Jeffrey A Frankel. Foreign Affairs. Volume 74, Issue 4. July 1995.
Reports of the dollar’s death have been greatly exaggerated. It is of course true that the value of the U.S. currency has fallen against the Japanese yen and Deutsche mark recently. It is also true that some measures of the dollar’s use as an international currency show a decline. These are long-running trends, however. There is little evidence so far of an abrupt acceleration or tipping in the use of the dollar. In particular, and contrary to widespread belief, the dollar’s standing as a reserve currency has actually increased in the 1990s. Furthermore, there is little likelihood that some other currency will supplant the dollar as the world’s premier reserve currency by 2020. One national currency or another must occupy the number-one position, and there is simply no plausible alternative.
There is a nice analogy with the international use of the English language. Nobody would claim that English is particularly well suited to be the world’s lingua franca by virtue of its intrinsic beauty, simplicity, or utility. Yet it is certainly the language in which citizens of different countries most often converse and do business, and increasingly so. One chooses to use a lingua franca, as one chooses a currency, in the belief that it is the one others are most likely to use.
Similarly, it is not that the dollar is ideally suited for the leading role. It has some characteristics that mar its appeal. Most important, the United States is a debtor country with a large deficit and few signs that it is getting its profligacy under control. But an international currency is one that people use because everyone else is doing it. Three of the four determinants of reserve currency status—economic size, developed financial markets, and historical inertia—support the dollar. The fourth factor—confidence in the value of the currency—could in principle disqualify the dollar if the Federal Reserve launched a high-inflation strategy, but that is unlikely to happen.
A reserve currency is one in which central banks choose to hold their foreign exchange reserves. Use as a reserve currency is one important aspect of being an international currency, or a currency used outside its home country. As a percentage of total reserves, the dollar declined gradually in the 1970s and 1980s (see graph). The mark’s share increased gradually over the same period. The yen’s share also increased, starting from very low levels in the 1970s.
The view that the dollar is losing its reserve currency role has suddenly become popular. The reason may be that pundits have otherwise been hard put to explain the dramatic depreciation of the dollar in 1994-95. Most of the traditional fundamentals would lead one to expect a strengthening dollar: U.S. interest rates have risen since February 1994, and American growth has been stronger, and inflation lower, than expected over this period. Furthermore, political disarray in Washington has been nothing compared to the weakness and disarray in Tokyo. Yet from February 1994 to May 1995 the dollar depreciated 20 percent against the yen and 18 percent against the mark. Financial commentators have seized on the declining reserve currency role of the dollar to explain this mystery. Their case has been buttressed by recent reports from East Asian central banks, whose reserve holdings are now an important share of the world total, that they are shifting out of dollars into yen. The case is also buttressed by the observation that the big movement in the foreign exchange market over the last year has taken place only against the yen and mark (and Swiss franc), the leading rival reserve currencies.
Other measures of international currency use besides reserve holdings are relevant as well. A second measure is the choice by smaller countries to peg their monies to major currencies. Twenty-three countries still peg to the dollar, as compared to 14 for the French franc. Here the mark and the yen are little used. Other measures include the frequency with which currencies are selected for use in imports and exports, international bonds and bank loans, and in foreign exchange trading. The pound sterling and Swiss franc still play major roles in the denomination of bond issues. Overall, however, these measures show the yen and the mark as the two most serious rivals for the dollar. These measures, like the reserve measure, show a gradual long-term decline in the dollar’s role, with little indication of dramatic recent acceleration.
The issue of the declining international role of the dollar is distinct from the issue of the declining value of the currency. For example, the strongest evidence of increased use of the yen in East Asia at the expense of the dollar over the last ten years is the rapid rise in the share of debt that emerging market countries owe in yen—most of it to Japan. However, such a shift does not put downward pressure on the yen-dollar exchange rate. If anything, when Japan increases the supply of yen assets in this way it puts downward pressure on the yen and upward pressure on the dollar. These debtors are now lamenting the debt-service cost of their yen obligations and may curtail their use of the yen for borrowing in the future.
Such fine points aside, the popular impression that the decline of the dollar as a reserve currency is correlated with the decline of the value of the dollar on the foreign exchange market is, overall, correct. If central banks shift their reserve holdings out of dollars and into yen or marks, that adds to the downward pressure on the value of the dollar at least as much as when private investors do so. The shift thereby works to reduce the market price of the dollar. Causality can also run in the reverse direction. If a history of dollar depreciation causes a loss of faith in the greenback as a stable store of value and unit of account, importers, exporters, borrowers, and lenders will become more reluctant to use it. This includes central banks: if they expect continued depreciation in the future, they may jump on the bandwagon, particularly the smaller central banks, who are less likely to feel some responsibility for the global system. If they sell dollars, the dollar will depreciate, fulfilling the pessimistic forecasts.
