http://online.wsj.com/article/SB10001424052748703313304576132170181013248.html
Very interesting stuff here....
Barry
MARCH 2, 2011
Why the Dollar's Reign Is Near an End
For decades the dollar has served as the world's main reserve
currency, but, argues Barry Eichengreen, it will soon have to share
that role. Here's why—and what it will mean for international markets
and companies
By BARRY EICHENGREEN
The single most astonishing fact about foreign exchange is not the
high volume of transactions, as incredible as that growth has been.
Nor is it the volatility of currency rates, as wild as the markets are
these days.
Instead, it's the extent to which the market remains dollar-centric.
Journal Report
Consider this: When a South Korean wine wholesaler wants to import
Chilean cabernet, the Korean importer buys U.S. dollars, not pesos,
with which to pay the Chilean exporter. Indeed, the dollar is
virtually the exclusive vehicle for foreign-exchange transactions
between Chile and Korea, despite the fact that less than 20% of the
merchandise trade of both countries is with the U.S.
Chile and Korea are hardly an anomaly: Fully 85% of foreign-exchange
transactions world-wide are trades of other currencies for dollars.
What's more, what is true of foreign-exchange transactions is true of
other international business. The Organization of Petroleum Exporting
Countries sets the price of oil in dollars. The dollar is the currency
of denomination of half of all international debt securities. More
than 60% of the foreign reserves of central banks and governments are
in dollars.
The greenback, in other words, is not just America's currency. It's
the world's.
But as astonishing as that is, what may be even more astonishing is
this: The dollar's reign is coming to an end.
I believe that over the next 10 years, we're going to see a profound
shift toward a world in which several currencies compete for dominance.
The impact of such a shift will be equally profound, with implications
for, among other things, the stability of exchange rates, the
stability of financial markets, the ease with which the U.S. will be
able to finance budget and current-account deficits, and whether the
Fed can follow a policy of benign neglect toward the dollar.
The Three Pillars
How could this be? How could the dollar's longtime most-favored-
currency status be in jeopardy?
View Full Image
See the share of global foreign-exchange transactions involving the
dollar, and the dollar's share of official global foreign-exchange
reserves. To understand the dollar's future, it's important to
understand the dollar's past—why the dollar became so dominant in the
first place. Let me offer three reasons.
First, its allure reflects the singular depth of markets in dollar-
denominated debt securities. The sheer scale of those markets allows
dealers to offer low bid-ask spreads. The availability of derivative
instruments with which to hedge dollar exchange-rate risk is
unsurpassed. This makes the dollar the most convenient currency in
which to do business for corporations, central banks and governments
alike.
Second, there is the fact that the dollar is the world's safe haven.
In crises, investors instinctively flock to it, as they did following
the 2008 failure of Lehman Brothers. This tendency reflects the
exceptional liquidity of markets in dollar instruments, liquidity
being the most precious of all commodities in a crisis. It is a
product of the fact that U.S. Treasury securities, the single most
important asset bought and sold by international investors, have long
had a reputation for stability.
WSJ's David Wessel sits down with three senior experts in
international finance - Edwin M. Truman, Joseph E. Gagnon and Eswar
Prasad - for a discussion on the major issues facing currencies and
the global economy.
Finally, the dollar benefits from a dearth of alternatives. Other
countries that have long enjoyed a reputation for stability, such as
Switzerland, or that have recently acquired one, like Australia, are
too small for their currencies to account for more than a tiny
fraction of international financial transactions.
What's Changing
But just because this has been true in the past doesn't guarantee that
it will be true in the future. In fact, all three pillars supporting
the dollar's international dominance are eroding.
First, changes in technology are undermining the dollar's monopoly.
Not so long ago, there may have been room in the world for only one
true international currency. Given the difficulty of comparing prices
in different currencies, it made sense for exporters, importers and
bond issuers all to quote their prices and invoice their transactions
in dollars, if only to avoid confusing their customers.
Now, however, nearly everyone carries hand-held devices that can be
used to compare prices in different currencies in real time. Just as
we have learned that in a world of open networks there is room for
more than one operating system for personal computers, there is room
in the global economic and financial system for more than one
international currency.
OECD Secretary-General Jose Angel Gurria sat down with Dow Jones FX
Trader during the meeting of G20 finance officials in Paris to talk
about global imbalances and the euro zone's debt crisis.
Second, the dollar is about to have real rivals in the international
sphere for the first time in 50 years. There will soon be two viable
alternatives, in the form of the euro and China's yuan.
