The US dollar is the current global currency, but since the financial crisis the dollar has appreciated sharply due to risky financial structures. The US accumulated large deficits raising doubts about the dollar's ability to remain the global reserve.
by Zsolt Darvas
13 September 2011
Public Service Europe
Can the euro or the Chinese renminbi challenge the supremacy of the dollar?
The US dollar still dominates global currency markets. It has appreciated sharply at the outbreak of the recent global financial crisis. This is remarkable, since risky American financial structures were the prime reason behind the crisis. The US economy accumulated large current account deficits before the crisis, which would have called for dollar depreciation. Also, the huge rise in the country's public debt, and the stalemate of its politics, should raise doubts about the prime role of the US dollar.
But global currencies enjoy inertia – the benefits of using currencies internationally actually increase with their use, which favour the incumbent currency. For example, while in terms of output the US overtook the UK, including its main colonies, at the beginning of the 20th century - the dollar became the dominant global currency only sometime after the Second World War.
Although, dollar dominance will not stay with us forever. In the period running-up to the crisis, some major developments have surfaced - which will shape the future. Most notably, new countries are emerging in terms of global output. And in about a decade from now - the US, the euro-area and China will have a broadly similar economic power. The world never had such an evenly distributed output before. Gradually, this should lead to a fall in the dollar's role - even though today neither the euro, nor the Chinese renminbi is in a position to challenge the supremacy of the dollar.
Also, in the late 1990s, an unprecedented process of reserve accumulation started. Parallel with financial liberalisation, capital flows became much more volatile leading to unmanageable excesses in several countries. Current account imbalances widened substantially, but only small and open deficit countries faced adjustment pressures. There was no mechanism to contain the build-up of external imbalances and to ensure policy correction at the national level of major players.
This will change, gradually. The global role of the dollar make it possible for the US to run otherwise unsustainable fiscal policies, but this may fight back. Also, the declining share of the American economy in world output will progressively undermine the ability of the government to back up the provision by the Federal Reserve of dollar liquidity - in times of crises. This could reduce the attractiveness of the dollar.
But how will the dollar dominance, and more generally, the 'international monetary system' - a set of practices, rules and institutions governing international payments, the choice of exchange regimes and the supply, holding and use of international reserves - change? There are three main scenarios. In the short-run, there may be repairs to the existing international monetary system - such as enhanced surveillance, a voluntary reform of exchange-rate arrangements; especially, in Asia, improved international liquidity facilities, accompanying domestic reforms such as the development of home-currency financial markets, and regional initiatives to complement current International Monetary Fund facilities. This scenario would not change the global role of key currencies that much. But over the next 15 years, more substantial changes could occur – either as a natural development after the repairs, or due to a sudden dollar crisis.
A multipolar world could emerge, largely due to market forces and national policies, which would be structured around two or three international currencies – presumably the dollar, the euro and the renminbi. The Chinese renminbi has a strong potential for internationalisation. If the euro area overcomes its current difficulties and additional reforms are introduced, the euro could graduate from a mainly regional to a truly global currency. These reforms should comprise streamlining of the external representation of the euro area, designing a "Eurobond" to serve as a safe reserve asset, and accepting the implications of a global currency - such as the provision of global liquidly at a time of a crisis. Without such reforms, the euro would remain handicapped and a bipolar world with the dollar and the renminbi may emerge.
Intense degree of international cooperation could lead to a multilateral scenario in order to strengthen international monetary order. New instruments need to be developed to help escape the pitfalls of regimes based on the dominant role of one or a few national currencies - fostering macroeconomic discipline and providing for international liquidity management. A system of this sort could build on the existing structures or rely on other, new vehicles. The repair scenario has the highest probability in the short run. The multi-polar scenario will become more likely within a 10-15 year horizon. And the probability of the multilateral scenario emerging is low, but can gain likelihood in case of major international financial crises.
The desirability of the scenarios - considering efficiency, stability and equity, is, unfortunately, negatively correlated with their probability. Both from a global perspective and also from the perspective of the euro area. Yet due to the globalised world and the driving forces for the change, the dollar is unlikely to enjoy such a long period of ascendancy - after losing its economic supremacy in the coming decade, as sterling enjoyed in the first half of the 20th century.
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