Market Forces: The Future of the U.S. Dollar

• China’s recent suggestion of a super-national reserve currency has received wide coverage.

• The idea reflects Chinese policymakers' unease about their U.S. dollar exposure.

• The U.S. dollar is likely to retain its reserve status, but other currencies are finding use as regional reserves.

With the U.S. engaging in quantitative easing and dramatic fiscal expansion, there is growing concern that the dollar could fall sharply. Holders of large quantities of U.S. dollars—especially the Chinese government—are naturally worried. Chinese policymakers are looking for ways to reduce their currency risk as their position grows. Premier Wen Jiabao has publicly alluded to the fear that the U.S. will inflate its way out of trouble, weakening the currency and lowering bond prices, both of which would hurt China’s holdings.

China remains by far the largest holder of U.S. dollars, though other Asian countries such as Japan, Taiwan, India and Korea also have hefty reserves.

In recent months, however, some have reduced their dollar holdings; part of this relates to the need to defend currencies that depreciated heavily at the end of 2008, but part also reflects the desire to reduce dollar exposure. India has reduced its official dollar holdings by $51 billion, or 17.5% from a year ago, and Korea has shed $58 billion, or 22%.

China, however, continues to accumulate dollars. In the 12 months to March 2009, its foreign reserves rose 27%, or $418 billion, to total nearly $2 trillion. This is enough to cover 32 months of imports, using February’s $60 billion of imports as a guide, and clearly vastly more than is necessary to forestall any short-term financing problems.

China’s decision to accumulate such large U.S. holdings in recent years was out of a desire to keep its export machine humming. Its U.S. dollar holdings were thought of as a hedge; the value in yuan-denominated terms was expected to fall as the yuan appreciates. In 2007, when the yuan was gradually appreciating against the dollar, estimates suggested the Chinese were losing about US$4 billion in value per month. The Chinese government largely accepted this as the cost of expanding exports.

Policymakers have belatedly realised that they are overexposed to the U.S. economy, and to the greenback, and are searching for ways to reduce their holdings. But the Chinese government faces many difficulties in unwinding its portfolio. China’s estimated $1 trillion in Treasury securities, for instance, are likely to have to be held to maturity, as any sales would prompt a panic and reduce the value of the rest of its holdings. There are also few other asset classes around the world capable of absorbing that amount of capital.

The recent proposal by People’s Bank of China Governor Zhou Xiaochuan about the creation of a super-sovereign currency, possibly using the International Monetary Fund’s Special Drawing Rights, faces many technical problems in implementation.

Searching for a new reserve

There are inherent difficulties in establishing a reserve currency. Chief among them is that a currency must be widely used as a medium of exchange, requiring a large supply. This is a major reason why the dollar was able to become a reserve currency; supply was plentiful around the world as the U.S. was willing and able to run large current account deficits. By contrast, despite Japan becoming the world’s second-largest economy, the yen did not gain traction as a reserve, because it was needed to pay Japanese exporters, leaving little to accumulate in central bank vaults.

Partly for this reason, the Chinese yuan is unlikely to become a reserve currency any time soon. The yuan faces an additional obstacle in that it is not fully convertible. But use of the yuan internationally is likely to increase. Although China runs a bilateral current account surplus against the U.S., it runs deficits with many countries from whom it imports commodities and components for export, especially in Asia. This could see the yuan become a minor reserve currency, similar to the role of the euro in Eastern Europe.

China recently signed a 70 billion yuan bilateral currency swap with Argentina, similar to agreements with Malaysia, Korea and Indonesia, allowing them to pay for imports with yuan.

A plausible scenario for the future is that, while the dollar will remain the world’s main reserve currency and the pricing medium currency for globally traded commodities, countries will seek to diversify their holdings. This is partly because the U.S. will run smaller current account deficits in the future and could even begin to run surpluses.