Great Graphic: The Dollar’s Role

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Marc Chandler
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This Great Graphic comes from Peter Coy and team’s article in Business Week. It succinctly shows three metrics for the internationalization of domestic currencies: global payments, international bonds, and foreign exchange reserves. It does not strike me as surprising, and the role of the euro as a payments currency reflects its role in intra-European trade. The substance of the article bears little relation to the inflammatory title:  “The Tyranny of the Dollar,” or the call-out: The incumbent international currency has been American for decades. Is it time for a regime change?  I get it, titles grab attention, but this one is deceiving. There is nothing that explains why the dollar’s role is tyrannical? Indeed, as the article notes, the US made dollar’s available to foreign central banks during the crisis, and even now. The dollar has been a public good provided by the US. Foreign banks participated in the Fed’s QE and subsequent operations more than many suspect. Indeed, it is precisely because the US has been more willing to deny countries and companies it disapproves of access to this public good, that it provides an opportunity for a workaround or alternative, and Coy & team recognize that.  However, and here too the substance of the article has it right. The alternatives are not particularly compelling. The role of the different currencies is not determined by some centralized world government of course, but by the independent decisions by thousands of economic actors.

Currency's Share of the Category in the International Monetary System Q4 2017 - Click to enlarge

Some mistake the policy under the Trump Administration as isolationist. From that assessment, they draw conclusions about the potential implications for the dollar and interest rates (spoiler alert: not good). What is Trump is not an isolationist? What if the US is not disengaging from the world but is not operating primarily through multilateral institutions? There is precedent for this kind of American behavior (see the war on Iraq for example, and the withdrawal from the Kyoto Protocol) though Trump takes it further. US military operations continue, and the recent Freedom of Navigation near a reef (that has been weaponized) that spurred Chinese ire is a timely example.

US foreign policy is better characterized as unilateralist rather than isolationist. If that is right, then what is happening is that as the dealer maker-in-chief, Trump, in effect, accepts that trade helps some and hurts others.  He argues that the US should get a greater share of the benefits from trade. And the reason it doesn’t is that someone is cheating.   It could be US and foreign businesses setting up supply chains that take jobs from America. It could be tariffs, trade subsidies, tax-incentives that other countries have implemented. It could be countries who intervene to keep their currencies down. As the trade agreement with South Korea and NAFTA 2.0 show, despite the bluster and rhetoric, Trump is not breaking from the liberal international order as he is trying to tilt the table more in America’s favor. Integral to his tactics is the implicit and explicit threat to walk away.

It is often pointed out that the dollar’s role in the world economy is greater than its share of the world’s GDP. This does not seem to be a fair metric. Several other currencies share of reserve assets is larger than their share of the world economy. However, in this approach, the fact that many countries are tied to the dollar, including China’s Special Administrative Region of  Hong Kong. Size of an economy alone does not determine the internationalization of a currency.

The authors suggest that the dollar is “hardly alluring these days…” The evidence including the recent Treasury International Capital report (TIC), the IMF’s reserve data (COFER which showed central banks and sovereign wealth funds boosted their dollar holdings by more than $50 bln in Q2, funding over half of the US current account deficit), and an appreciating dollar (against most major and emerging market currencies) this year offer a prima facie opposite case. Mutual fund flows also show a preference for US equities over European and emerging market equities. The S&P 500 is up about 8% this year and is easily the best performer among the other major markets.

The US interest rate premium is either at historic wides or multiyear highs compared with most countries. The German yield curve is negative out five years, and Japan’s is negative through six-year maturities. Spain can be paid when it borrows for two years.

In my work, I have offered two scenarios for the demise of the dollar’s role in the world economy. If there was a clear, compelling alternative. People and institutions voting with their pocketbook say there is not one. Alternatively, the US could abdicate, and there are some who already are claiming that providing the numeraire is not worth the cost, which is a counterpoint to the often-quoted French claim of “exorbitant privilege.” Some suggest that the Trump Administration is in fact abdicating. I am not convinced. It may be a more aggressive and riskier strategy, but the US is not surrendering.

How many countries want to take over the dollar’s role? Despite the exorbitant privilege apparently at stake, Coy & Co. cite only Europe and China that want to supplant the dollar. Even this is a misreading of the situation. If Europe wanted to boost the internationalization of the euro, they could have offered swap lines to eastern and central European countries, for example, and this failure arguably part of the Visegrad’s complaints. Europe may be chaffing under the US embargo against Iran, but several countries, including France and the Netherlands, appear moving toward compliance.

China says it does not like a unipolar world, but its officials, unlike many journalists, know that it is not ready institutionally to assume much of the dollar’s role.  It may one day.  It does not mean it will not try to keep the US off-balance, like promoting the use of the SDR, which incidentally has not gone anywhere, but taking them at face-value seems to be naive.

China’s capital account is not fully convertible. Capital controls in place. There is a lack of transparency. The currency is heavily managed.  Many of the economic reports seem aspirational in nature rather than actual. As the chart shows, the Chinese yuan is still a small player in the international currencies, even if it is the most actively traded emerging market currencies. There is much wood to be chopped for it even be more important than the yen.

One of the implications of the Triffin Paradox that the Business Week article addresses is that in order for there to be a sufficient quantity of the reserve asset, the country providing it must make it available. How does this happen?  Primarily through current account deficit. The Triffin Paradox is that the more the reserve asset in demand the more the providing country must run external deficits, which over time undermine the confidence in the currency. Europe and China insist on running current account surpluses.

Cut through the rhetoric about the “dollar paradox shows signs of unraveling’ rhetoric of Coy & com. and look at data. Foreign central banks hold $6.5 trillion in US dollar assets as reserves. Can the euro or yuan or some combination absorb this?