The Sabrient Blog

As the Dollar reached 15-month low {and} Euro presses back above $1.50, there are bound to be renewed questions such as: Is the Dollar Fading as No. 1 Reserve Currency? Given that, this post will look at some points of view of that particular question starting with the economists quoted in that second linked article above at US Banker magazine.

What Economists Predict.
While the future may be hard to predict, economists are happy to provide educated guesses on the time frames for when structural changes may occur. Aside from a total and complete melt down of the present economic environment, Joseph Rosta {writer of last linked article} provides the views of 5 economists and what time frame they think it is possible {but unlikely} that the US fades as the number one reserve currency. Let me start with a quote by David  Wyss in Rosta’s article.

“A shift away from the dollar probably should happen, but it won’t happen overnight,” says Standard & Poor’s chief economist David Wyss. He sees a 10-year process, with the dollar losing its dominant position to a basket of currencies. “You can’t have a world currency before you have consistent global regulatory and fiscal policy,” according to Wyss.

Wyss does not explain why it “should happen” and it may not be good for the overall world economy even if it does. If in fact the world is moving toward a “basket of currencies” or a “world currency” then yes a global regulatory agency would be needed. Without a cataclysmic event like a world war then it is unlikely that would even be possible. For example, it took the Euro nearly 50 years to get started and that was between a relatively small number of countries of approximately equal economic development. This basket of currencies would have to be “managed” in certain ways and the most obvious candidate for it is the IMF with its Special Drawing Rights international reserve asset {SDRs}. This suggestion even has historical precedence going back to WWII.

Regarding an expanded SDR, Rosta quotes Steven Pearson, head of G10 currency strategy at Bank of America Merril Lynch:

Brazil, Russia, China and India are pressing for an expanded SDR, Pearson adds, but there are few stable currencies that are broadly enough traded to merit inclusion. Today SDRs are a mix of the dollar (44 percent), the euro (34 percent), the yen (11 percent) and the pound sterling (11 percent). Instead, the most likely near-term scenario will be a rebalancing of central bank currency holdings away from the dollar.

Correct. But if the near-term scenario is to rebalance holdings then the question is why has it not been done already and with as little fanfare as possible?

One likely explanation is the idea of isolation paradox. That is that an individual {think China} may not be willing to change behaviors unless others agree to it also. Most of the Newly Industrialized Countries {NICs} have been export competing and with this maintaining a low valued currency with respect to the US dollar. As a result they have been accumulating excess reserves. Now even the Chinese Dragon is afraid of being the leader and changing paths alone. More technically I am thinking of the Stackelberg leadership model {Stackelberg competition} but without the presumed leader of the NICs willing to make the first move.

One dilemma with SDRs is that while trade patterns worldwide would dictate a certain percentage breakdown of the currencies in the basket of a SDR that does not indicate that the levels of reserves of any particular country would coincide with those divisions.

For example, trade between Iran and the USA is nearly nothing so that the reserve percentages held by Iran should be very low in USD. And even putting aside the political aspects of the reserve decisions, they may not wish to hold that much USD indirectly in dollar reserves. Secondly, they may not just be looking to hold reserves as individuals do with cash with respect to the “transaction demand for money.” They may be holding it in reserves for speculation or hedging which would indicate holding not just the cash but in fact highly liquid financial instruments like T-bills. And as another economist states the following:

“SDRs are an old saw raised perennially, but without a government and central bank behind them they cannot become important,” observes Paul Bennett, a fellow of Columbia University’s program in law and economics.

He gives the remnimbi another 20 years before it challenges the dollar. And Bennett predicts a gradual increase in the use of euros as reserve holdings, “but nothing dramatic.”

Without the discipline of a government that is held accountable then I too would agree that it is unlikely, and fear of worldwide inflation could appear as the Americans objected strongly in the formation of the SDRs in the IMF. There is already a growth of euros as a reserve currency and it seems reasonable that it would continue especially based on trading patterns, but there are most definitely obstacles to the the remnimbi and to a lesser degree the euro. Back to Pearson’s statement:

Others don’t believe a brand new currency is likely, and doubt the remnimbi will be ready to take its place as a reserve currency anytime soon. “The remnimbi would have to be freely exchangeable and deliverable, and it’s not,” says Steven Pearson.