Americans especially tend to discount the staying power of the euro,
but it isn't going anywhere. Contrary to some predictions, European
governments have not abandoned it. Nor will they. They will proceed
with long-term deficit reduction, something about which they have
shown more resolve than the U.S. And they will issue "e-bonds"—bonds
backed by the full faith and credit of euro-area governments as a group
—as a step in solving their crisis. This will lay the groundwork for
the kind of integrated European bond market needed to create an
alternative to U.S. Treasurys as a form in which to hold central-bank
reserves.
China, meanwhile, is moving rapidly to internationalize the yuan, also
known as the renminbi. The last year has seen a quadrupling of the
share of bank deposits in Hong Kong denominated in yuan. Seventy
thousand Chinese companies are now doing their cross-border
settlements in yuan. Dozens of foreign companies have issued yuan-
denominated "dim sum" bonds in Hong Kong. In January the Bank of China
began offering yuan-deposit accounts in New York insured by the
Federal Deposit Insurance Corp.
Allowing Chinese companies to do cross-border settlements in yuan will
free them from having to undertake costly foreign-exchange
transactions. They will no longer have to bear the exchange-rate risk
created by the fact that their revenues are in dollars but many of
their costs are in yuan. Allowing Chinese banks, for their part, to do
international transactions in yuan will allow them to grab a bigger
slice of the global financial pie.
Admittedly, China has a long way to go in building liquid markets and
making its financial instruments attractive to international
investors. But doing so is central to Beijing's economic strategy.
Chinese officials have set 2020 as the deadline for transforming
Shanghai into a first-class international financial center. We
Westerners have underestimated China before. We should not make the
same mistake again.
Finally, there is the danger that the dollar's safe-haven status will
be lost. Foreign investors—private and official alike—hold dollars not
simply because they are liquid but because they are secure. The U.S.
government has a history of honoring its obligations, and it has
always had the fiscal capacity to do so.
But now, mainly as a result of the financial crisis, federal debt is
approaching 75% of U.S. gross domestic product. Trillion-dollar
deficits stretch as far as the eye can see. And as the burden of debt
service grows heavier, questions will be asked about whether the U.S.
intends to maintain the value of its debts or might resort to
inflating them away. Foreign investors will be reluctant to put all
their eggs in the dollar basket. At a minimum, the dollar will have to
share its safe-haven status with other currencies.
A World More Complicated
How much difference will all this make—to markets, to companies, to
households, to governments?
One obvious change will be to the foreign-exchange markets. There will
no longer be an automatic jump up in the value of the dollar, and
corresponding decline in the value of other major currencies, when
financial volatility surges. With the dollar, euro and yuan all
trading in liquid markets and all seen as safe havens, there will be
movement into all three of them in periods of financial distress. No
one currency will rise as strongly as did the dollar following the
failure of Lehman Bros. There will be no reason for the rates between
them to move sharply, something that would potentially upend investors.
But the impact will extend well beyond the markets. Clearly, the
change will make life more complicated for U.S. companies. Until now
they have had the convenience of using the same currency—dollars—
whether they are paying their workers, importing parts and components,
or selling their products to foreign customers. They don't have to
incur the cost of changing foreign-currency earnings into dollars.
They don't have to purchase forward contracts and options to protect
against financial losses due to changes in the exchange rate. This
will all change in the brave new world that is coming. American
companies will have to cope with some of the same exchange-rate risks
and exposures as their foreign competitors.
Conversely, life will become easier for European and Chinese banks and
companies, which will be able to do more of their international
business in their own currencies. The same will be true of companies
in other countries that do most of their business with China or
Europe. It will be a considerable convenience—and competitive advantage
—for them to be able to do that business in yuan or euros rather than
having to go through the dollar.
U.S. Impact
In this new monetary world, moreover, the U.S. government will not be
able to finance its budget deficits so cheaply, since there will no
longer be as big an appetite for U.S. Treasury securities on the part
of foreign central banks.
Nor will the U.S. be able to run such large trade and current-account
deficits, since financing them will become more expensive. Narrowing
the current-account deficit will require exporting more, which will
mean making U.S. goods more competitive on foreign markets. That in
turn means that the dollar will have to fall on foreign-exchange
markets—helping U.S. exporters and hurting those companies that export
to the U.S.
My calculations suggest that the dollar will have to fall by roughly
20%. Because the prices of imported goods will rise in the U.S.,
living standards will be reduced by about 1.5% of GDP—$225 billion in
today's dollars. That is the equivalent to a half-year of normal
economic growth. While this is not an economic disaster, Americans
will definitely feel it in the wallet.
On the other hand, the next time the U.S. has a real-estate bubble, we
won't have the Chinese helping us blow it.
Dr. Eichengreenis the George C. Pardee and Helen N. Pardee professor
of economics and political science at the University of California,
Berkeley. His new book is "Exorbitant Privilege: The Rise and Fall of
the Dollar and the Future of the International Monetary System." He
can be reached at [email protected].
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