USD Retains Global Currency Heavyweight Title

From time to time, Morningstar publishes articles from third party contributors under our "Perspectives" banner. If you are interested in Morningstar featuring your content, please contact Online Editor Holly Cook (holly.cook@morningstar.com). Here, Erik S. Weisman, portfolio manager and sovereign fixed-income analyst at MFS explains why there is currently no obvious dominant currency other than the greenback.

Many market participants and observers have declared as inevitable the decline of the US dollar as the world's dominant currency. And there are certainly reasons to be bearish on the USD. The recent global credit crisis was essentially created in the United States; the broad, trade-weighted USD lost over a quarter of its value from early 2002 through mid-2008; the United States is no longer the primary engine of global economic growth; public debt dynamics in the United States are unsustainable; internationally, the United States is the largest debtor nation in the world; etc.

However, when thinking about alternatives to the USD, no other currency presents itself as an obvious choice.

1. Despite the breadth and depth of euro markets, the single currency has never exhibited the characteristics of an optimal currency area, as the current volatility surrounding Greece emphatically demonstrates.(1)

2. Japan's lost decade has lasted 20 years, and its continued overcapacity, increasingly entrenched deflation, and terrible demographics do not lend themselves to a more important role for the yen.

3. The British pound is yesterday's global currency, does not support a large enough global market, and suffers from many of the same public-sector debt problems that plague the United States.

4. The Chinese renminbi does not service markets that are anywhere near as deep and broad as US markets, its exchange rate is pegged or tightly managed to the USD, its capital account is closed (i.e. China's currency is not free to exit and enter the country), and China's legal and property-rights framework is not consistent with western standards.

5. No other currencies are worth mentioning.

Furthermore, the idea that a currency basket like the IMF SDR (special drawing rights, a weighted basket of the USD, euro, yen, and pound) could be used to take the place of the USD is logistically very problematic.(2)

In order for a global currency basket (or any currency) to become a viable alternative to the USD, it must become a reliable store of value, medium of exchange, and unit of account for the global public and private sectors (household and corporate). The SDR, which has been around for 40 years, has either failed in these areas or is not suited to address them. Similarly, John Maynard Keynes' post World War II notion of a global currency (the bancor) never got off the ground.

Even if one believes that China is destined to replace the United States as the dominant global economic power, an examination of the handoff from the British pound to the USD as the primary world currency is instructive. While the United States surpassed Britain by most economic measures in the late nineteenth and early twentieth centuries, the USD did not become the principal global currency until after World War II. Moreover, recent academic research has found that the USD and the pound shared reserve currency status during the period between the World Wars.(3) This experience suggests that, firstly, there can be a long lag between attaining global economic dominance and achieving global currency status and, secondly, there need not be only one primary world currency at any given time.(4)

Despite the aforementioned problems associated with USD markets, a recent Federal Reserve Bank of New York paper shows that over the past 15 years the USD has maintained the scope of its global status by most measures.(5)

These measures include: the percentage of USD banknotes held overseas, the share of global foreign exchange regimes tied to or managed against the USD, the proportion of global foreign exchange reserves held in USD (Exhibit 1) (6), the percentage of foreign exchange transactions denominated in USD, the proportion of international trade invoiced in USD, and the USD share in international debt markets. To the extent the USD is perceived as under siege, it isn't easy to see in the data.

None of the preceding arguments should be taken to mean that the USD won't depreciate in value versus other currencies. It likely will continue to decline on a trade-weighted basis over the medium term, especially against emerging-market currencies. But while the USD ultimately may lose its dominant status some day, given its current role as the global currency and the historical importance of inertia, it is hard to see its global role being displaced any time soon.

1. 16 countries have adopted the euro as their sole legal tender. However, according to the theory of optimal currency areas, the eurozone is deficient. While the eurozone does have a single monetary policy, free capital mobility, and unfettered trade, it is missing some crucial elements. Unlike the United States, the euro region does not have a central fiscal policy, a lender of last resort, or a single set of financial regulations and sole financial superviser. Moreover, while labour mobility within the euro area is totally liberalised, in practice labour movement is quite limited. These shortcomings were recognised well before the inception of the euro and even Romano Prodi, President of the European Commission from 1999 to 2004, intimated that progress on these issues would be necessary to ensure the sustainability of the euro. In fact, he suggested in 2001 that it would likely take a crisis to force the member countries to tackle these problems. We shall see whether the Greek crisis precipitates greater economic union (in which case the euro likely would become a much more compelling alternative to the USD) or unmasks the euro as an inherently flawed experiment.

2. Others have argued that the real problem is the weakening confidence in the idea of fiat currencies (i.e., currencies not backed by hard assets). In this vein, some have suggested the reintroduction of some sort of gold standard. Obviously, this, too, has almost insurmountable logistical problems.

3. See the work of University of California (Berkeley) economics professor Barry Eichengreen.

4. The current market focus on sovereign risk may hasten the day of reckoning for some countries with poor public debt dynamics. However, the UK, Japan, and several countries in the eurozone would likely face this problem well before the United States. In this event, the USD would probably benefit from a flight to safety, at least temporarily. While China eventually might be the ultimate beneficiary of this sort of turmoil, the renminbi is just not ready to be a global currency.

5. Linda S. Goldberg, “Is the International Role of the Dollar Changing?”, Current Issues, January 2010: 16.

6. Although the percent of global foreign exchange reserves (FXR) denominated in USD is down over the last decade, this result is somewhat misleading. First, with the introduction of the euro, member countries’ holdings of legacy European currencies were reclassified as local currency, as they were converted to euros and were no longer included as FXR. This effect “artificially” boosted the share of USD in global FXR at the end of the 1990s. Second, much of the decline in the share of FXR denominated in USD since 2001 is because of the USD having fallen in value versus the other major currencies.

Erik S Weisman is portfolio manager and sovereign fixed-income analyst at MFS. The views expressed in this white paper are those of the author and are subject to change at any time. These views do not necessarily reflect the views of MFS or others in the MFS organisation.