Will the dollar remain the reserve currency?

• Position: A SYMPOSIUM OF VIEWS

Is the rising global chorus to replace the dollar a reflection of far deeper problems in the world financial system?

Two dozen noted observers share their outlook

A tectonic shift is beginning.

WILLIAM H. OVERHOLT

President, Fung Global Institute

For the foreseeable future, the dollar will be the world's largest reserve currency holding and the most important currency for financial security. Only the dollar provides the deep pool of liquidity necessary for massive crisis trades. Only the U.S. Federal Reserve is trusted to act decisively in crises. The euro is a collection of puddles of liquidity and the ECB is not seen as decisive. While U.S. economic policy and stability are questioned, relative to the European Union and Japan the U.S. position continually strengthens.

Beneath that position, however, a tectonic shift is beginning.

The rise of the rest, particularly China, steadily dilutes the importance of the United States. Countries gradually diversify their reserves. Asian swap agreements gradually dilute the importance of dollar liquidity. Denomination of trade in euros grows steadily, in RMB spectacularly. China's [yen] 2.4 trillion of active swap agreements promote local currency trade and investment.

Second, the Fed is mobilizing resistance to the dollar. The first big decline in the role of the dollar followed the 1971 dollar devaluation, which helped stimulate the subsequent emergence of the euro. Then-Treasury Secretary John Connally dismissed foreign pain with "It's our currency, it's your problem," and other countries reacted. In today's more globalized world, Fed policies are spreading much more pain--property and debt bubbles, inflated prices of staple foods, resultant political instability--over a much longer period of time. While Germany belatedly modified its inward-looking approach to monetary policy just enough to save Europe, the United States has failed to modify Fed norms to befit its hegemonic global role. While Connally's bluntness has been replaced by bureaucratic professorialism, the message is still "It's our currency, it's your problem," supplemented in foreign eyes by "Let the Egyptians eat cake." In a world out of balance, with unusual, aggressive, and distortive monetary policies, there is a vacuum in the international monetary system. The debilitating consequences for the dollar's role will dwarf 1971.

Third, reactions against the widespread U.S. use of sanctions against any institution that clears in dollars and offends U.S. foreign policy have been dramatic. A rush into Hong Kong dollar transactions, to avoid U.S. clearing, has strained Hong Kong monetary authorities' ability to manage the huge surges. Major institutions now avoid SWIFT and CLS because clearing through U.S. firms entails risk of future sanctions. If the stampede continues, this will weaken U.S.-based clearing institutions and evolve away from U.S. dollar proxies to unlinked substitutes.

U.S. refusal to reform and expand the International Monetary Fund and World Bank has backfired. China Development Bank is now more important than the World Bank. Together with originally small initiatives like the BRICS bank and the Asian Infrastructure Investment Bank, this may create a rapidly expanding RMB-based sub-system.

The dollar is secure against challenges from the yen and euro. The RMB currently lacks characteristics of a global currency, including deep, open capital markets, a trusted legal system, and market-determined currency and interest rates. But these weaknesses may fade quickly. The RMB has already surged past the euro as the second currency of international trade. A quarter-century from now, the global monetary system may have two major currencies, the dollar and the RMB, and highly diversified swaps and foreign exchange reserves rather than dollar hegemony. Only if Europe unifies politically could the euro become a co-leader.

Triffin's prediction was wrong, but his concerns were valid.

WILLIAM R. WHITE

Chairman, Economic Development and Review Committee, OECD

The dollar remains the world's main international reserve currency. This dominance has been maintained in spite of a sharp fall in the share of global GDP produced by the United States and a continuous rise in the net external liabilities of the United States. Decades ago, economist Robert Triffin predicted the latter would eventually undermine confidence in the dollar, potentially leading to a crisis that would cause great harm to everyone--including the United States.

