It accounts for 63 percent of global foreign exchange (FX) reserves, which have increased from $3.4 trillion to $6.8 trillion in the last five years, and 86 percent of all FX transactions; 72 countries peg to or manage their FX rates against it. It is used to price oil and most other globally traded commodities. More than half of the physical dollars in circulation are held outside the US.
The euro, on the other hand, accounts for 27 percent of global FX reserves, up from 18 percent in 2000, and 37 percent of all FX transactions; 26 countries peg to or manage their FX rates against it. The role of the US dollar as the major reserve currency has become increasingly controversial, especially in the aftermath of the global financial crisis that some blame largely on the excessive global financial imbalances, reflected in the rapid rise of global FX reserves and sharp fluctuations in FX rates (see my column “China challenges US dollar’s dominance,” March 30, 2009).
Two recent International Monetary Fund (IMF) staff position notes, “The Debate on the International Monetary System” and “Global Imbalances: In Midstream?” cover cogently the major issues in the debate over the global role of the dollar.
As its contribution to this debate, McKinsey Global Institute (MGI), the research arm of the consulting firm McKinsey & Company, issued last month a provocative discussion paper titled “An Exorbitant Privilege? Implications of Reserve Currencies for Competitiveness.” The MGI, through its independent research, combining the disciplines of economics, technology and management, investigates the long-term global trends that shape business, government and society. Its research synthesizes, using the “micro-to-macro” approach, the McKinsey consultants’ microeconomic experience and knowledge at the company and industry level with internal and external macroeconomic expertise.
The MGI study, which is interested ultimately in the potential effects of any change in the current reserve currency system on the international competitiveness of companies and nations, poses a critical question: What costs and benefits are derived from being a reserve currency, a currency in which central banks hold their foreign exchange reserves, with which they can try to affect the exchange rates of their currencies? It tries to answer this question for the US dollar and the euro. Its answer in a nutshell, against the “conventional wisdom,” is that the financial net benefit of being a global reserve currency is relatively insignificant, implying that the US dollar does not enjoy any exorbitant privilege. In a relatively “normal” year for the world economy, such as the year to July 2008, the US is estimated to get a modest annual net financial benefit of between $40 billion and $70 billion, a mere 0.3 percent to 0.5 percent of its gross domestic product (GDP). (This direct net benefit converts to an overall, direct plus indirect, GDP benefit of between $115 billion and $185 billion.) In a “crisis” year, such as the year to June 2009, however, the direct impact on the US is estimated between a net cost of $5 billion and a net benefit of $25 billion. As for the euro, the small costs and benefits from being the secondary global reserve currency mostly cancel each other out in a “normal” year, with an estimated annual net benefit of only $4 billion, with a rounding error of zero. The costs relative to the benefits are expected to rise as its global role continues to increase.
There are different benefits and costs, estimated separately by the MGI study, from being a reserve currency. The two major benefits are the income from seigniorage, i.e., the interest-free loans extended by nonresidents who hold the reserve currency notes and coins, and the lower interest costs of reserve currency country private and public sector borrowers enabled by the foreign sales of reserve currency government securities. These cheaper credit benefits are partly offset by the lower interest earned by reserve currency country savers. The major cost is the negative impact of the reserve currency’s appreciation or overvaluation, caused by net capital inflows, on the reserve currency country’s international competitiveness through lower exports and higher imports. This cost is partly offset by the cheaper imports enjoyed by reserve currency country private sector consumers and producers. The MGI study admits that there are significant qualitative factors, such as policy autonomy as well as geopolitical and strategic benefits, not captured by its financial cost-benefit analysis.
The MGI study concludes that the US might be increasingly ambivalent about protecting the primary global reserve currency status of the dollar. Why? Because the politically more pressing domestic economic objectives of lower unemployment and higher growth would weaken the dollar through widening budget deficits and heavier public debt burdens, and hence erode the dollar’s attractiveness to countries such as China. Tight US fiscal and monetary policies to strengthen the dollar to benefit foreign lenders to the US would be politically too costly to home.
Similarly, the study finds scant justification for the eurozone countries to accelerate the speed with which the euro catches up with the dollar as a reserve currency, in light of the accompanying appreciation of the euro that would slow down the eurozone’s recovery from the global crisis. This would mean an unmanaged reserve currency system in which the dollar and the euro face uncertain futures as global reserve currencies with more FX rate volatility and destabilizing cross-border capital flows. In that case, the US and the eurozone might be less reluctant to consider, the study suggests, multi-polar international monetary system reform proposals that distribute the benefits and costs more broadly, such as the one that would assign the primary reserve asset status to the IMF’s Special Drawing Rights (SDR).
But we know that the rise, reign and fall of national currencies, such as the British pound sterling and the dollar, as global currencies occur over several decades, reflecting long-term shifts in global economic, political and military power. Trying to turn the SDR, a weighted currency basket currently consisting of the dollar, the euro, the yen and the pound sterling, into a global currency by an international agreement has been aptly compared to the failed attempt to establish Esperanto as the dominant world language. Although it might take several decades to happen, requiring fundamental changes in China’s financial system, we cannot rule out the emergence of the renminbi, once fully convertible, as the next dominant global currency as the Chinese economy, already the world’s largest exporter, continues to fortify its global dominance.