Does it matter whether the dollar retains its role as an international reserve and vehicle currency? There are four advantages for a country of having its currency used internationally. It is certainly more convenient for a country’s exporters, importers, borrowers, and lenders to be able to deal in their own currency rather than foreign currencies. The global use of the dollar, as with the global use of the English language, is a natural advantage that American businesspeople tend to take for granted.
There is also more business for the country’s banks and other financial institutions. There need be no firm connection between the currency in which banking is conducted and the nationality of the banks (nor between the nationalities of the savers and borrowers and that of the intermediating bank). Nevertheless, it stands to reason that U.S. banks have a comparative advantage at dealing in dollars. Only U.S. banks have access to the safety net provided by U.S. regulatory authorities (access to the discount window, and so forth).
Next is what is called “seigniorage.” This is perhaps the most important economic advantage of having other countries hold one’s currency. They must give up real goods, services, or capital to pay for the reserves they hold. Just as American Express profits whenever people hold its traveler’s checks, which they are willing to do without receiving interest, so the United States profits whenever people in Argentina or Russia hold dollars that do not pay interest. Wherever hyperinflation or social disorder undermine the public’s faith in the local currency, the American dollar is the preferred alternative. (The drug trade and other illegal activities are another source of demand, of course.) Federal Reserve Board Governor Lawrence B. Lindsey, in a 1994 speech that reminded Americans of the benefits of international currency status, estimated the cumulative additional Fed currency seigniorage since 1981 to be some $64 billion. This is a growing source of revenue. Another calculation suggests that the United States now derives about $12 billion a year in seigniorage from foreign holdings of U.S. currency, which are conservatively estimated at 60 percent of total dollar currency in circulation.
There is an another (much smaller) component of seigniorage in addition to the currency component. Most foreign central banks and other investors hold their dollars in the form of interest-paying Treasury bills. To the extent the reserve currency role of the dollar allows the U.S. Treasury to pay a lower interest rate on its liabilities than other borrowers must, the difference is a further source of seigniorage.
Finally are the benefits to political power and prestige. These are decidedly nebulous. Nevertheless, the loss of key currency status and the loss of international creditor status have sometimes been associated, along with such non-economic factors as the loss of colonies and military power, in discussions of the historical decline of great powers.
The responsibilities commensurate with Japan’s new status as a great economic power that many Americans have urged on Japan in the abstract, will—when realized concretely—increasingly be seen as Japanese gains at U.S. expense. Examples include increased roles for Japan in the United Nations and International Monetary Fund (IMF) in return for Japanese financial contributions, as in connection with the Persian Gulf War and the recent Mexican peso crisis.
So is a portfolio shift by central banks from dollars to yen to blame for the recent depreciation of the dollar? Contrary to widespread belief, the latest official figures show that the yen’s share in reserve holdings fell slightly in 1994. The mark and dollar shares were approximately flat. Relative to 1990 levels, the yen’s share is down slightly, the mark’s share down more substantially, and the dollar’s share is up more than seven percentage points. The recent data show no acceleration in the long-standing downward trend in the dollar’s share; if anything, they show the reverse. What is going on?
The Bank of Japan and major European central banks in the early 1990s bought up dollars on the foreign exchange market to prevent the value of the dollar from falling against their own currencies as much as it otherwise would. They may not be happy with this situation, but they find it preferable to the alternative. It is the same thing they have done regularly for three decades. Will they continue to do so?
Four major conditions determine whether a currency is an international currency. First is history. There is a strong inertial bias in favor of using whatever currency has been the reserve currency in the past. An exporter, importer, borrower, lender, or currency trader is more likely to use a given currency in his or her transactions if everyone else is doing so. For this reason, the world monetary system tends to center on individual currencies for long periods of time. The pound remained an important international currency long after the United Kingdom lost its position as an economic superpower. Inertia favors the continued central role of the dollar.
Second, the currency of a country that bulks large in the world economy has a natural advantage. The U.S. economy is still the world’s largest in terms of output and trade. Alarmist fears notwithstanding, it is unlikely that Japan, a country with half the population, far less land, and far fewer natural resources, will surpass the United States in sheer economic size.
