It’s a sign of America’s strength and its position as leader of the free world that the dollar is the world’s reserve currency.
Just as English is the closest we’ve come to an internationally accepted language, the dollar is a common denominator, held in reserve by governments and institutions around the world, and used in international transactions.
But that may be changing. And if it does, we can blame ourselves – or, more specifically, the Federal Reserve Board.
Why should we care? With reserve currency status, the U.S. can:
- Purchase imports and borrow internationally at a lower rate than other nations, because we don’t need to exchange our currency to do so. The lower rate saves America about $100 billion a year.
- Avoid a potential currency crisis. When countries don’t have enough foreign exchange reserves to maintain the country’s fixed exchange rate, they face a currency crisis. The result is typically attacks by speculators in the foreign exchange market and the devaluation of the currency.
- Run higher trade deficits with less economic impact.
- Print money to pay off its debts.
- Preserve America’s status as a world leader. The dollar’s reserve currency status is a symbol of American strength. A loss of that role would be a sign of the country’s diminished status.
So if the dollar loses its reserve currency status, America is in trouble. Government debt will rise, the cost of imports will be higher and the economy will suffer.
Historically, the world’s reserve currency status has changed hands about every century or so. Previous countries with reserve currency status include Portugal, Spain, The Netherlands, France and Great Britain. It’s not the 1400s anymore and Portugal is not about to take over again, but there are plenty of challenges to continued U.S. world reserve currency status.
Throwing BRICS at the Dollar
First, the BRICS countries have agreed to form their own development bank and reserve fund as an alternative to the World Bank and the International Monetary Fund (IMF). The BRICS include Brazil, Russia, India, China and South Africa, which together have a population of about 3 billion (the world population is 7.1 billion).
The bank will be formed with $50 billion in capital – $10 billion from each country – while the reserve fund will have $100 billion, including $41 billion contributed by China.
As Russian President Vladimir Putin put it, the alliance is part of “a system of measures that would help prevent the harassment of countries that do not agree with some foreign policy decisions made by the United States and their allies.”
We’re not sure what he means by harassment. Sending food instead of weapons to Ukranian insurgents? Engaging him to broker a chemical weapons deal with Syria? Ignoring the refugee status he granted Edward Snowden?
President Obama didn’t make any statement that we could find about the new BRICS bank, but he did announce increased sanctions against Russia on Wednesday, targeting two Russian energy firms, a couple of financial institutions, six arms manufacturers and four individuals.
Putin responded by threatening actions against American companies operating in Russia, while Prime Minister Dmitry Medvedev said the sanctions are pushing Russia’s relations with the West “back to the 1980s,” adding that Russia “will have to pay more attention to military and security spending.”
We can take some consolation in knowing that the BRICS countries announced the capital being contributed to their bank and reserves in dollars, not in rubles or yuan.
The IMF Also Wants to Oust the Dollar
The BRICS aren’t the only ones talking about replacing the dollar as the currency of choice for reserves. A proposal made by the IMF in 2011 to replace the dollar with SDRs, also known as special drawing rights, is still being discussed.
The IMF describes the SDR as “an international reserve asset, created by the IMF in 1969 to supplement its member countries’ official reserves. Its value is based on a basket of four key international currencies, and SDRs can be exchanged for freely usable currencies.”
The key phrase here is “created by the IMF.” SDRs have not gained much traction since 2011, but the point is that the BRICS are not alone in taking aim at the not-so-almighty dollar.
Why They’re Called Emerging Countries
The changing make-up of the world economy is another threat to U.S. reserve currency status.
The U.S. economy accounted for 32.2% of the world’s gross domestic product (GDP) in 2001 and by 2011, that number dropped to 23.7%.
Much of the shift is due to China’s growth. China accounted for less than 10% of the world’s official foreign exchange reserves in 2000, but by 2011, China accounted for more than 30% of reserves.
From 2000 to 2011, official reserves of emerging economies grew nearly nine-fold, so that they accounted for 67.4% of total reserves, or $6.53 trillion. Their share of global GDP also increased from less than 20% in 1999 to more than 30% in 2011.
Strength Through Weakness
We initially blamed the Fed for playing a key role in the potential demise of the dollar as the world’s currency. That’s because the Fed’s easy money policy weakened the dollar. When the supply of dollars increases, assuming demand remains the same, its value will decrease.
Those who lend money to the U.S. know they will be paid back in dollars. But if the dollar continues to weaken, the value of what they’re paid will, of course, be lower.
The weak dollar has also made it more difficult for foreign countries to compete with U.S. exporters, who benefit from a weak dollar.
How Long Before the Dollar Dies?
Some predict that the dollar will be gone in six years. Others say a decade. In spite of strong efforts to unseat it, though, it could persevere.
As Bloomberg noted, “The dollar hasn’t budged from its top spot for the past three decades, withstanding repeated efforts to unseat it. Almost 90 percent of the $5.3 trillion a day in foreign-exchange transactions last year involved the dollar, the same share as in 1989, data from the Bank for International Settlements show. More than 80 percent of trade finance was done in dollars in 2013, according to Swift, a global financial-messaging network.”
How long the dollar will continue as the world reserve is anyone’s guess, but the shift to another currency will likely take place gradually. Our guess is that the yuan is more of a threat than the SDR.