We are a lucky generation. We are the ones chosen to raise questions that remained mystically under the waters until the storm of recession hit us. It taught us how to swim. We came out of it; stronger, wiser and more resilient. However, we are still learning, maturing, searching for answers. Today the world economy, after witnessing the greatest hit in 70 years, is wondering what life will look like after the storm has settled. It is grappling with fundamentals of unemployment, burgeoning inflation, current account deficits, negative growth, zero interest rates and along with it, depreciating value of money. In the midst of all this, sits the US dollar like the king of a lost empire. Will the dollar maintain its reserve currency status even after its depreciation and regain the faith of the nations? Or will it be replaced by some other currency, shifting the power balances among the nations forever?
Let's go back into history
Prior to World War 1, the international standard of holding currency was against gold. Once gold was concentrated in the vaults of central banks and treasuries, there was an incentive to substitute it with bills and deposit claims which bore interest but were convertible into gold. Here sterling bills and deposits were the most important form, simply because Britain was the world's preeminent trading nation, absorbing more than 30 percent of the exports of the rest of the world in 1860. Up till 1914 about 60 percent of world trade was settled in sterling. Britain borrowed short and lent long, acting as a banker to the world. Before World War I, dollar was scarcely used in international transactions. There existed no central bank to operate in the open market and ensure market liquidity. This changed with the founding of the Federal Reserve. The establishment of Federal Reserve in 1914 enhanced the liquidity of the New York market and heightened its attractions as an international financial center. Its shares of global trade and foreign lending were markedly higher in the 1920s than they had been before WW1, leading to a considerable expansion in the dollar's role as a means of payment for international transactions between private parties. The advent of the World War 2 and the Brettonwoods system thereafter saw the primacy of the dollar in international transactions, rooted in law. The second half of the 20th century saw the greenback accounted for as much as 85 percent of global foreign exchange reserves.
We are now in the 21st century.
The US was viewed as the financial superpower and a banker to the world for quite some time. However, post-recession, it has become the world's largest debtor. The US lent out more than its deposits, inserting too much of liquidity into the system, leading to depreciation of the dollar. The crash of Lehman Brothers and the consequent events caused countries to lose faith in dollar and they started selling it off, leading to even further depreciation. US is running current account deficits worth 5% of its GDP, net negative capital, high inflation and zero interest rates. In such a scenario will the world central banks still accept the dollar as reserve currency? This depends, first and foremost, on America's own policies. Serious economic mismanagement could lead to persistence of unsustainably large current account deficits, accumulation of large external debts, and resulting high inflation rates and dollar depreciation. The British inflation rate that ran at roughly 3 times U.S. rates over the first three quarters of the 20th century, along with repeated devaluations against the dollar, played a major role in sterling's loss of reserve currency status.
Reservations against the dollar have already started being voiced by Italian economy minister Giulio Tremonti, People's Bank of China Governor Zhou Xiaochuan and Nobel Laureate Joseph Stiglitz.
Competitors to the dollar
Based on economic size, there are potential competitors to the dollar on the horizon, most notably the euro. The share of the euro in total international reserves has grown in the last decade, from 18 percent when the single currency was created to more than 25 percent today. By one estimate, it could overtake the dollar by 2022. Looking further ahead, China's dynamic growth may lead to the Yuan becoming more widely accepted internationally. Thus it is potently visible that the dollar is under threat.
Of course, merely replacing one dominant currency with another would do little, if anything, to alleviate the concerns that have been expressed about the current system. Potentially better would be a system where multiple currencies operate on a par. It is unclear, however, whether such a system could emerge on its own-given network effects-and, how stable it would be. In fact, the increased scope for arbitrage among the major reserve currencies could make such a system unstable, unless tight policy coordination among reserve issuers is achieved.
To combine the advantages of multiple and single currency systems, a basket-based reserve system, perhaps built on the IMF's Special Drawing Rights (SDRs), could be envisaged. This makes it more stable: if one of its constituent currencies depreciates, the share of the others in the basket rises proportionately, dampening the volatility of the basket. However, for the SDR to take on such a significant role, its liquidity would need to increase massively. While an increase in demand (from BRIC central banks) and supply of SDR assets (from the Fund) have recently materialized, the scale remains limited-about 4 percent of global reserves. Generating a liquid SDR market of the size needed to create a new reserve currency would be a major undertaking.
A more ambitious solution would be to move to a truly global currency that would circulate alongside countries' own currencies and would offer a store of value truly disconnected from economic conditions and policies in any country. To achieve this, one would need to set up a global monetary institution that would issue the global currency depending on global economic conditions, and that could act as a global lender of last resort. It would need to have an impeccable balance sheet and governance arrangements that engender widespread acceptability. Given the practical and political challenges it raises, this option is probably one for the very long time horizon. But considering the major developments of the past including establishment of IMF and World Bank, it does not seem altogether impossible.
The political angle:
Changing the world's reserve currency is something that doesn't happen very often. The US has enjoyed hegemony really since the end of World War 1. However, that is no reason to suggest that the dollar's influence will continue. The US has been criticized for printing more and more dollars without sufficient gold reserves. Also the Euro economy is now as large as the US. The Euro may also be seen as more politically desirable. European countries were less willing to get involved in Iraq and many accuse the US of an 'imperial overreach' with too many foreign bases and interference around the world. The European Union by contrast provides greater diversity and is politically more attractive, especially to Middle Eastern countries. The Middle Eastern countries' preferences can definitely not be ignored as they control, to a large extent, the import bills of the rest of the world, including US. It is in fact speculated that the Gulf Arabs, China, Russia, Japan and France plan to end oil trading in dollars. This would lead to falling dollar demand and rising demand for the replacing currency, change in volumes traded in dollar vis-à-vis the other currency and gradually an official replacement of dollar.
However, on the other hand, Obama's appointment as president has instilled some hope among countries with respect to US policies. There are expectations regarding improvement in economic variables and a good chance of the dollar regaining credibility.
What does it mean for India?
The dollar's share in India's new reserves has fallen from 63% in1999 to 37% in 2009. Suresh Tendulkar, economic advisor to Manmohan Singh is urging the government to hold fewer dollars. Holding more dollars means depreciating value of forex reserves along with the depreciating dollar. Rupee has risen to 46 per dollar, and it makes sense to peg the rupee against a stronger currency, say the euro. This will also encourage exports and discourage wasteful imports. However, India would not give up on the dollar so easily, considering that it wishes to maintain long term relations with the US, and such a step can potentially hamper them. Thus, India would prefer to stick with the dollar as much as possible.
Whether the dollar is actually replaced or not, only time will tell. The world might prefer a state of inertia, letting the dollar prevail, unless some crisis emerges, calling for some drastic action. Or else, voices raised against the dollar could translate into effect, actually changing the existing set up and gradually pulling the carpet off the dollar's feet. Whatever be the case, I know one thing for sure, it's a long wait.