Third, the country’s financial markets must be not only free of controls but also deep and well developed. The large financial marketplaces of New York and London clearly benefit the dollar and pound relative to the mark. Tokyo financial markets came a long way in the 1980s but still lag behind New York and London. Many of the steps that the United States urged on the Japanese in the 1984 yen-dollar negotiations were designed to encourage the development of markets in Tokyo in bankers’ acceptances, commercial paper, short-term government securities, and hedging instruments. The explicit goal was precisely to facilitate the internationalization of the yen. While such steps have been taken in Japan over the last ten years, these markets remain as yet relatively less developed. It has been argued that a strong central bank and large financial sector to counterbalance the political influence of the trade sector are also important; the point is to be able to resist political pressure in favor of depreciating the currency to help sell goods.
Fourth is confidence in the value of the currency. Even if a key currency were used only as a unit of account, a necessary qualification would be that its value not fluctuate erratically. A key currency is also used to hold assets (firms hold working balances of the currencies in which they invoice, investors hold bonds issued internationally, and central banks hold currency reserves). Here confidence that the value of the currency will be stable, and particularly that it will not be inflated away in the future, is critical.
The monetary authorities in Japan, Germany, and Switzerland in the 1970s established a better track record of low inflation than the United States. Given the good U.S. inflation performance over the last ten years, stability is no longer such a concern as it was formerly. A more important negative for the dollar is that the United States is now a large-scale debtor country. Indeed, 1994 was the first year in which the country actually paid out more in interest, dividends, and repatriated profits to foreigners on their past U.S. investments than it received on its own past investments abroad. Even if the Federal Reserve never succumbs to the temptations or pressures to inflate away the U.S. debt, the continuing U.S. current account deficit is always a possible source of downward pressure on the dollar. Such fears make dollars less attractive.
It is a fairly safe call that in the year 2020 the dollar will still be the world’s favorite reserve currency. None of the alternative candidates is plausible. If the European Economic and Monetary Union were to come into existence in the latter part of this decade, as many European leaders are planning, then the European currency unit, or whatever the new currency would be called, would be a prime contender to take over a major global role from the declining dollar. According to the terms of the 1991 Maastricht treaty, European leaders must decide whether a majority of members meets the criteria to qualify for the EMU in 1997. It is already clear that very few will satisfy the criteria, perhaps even by the second-chance deadline of 1988. If the leaders try to force the pace, they may end up with a repeat of the foreign exchange market crisis of September 1992. In the meantime, since that crisis the use of the ECU to denominate bonds and loans has stagnated.
The mark has substantial monetary influence in Europe now. At least one currency, the Estonian kroon, pegs to the mark formally, and others such as the Austrian schilling and Dutch guilder virtually do so. German monetary policy is a major determinant of interest rates throughout the continent. But if most Europeans are reluctant to subordinate their countries’ monetary policies to the Bundesbank—which is ultimately the stumbling block to the EMU—they are even less likely to countenance an enhanced formal role for the mark in Europe. Countries outside Europe have still less incentive to link to the mark officially. Use of the mark in private transactions remains handicapped by Germany’s underdeveloped financial markets.
The yen will probably continue to gain ground, particularly in East Asia. But no country yet pegs its currency to the yen. Indeed, a Pacific country that seeks to stabilize the value of its currency in terms of a basket of currencies, whether tightly or (more often) very loosely, generally gives far more weight to the dollar than the yen. East Asian countries still conduct a great deal of their trade and investment with the United States and the rest of the western hemisphere, and they wish to keep it that way. They will continue to use the dollar as long as the rest of the world does.
The dollar’s record of depreciation may motivate central banks to shift some of their reserve holdings to the mark and yen, as they did in the 1970s and 1980s, Or to use these currencies in other ways. But neither of these currencies nor the ECU is likely to supplant the dollar as the premier international currency anytime soon.
The Long Shot
The latest data do not support the popular impression that there has been a dramatic acceleration in the decline of the dollar’s reserve currency role, at least not up to the end of 1994. Reserve currency status is lost over the course of decades as a result of slow growth and deficits. It is not likely to be lost in the course of a few months.
Just as the death of the dollar as a reserve currency has been oversold, so the dollar itself may be oversold in the foreign exchange market. Many investors who lost money on the dollar in 1994 and early 1995 have decided that the dollar can only go down and the yen can only go up. They are wrong. Exchange rates can move up as easily as down. In light of the present 5-point interest differential in favor of the dollar, the yen at some 80 to the dollar is not a good bet.