Even if Nouriel Roubini is cheering this on it does not change those facts of “exchangeable and deliverable.” It also has to be robust enough to have “hot money flows” both in and out without disrupting trade flows. It must in fact be a world leader in openness to flows of goods and services and in fact have the most direct trade with all other nations. So far only the USA fits those shoes. While the Europeans may be relatively open, I am just not sure that they would be willing to face uncertainty as the world reserve currency when financial institutions like the eurodollar markets rose up because of restrictive banking practices in the USA.

Keith Leggett, senior economist at the American Bankers Association states that the dollar will still be “a major component in these portfolios” which is supported by trade flows which are unlikely to change over the near future. And lastly, Scott Anderson, vice president and senior economist at Wells Fargo, states that any shift away from the dollar could take 10 years at least.

Barry Eichengreen , professor of economics and political science at the UC Berkeley, states his forecasts for the dollar at Reports of the dollar’s death are exaggerated:

Beyond this, the dollar isn’t going anywhere. It is not about to be replaced by the euro or the yen, given that both Europe and Japan have serious economic problems of their own. The renminbi is coming, but not before 2020, by which time Shanghai will have become a first-class international financial center. And, even then, the renminbi will presumably share the international stage with the dollar, not replace it.

The rest of the article is worth reading and spells out much of the points made at The Sabrient Blog » Macro View of the Markets.

A Counter Voice and a Short Term Prediction.
But there are still some that predict the collapse of the dollar much sooner as Daisuke Uno, Sumitomo Mitsui Banking Corp.’s chief strategist, states at Dollar to Hit 50 Yen, Cease as Reserve, Sumitomo Says:

“The U.S. economy will deteriorate into 2011 as the effects of excess consumption and the financial bubble linger,” said Daisuke Uno at Sumitomo Mitsui, a unit of Japan’s third- biggest bank. “The dollar’s fall won’t stop until there’s a change to the global currency system.”
…
“We can no longer stop the big wave of dollar weakness,” said Uno, who correctly predicted the dollar would fall under 100 yen and the Dow Jones Industrial Average would sink below 7,000 after the bankruptcy of Lehman Brothers Holdings Inc. last year. If the U.S. currency breaks through record levels, “there will be no downside limit, and even coordinated intervention won’t work,” he said.

There is no denying the effects of the most recent financial crisis, but it takes more than just momentum analysis to predict a crash. If we look at other similar events then we can note that even given Japan’s financial collapse and subsequent lost decades, the yen is still used as a reserve currency. The USD also experienced huge changes in value during the mid 1980s and still maintained it reserve currency status and much of that was done with policy coordination. Unlike the experiences in Japan, there is likely to be much more policy coordination for the USD as no one wants to lose the “borrower of last resort”. Lastly, the US has been a much more flexible economy and more than likely will adapt more quickly to the changing world economy. For a fairly long article about some of these last points, see Tyler Cowen’s: Last Man Standing.

Menzie Chinn at Econbrowser has some analysis of short term prospects of the USD at The Dollar.

Both series are plotted in logs, and exchange rates defined such that up implies a stronger dollar. In both cases the 95 percent interval is shown. What is clear is the (geometric) mean forecast for the dollar implies relative stability. It’s true that the lower bound implies some depreciation over the next year — but no more than 5.6 percent decline (in log terms). That’s hardly calamitous. But it would be helpful in terms of facilitating rebalancing (as I pointed out a few weeks ago [6] [7], dollar decline makes a lot of sense, perhaps even more than the 5.6 percent implied by the lower bound).

If one is more concerned about the dollar’s value against major currencies (perhaps because of an interest in cross-border valuation effects on financial assets), one would want to see how the dollar evolves against the euro. Here, it appears the mean forecst implies strength over the medium term. Even the scenario for the weakest dollar implies no more than a 7.5 percent decline, at the 3 month horizon.

Nothing to Fear except Fear Itself?
There are logical reasons to conclude that the USD will maintain its status with some weakening in reserve holdings of the USD but that should be overall a good thing to unwind the global imbalances. I find nothing that can credibly replace the dollar for the foreseeable future.

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