A cabal plotting against the dollar?
A report in Britain’s Independent newspaper that Gulf Arab states are in secret talks with Russia, China, Japan and France to replace the U.S. dollar with a basket of currencies for trading oil is almost certainly an exaggeration. It has already been denied by many of the countries allegedly involved.
Redenominating the currency for oil transactions is a hardy perennial. It crops up every few years in response to political concerns about U.S. hegemony in the Middle East and the threat to impose sanctions on a major producer (Iraq, Iran), or worries about the impact of dollar weakness on producer-country revenues.
No doubt renewed concerns about future dollar devaluation have prompted another bout of soul-searching among central bankers and lower-level finance ministry staff about the merits of diversifying oil invoicing and reserve holdings into a broader range of currencies.
Even at high level, there have been increasing hints that senior policymakers are thinking about the dollar’s role in long-term monetary relations. China’s central bank governor Zhou Xiaochuan openly discussed the need for diversification earlier this year. But it is very unlikely these informal discussions about very long-term objectives have reached the stage of formal policy planning.
RESERVE CURRENCIES IN A MULTIPOLAR WORLD
I wrote earlier this year that the financial crisis that erupted in 2007 was likely to prove a cataclysmic shift every bit as significant for the world monetary system as the outbreak of the World War One or the suspension of convertibility in 1971. It marks the ending of an era in which the U.S. dollar has been the undisputed reserve currency for making international payments and storing wealth.
The dollar is not about to lose its reserve status completely. But it will become less “special”. In future, it will increasingly have to share its reserve status with the euro, the yen and perhaps the currencies of other advanced economies. In time, it may even have to share its status with China’s yuan.
In fact the whole concept of a single reserve currency (the U.S. dollar) and a principal reserve asset (U.S. Treasury bonds) is set to undergo a profound shift. Policymakers, businesses and households will in future think about and hold a whole portfolio of competing reserve currencies and assets. Multipolarity in the world of security and economic relations is set to be matched by a world of multiple reserve currencies.
GLOBAL IMBALANCES AND THE TRIFFIN DILEMMA
Outside the United States, most policymakers and analysts agree that the world’s reliance on the dollar as the sole reserve asset for trade and official exchange holdings contributed to the global imbalances and policy errors that culminated in last year’s financial meltdown.
In a re-run of the Triffin dilemma of the 1960s, the United States has been forced to run persistent current account deficits to meet global demand for liquidity and reserve assets. But the resulting build up of dollar denominated liabilities has led to widespread doubts about whether the United States can meet its obligations or may be forced to devalue.
In the wake of the crisis, it is clear the United States will have to devalue its way out of recession, cutting the purchasing power of U.S. households and businesses, while inflicting substantial losses on the foreign exchange holdings of overseas central banks.
As U.S. Treasury Secretary Henry Fowler noted in the mid-1960s: “Providing reserves and exchanges for the whole world is too much for one country and one currency to bear”.
But that does not mean that switching to a world of multiple reserve currencies will be quick or easy, and it will not necessarily solve the problem of fluctuating revenues for the major oil-exporting countries.
OBSTACLES TO DIVERSIFICATION, STABILISATION
The first problem for central banks concerns the transition: how to reduce existing dollar holdings and cut new purchases without triggering a loss of confidence and the very exchange losses they are seeking to avoid. For an individual central bank, it might be possible to reduce exposure gradually and in secret, but this is not really a solution for central banks as a group.
In the end they may have to accept some permanent losses on their reserve portfolios as the price for restarting global growth and ending their exclusive reliance on the dollar. Extinguishing the dollar’s reserve status (at least in part) will reduce some of the specialness and premium built into its value as a medium of exchange and store of value. Some losses on the central banks’ portfolios therefore appear inevitable.
But the timing of any shift is politically sensitive for both the United States and its creditors. China’s policymakers are wary about realising losses from their ill-fated reserve accumulation strategy. They are worried about a public backlash when it becomes clear that they have invested the product of the country’s hard-earned exports into devalued U.S. Treasury paper.
For the United States, loss of exclusive reserve currency status would be humiliating confirmation that the “hyper-power moment” is giving way to a more multipolar world. At a practical level it would reduce the room to manoeuvre for both the Federal Reserve and the U.S. Treasury. Senior U.S. officials are careful to reiterate their belief that reserve status will not be challenged, though many of them must privately realise the incongruousness of the United States being the sole issuer of reserve assets as its share of the global economy shrinks.
Even if the transition problem can be resolved, the other question is what currencies will share reserve status in future. The euro and yen both have some potential and are acquiring reserve-like characteristics, with some evidence central banks have begun to hold more of both currencies. But sterling, the Swiss franc and Australian dollar are too small to play more than a marginal role, and the reserve problem will not be fully resolved until China’s yuan becomes convertible for international transactions on both current and capital account.
CURRENCY VOLATILITY ONLY ONE PROBLEM
For oil exporters, shifting from dollar pricing and invoicing to a basket of currencies would remove one source of volatility in export earnings. But as I have argued elsewhere, currency movements have been only a marginal influence on oil prices and producer-country revenues and account for only a relatively minor part of the overall volatility [ID:nLU733472].
Changes in global liquidity conditions, manufacturing growth, speculation and the relative market power of producers and consumers have all played a far more important role. Removing the instability associated with currency changes is therefore unlikely to produce the hoped-for stabilisation in producers’ revenues and purchasing power unless these other sources of volatility are also reduced.
In the end, the dollar’s exclusive reserve currency role will be gradually eroded over the next 10-20 years, just as sterling’s reserve status faded in the first part of the 20th century. But the coup de grace will be delivered by changing trade patterns and the growing economic weight of Asia in the global economy, rather than some secret “cabal” of oil-country and emerging-market ministers.