The Buck Stays Here

Five years ago, questioning the dollar’s status as the world’s reserve currency was confined to abstruse think-tank musings. How times have changed. The 2008 financial meltdown of the U.S. subprime mortgage market pushed debates about the dollar into the public eye. In September 2009, World Bank President Robert Zoellick warned, "The United States would be mistaken to take for granted the dollar’s place as the world’s predominant reserve currency. Looking forward, there will increasingly be other options to the dollar." This year’s political meltdown in Washington has only exacerbated the issue. HSBC now predicts that China’s currency will rival the dollar sometime this decade.  

The obstacles to a shift away from the dollar are still formidable. A useful global currency provides three necessary functions: It should serve as a medium of exchange for cross-border transactions, a unit of account to determine prices, and a store of value for those wishing to hold liquid assets. Measures like official currency reserves, invoiced international transactions, and international debt securities confirm that the dollar still surpasses any other currency in providing a unit of account and a medium of exchange. As a store of value, however, the dollar has become more suspect. Gyrations in the price of gold and the exchange rates of the Australian dollar and Swiss franc suggest at least a modest effort to diversify away from the greenback.

About a year ago, I argued in International Relations of the Asia-Pacific that "neither the opportunity nor the willingness to shift away from the dollar is particularly strong." That was before a global economic slowdown and a downgrade of U.S. debt by Standard & Poor’s, however. So has the world changed enough to require me to retract that conclusion? Not really.

For the dollar’s reserve currency status to fundamentally change, both public and private actors would need to prefer alternatives to holding and using dollars. Yet there remains no attractive alternative to the dollar as a reserve currency. In terms of currency reserves, the closest peer competitor to the dollar is the euro. The eurozone, however, has achieved the signal feat of making the United States look relatively stable by comparison. Furthermore, the European Central Bank (ECB) doesn’t seem to want the euro to become the new reserve currency. It has placed high barriers on any country joining the eurozone and seems more intrigued by the idea of kicking out some of the periphery countries than expanding the euro’s use overseas. In January 2009, ECB President Jean-Claude Trichet flatly stated, "I strongly disagree with those who say that the euro has been created to compete with the U.S. dollar. Let’s be clear: The ECB is not campaigning for the international use of the euro."

The other long-standing alternatives have even greater problems. The yen, pound, Swiss franc, and Australian dollar are all based in markets too small to sustain the inflows that would come from reserve currency status. A return to the gold standard in this day and age would be completely infeasible. Economist Barry Eichengreen recently detailed in the National Interest the domestic deflationary costs if the United States alone went back onto gold. And a global gold standard would have the same problem — the liquidity of the global economy would be held hostage to the vagaries of the gold supply.

There is, of course, the Chinese renminbi. China’s currency remains inconvertible for now. For the past few years, however, authorities in Beijing have taken incremental but appreciable steps to promote the international use of the renminbi to settle accounts in international trade. With the intention of turning Shanghai into a global financial center by 2020, Chinese authorities are even tinkering with the idea of liberalizing the capital account as well. The only bet speculators are making on the renminbi these days is that it will appreciate in value. Surely it will be a worthy challenger to the dollar?

Despite these steps, turning the renminbi into a convertible reserve currency would require a fundamental and costly transformation of China’s domestic political economy. For the renminbi to be a truly global currency, Beijing would have to allow the following to happen: full currency convertibility combined with a dramatic appreciation in the value of the renminbi, greater liberalization and transparency in the domestic financial sector, and a dramatic decline in the book value of its dollar holdings.

Each of these steps requires a rupture of the current rules of the game in China. A convertible, appreciating renminbi will hit the country’s export sector hard. Leaders in Beijing will also be extremely reluctant to cede their control over the country’s financial sector. Indeed, if the 2008 financial crisis taught them anything, it was that direct control over the banks was the best way to pump up China’s economy during a downturn. Turning the renminbi into a serious international currency weakens a key policy lever. To be sure, there would be some compensating benefits: imports would be cheaper for Chinese consumers, for one thing. But as the good folks at Eurasia Group have recently observed, China’s political class is far too risk-averse to contemplate such a drastic sea change in their domestic political economy. Even Beijing’s baby steps toward internationalizing the renminbi have led to domestic criticism.

Despite these roadblocks, it would be possible for a concert of countries to decide, for geopolitical and economic reasons, that they would be willing to bear the temporary burden of switching reserve currencies. According to former U.S. Treasury Secretary Henry Paulson’s memoir, Russia seemed particularly eager to attempt this feat as the 2008 financial crisis started.

If anything, however, the shifts in the geopolitical winds have made this possibility even less likely than it was three years ago. China would have to be the de facto leader of such a concert. Its foreign-policy belligerency in 2009 and 2010, however, raised threat perceptions across the Asia-Pacific region about Beijing’s martial intentions. Beijing might view fishing boat skirmishes, rare-earths embargoes, and territorial claims in the South China Sea as simply a rising power trying to punch its weight. To the rest of the region, however, these actions require a hedging strategy against China’s ambitions — which means not antagonizing the United States. The very countries that China would need to cooperate with on currency matters are the ones that are warier than they were three years ago.

The dollar is not going anywhere — unless, of course, the United States political system were to torpedo it through repeated acts of self-sabotage. Given how the debt debacle played out this summer, that now seems possible. It is equally possible, however, that in witnessing the wild market reactions to political shenanigans, both sides of the partisan divide will recoil from brinkmanship.

Despite the popularity of bashing America’s trade deficit, few politicians have made the connection between it and the dollar’s reserve currency status. As long as other countries need to buy dollars as part of their reserves, its exchange rate value will be higher than it otherwise would be, rendering some sectors uncompetitive. A December 2009 McKinsey report argued that, over time, the benefits of the dollar’s status would decline compared with its costs. To give up the dollar’s status, however, would be a tacit acknowledgment about the decline in American power — and no politician wants to make that claim.

If current economic trends continue, there will come a time when the dollar’s reign will end. Every major political actor in the global political economy, however, has strong incentives to forestall that day — until they are no longer in office.