable financial system. They may either fail to adequately meet the demand of a
growing global economy for liquidity as they try to ease inflation pressures at home,
or create excess liquidity in the global markets by overly stimulating domestic
demand. This is known as Triffin¶s Dilemma.

So what exactly is SDR? SDR is a representation of 4 major currencies ± comprising 44 per

cent US dollars, 34 per cent euros, 11 per cent yen and 11 per cent pound sterling. Presently
SDRs are too few in circulation, the outstanding amount being $33bn. Even with the new
tranches lately issued by IMF, it will still constitute less than 5 per cent of the world¶s foreign
currency reserves.

However, there are 2 important problems that need to be addressed before SDRs can phase
out the USD.

1.c If $3 trillion in SDRs are created, then how will the conversion take place without the
value of USD taking a hit? If it is done outside the market, then who will bear the
exchange risk i.e. hold all those depreciating US dollars?

USD as International Reserve Currency Page 9c

 2.c The currency composition of SDR needs to be changed to make it more cyclical-
proof. It needs to reflect the change in the economic power shift.

With the above constraints impeding the rise of SDRs, it would take a herculean effort to
erect a new global financial architecture. Though theoretically feasible, it seems only a
remote possibility that the SDRs would replace the US Dollar in the near future.

Conclusion
There is no doubting the fact that US Dollar has enjoyed the cult status for decades now.
However, with its value depreciating because of the Fed¶s monetary stance and the emerging
economies raising apprehensions, the USD being replaced as the international reserve
currency seems possible but to say that it would happen in the next 10 years would not be
wise. Thus, we believe that USD would continue to be the currency of choice with a slow
phasing out. Out of the alternatives, Euro makes for the strongest case to replace USD at the
moment. The Renminbi & the SDRs involve large-scale changes in the Chinese model of
growth and the global financial system respectively which at the moment don¶t seem feasible.

References:
Chinn and Frankel, 2005, ³Will the euro eventually surpass the dollar as leading international
reserve currency?´
Helmut Reisen, ³Is the US Dollar Empire falling?´
Manoj Pant, The Economic Times, ³Is the dollar history?´
Barry Eichengreen, ³The Irresistible rise of Renminbi´
Onno Wijnholds, ³The Dollar¶s last days?´
Barry Eichengreen, ³Sterling¶s Past, Dollar¶s future : Historical perspectives on reserve
currency competition´
Alan S. Blinder, ³ The role of the Dollar as an international currency´

USD as International Reserve Currency Page 10c