Why has this not happened? One reason is that core factors supporting the international use of the dollar remain in place. To this first mover argument must be added simple inertia and the fact that there is no obvious candidate to replace the dollar. True, in some areas other currencies are being used along with the dollar, but the pace of change has been slow and this seems likely to continue. A variety of fears and institutional shortcomings still limit the international usefulness of other currencies. In sum, the future of the dollar's reserve currency status seems quite certain.

Yet to say something could happen is very different from saying something should happen. Triffin's initial concerns remain valid. Albeit interrupted by sharp upward spikes, the effective value of the dollar has been declining since the breakup of the Bretton Woods system. Holders of dollar-denominated assets have thus for years been suffering steady losses, or at least relatively low rates of return. Nevertheless, the decline in the dollar has not led to a current account adjustment sufficient to stop the rise in net foreign debt. At some point, perhaps sparked by political deadlock and fiscal dominance in the United States, the long-awaited crisis could yet materialize.

However, this failure of the external adjustment mechanism is only one of many reasons for suggesting we need to revisit urgently the issue of the international monetary system. First, a wide body of evidence now indicates that "spillovers" from the monetary policies of the large advanced economies, not least the United States, affect other countries. Moreover, the cocktail of suggested protective measures, including "free floating," seems wholly inadequate. Second, global credit and monetary expansion is dangerously unanchored. Whether to push a currency down or to prevent it from going up, central banks around the world have expanded the size of their balance sheets by unprecedented amounts. Given the complexity of cross border interactions, we simply have no idea how all this might end. Third, in the event of a crisis calling for significant international liquidity support, the source of that support is by no means obvious.

Since the breakdown of Bretton Woods, we have had a non-system, devoid of rules, in which every country acts in pursuit of its own short-term interests. It needs to be replaced with a cooperatively agreed system that will avoid the dangerous shortcomings described above. In this way, the longer-term interests of all countries, including the United States, will be better served.

There are no plausible candidates to dethrone the dollar. That is bad news for the U.S. economy.

JOSEPH E. GAGNON

Senior Fellow, Peterson Institute tor International Economics

Nothing should ever be taken for granted. Research shows that inertia matters for a reserve currency, but it is not everything. Also important are economic size and openness, macroeconomic stability, and financial policies that encourage or discourage a currency's use by foreigners. On these criteria, there are no plausible candidates to dethrone the dollar in the foreseeable future. That is bad news for the U.S. economy.

Once upon a time, in a world of scarce capital, the so-called "exorbitant privilege" of the United States--that is, the ability to borrow cheaply from the rest of the world--may have been a worthwhile benefit of the dollar's role as the world's premier reserve currency. In today's world of currency wars and zero interest rates, governments want to lend abroad rather than borrow. They send capital abroad to push down the values of their currencies in order to boost exports and economic growth. Official purchases of foreign exchange reserves and other foreign assets--mainly U.S. dollars--have exploded since 2000 to unprecedented levels as a share of global GDR Some countries go further and actively discourage or prohibit foreign purchases of their currencies, most notably China and, intermittently, Brazil.

Unfortunately for the U.S. economy, the U.S. government has been unwilling to take effective measures to level the playing field. Such measures could include selling comparable quantities of dollars in exchange for foreign currency reserves, taxing foreign purchases of dollars, and eliminating some of the many exemptions on the U.S. withholding tax on income earned by foreign holders of U.S. assets. None of these measures contravenes international law. All of them would offset the recent upward pressure on the dollar that is threatening the gathering U.S. economic recovery.

By the way, the currency in which oil or other international commodities are priced has no economically meaningful implications. Commodity prices are highly volatile regardless of the currency in which they are quoted. Deep global foreign exchange markets make it equally easy to pay in dollars, euros, yen, or any other currency whose trading is not restricted by its own government or by international sanctions. The power of such sanctions depends on the collective economic weight of the countries that enforce them and not on the currency of the underlying transactions; U.S. banks are not allowed to deal with many Iranian institutions, whether in dollars, rubles, or rials. What does matter is the currency in which commodity exporters hold their earnings. The problem again is too much holding of dollars, not too little.

It is both certain and uncertain!

MOHAMED A...