There is, however, an alternate scenario. Foreign central banks cod tire of their ever-increasing holdings of dollars—particularly the newly important central banks of East Asia. They could dump dollars in 1995 and thereby push the value of the currency even lower than its already low levels against the yen and mark.
To make the alternate scenario look especially worrisome, consider the following question: Who is financing the U.S. trade deficit? The international deficit in goods and services reached 1.7 percent of GNP in 1983, which at the time was a record unheard of in the twentieth century. It peaked at 3.4 percent in 1987. A big depreciation in the dollar over the last ten years has helped make American goods much more competitive on world markets. Despite the effects of this newfound competitiveness, however, the deficit in goods and services was a still hefty 1.6 percent of GDP in 1994. The trade deficits are virtually certain to continue, so long as the U.S. national savings rate remains at the depressed levels where it has been ever since 1982. U.S. net national savings fell to roughly 2 percent of GNP, down from between 7 and 8 percent in the 1950s, 1960s, and 1970s.
These trade deficits must be financed one way or another. The U.S. deficit was initially financed primarily by net banking inflows in 1982-83, then by sales of securities to foreigners in the mid-1980s, beginning primarily with Treasury securities and progressing to corporate bonds and equities, then by sales of companies and real estate in the late 1980s. It was through these sales of assets to foreigners that the United States became the world’s largest international debtor. In 1990 private residents in Japan and elsewhere lost their enthusiasm for investing in the United States; the net inflow of private long-term capital sharply diminished. In 1991 transfer payments associated with Operation Desert Storm financed the U.S. trade deficit. In 1992 and 1993 purchases of dollars by the Bank of Japan and other foreign central banks did so.
What happens when the foreign central banks grow weary of increasing their dollar holdings? If foreign private investors do not renew their interest in dollar investing, the currency will have to depreciate yet further.
Such concerns become sharper when one focuses on the reserve holdings of developing countries. As a result of recent balance-of-payments surpluses, these countries’ holdings are now almost as big as holdings by industrialized countries. The worry is that the newly important central banks in East Asia and elsewhere are less likely to feel the same civic responsibility for supporting the dollar standard the traditional Group of Ten countries supposedly do.
There are reports that East Asian central banks, stung by past losses on their dollar holdings, have recently begun to switch their reserves from dollars to yen on a large scale, notwithstanding the IMF numbers. Assuming the reports are true, there are two possible ways of reconciling this conflicting information. The first is that the statistics reported to the IMF are in error. One major omission is known. Taiwan is not included in the statistics because it is not a member of the IMF. Yet its $93.2 billion of reserve holdings is the second-highest in the world after Japan. Taiwan is reported to have been reducing its dollar holdings by about 4 percent in each of the last several years, to about 57 percent of its total at the end of 1994 and 54 percent at the end of March 1995. Even when one makes the appropriate adjustment, however, the worldwide dollar share is still above the 1990 level.
The second possibility is that large shifts out of the dollar have taken place since the end of 1994. Reports of such shifts in early 1995 have come from such countries such as China and Thailand. According to the May 10 Financial Times, the central bank of China has raised the non-dollar component of its reserves to 25 percent in early 1995 from 10 percent, where it stood at the end of 1994. This $8.7 billion shift reduces the dollar’s share of the world total by another 0.8 percent.
It is quite possible that 1995 figures will show a substantial drop in the dollar share. Central banks would have to dump a lot of dollars in 1995, however, before the reported share fell below the level in 1990.
A return to the gentle downward trend of the 1970s and 1980s would not be surprising. The dollar’s long-term decline can be explained by the declining share of the United States in world GDP. The U.S economy accounted for almost half of gross world product in the aftermath of World War I; it is now down to about one-quarter. This says at least as much about the economic success of other countries as the shortcomings of the United States. The postwar reconstruction of Europe and Japan and, more recently, the industrialization of poor countries in East Asia and elsewhere have been both desirable and to some extent the inevitable result of catch-up. As the debate on competitiveness has taught (Foreign Affairs, March/April and July/August 1994), popular concern about the economic standing of the United States relative to its trading partners is useful if and only if it helps focus attention on the structural causes of low productivity growth: the low rate of national savings and the consequent low rates of investment in physical and human capital. The gradually declining international role of the dollar is but one more symptom of these deficiencies.