It has been previously said that “if the U.S. catches a cold, then the world sneezes.” For better or for worse, this has been mainly because the U.S. dollar acts as the world reserve currency. This means it is the currency most widely held by governments and institutions in their foreign exchange reserves. It is also the currency mainly used for international trade, and international pricing of global commodities such as gold, oil, and other assets. However, it seems that several changes have already started in the global currency market that may challenge the current status quo.
The dollar’s challenge
Today it is estimated that over 60 percent of all foreign currency reserves and trades in the world are in U.S. Dollars. However, this was not always the case, as it was the British sterling that was the main international currency prior to 1914. This was mainly due to Britain’s great imperial power, and London’s liquid financial markets. It was only until the end of the Second World War that the U.S. dollar became the world’s international currency, as it reflected the perceived stability of the U.S. economy. It is this stability that was tested in the last major financial crisis of 2008, which shook through the world after emanating from the U.S. real estate bubble. Moreover, despite the large build-up of foreign exchange reserves, there were severe dollar shortages that tested the resilience of the world’s financial systems whilst sharply increasing the cost of U.S. dollar borrowing.
The inherent burden of housing the world’s reserve currency is that the U.S. must continue to run a balance of payment deficit to meet the growing demand. However, it was this outstanding external debt that caused investors to lose confidence in the value of the reserve assets. In turn, this caused a financial shock spillover to emerging economies, which slowed down their growth trajectory.
China was the first to criticize the situation in March of 2009 as voiced by Zhou Xiaochuan, the governor of the Public Bank of China, who called for a reform of the international monetary system. Even the International Monetary Fund (IMF) has been pushing for replacing the U.S. dollar as a world reserve currency for a number of years. Last year’s IMF report “Enhancing International Monetary Stability” details the problems of the U.S. dollar as the reserve currency, and pushes for a larger role for Special Drawing Rights (SDRs). Historically the SDRs were established and used since 1969 to supplement a shortfall of preferred foreign-exchange reserve assets, namely gold and the U.S. dollar, but can be only used within the IMF. Hence, the IMF report posited a new world currency that replaces all national currencies, and suggested naming it “bancor” in honor of Keynes who conceptualized the idea in the early 1940s. The advantage of this true world currency is that it would facilitate trade, and make the world less reliant on a single economy such as the U.S.
Winds of change
Even though the U.S. dollar remains the official world reserve currency, its use as an international trade currency has already started to decrease. Most of the change was led by China, which has been making a series of agreements to move away from the U.S. dollar in international trade. In fact, China and Russia have been using their own national currencies when trading with each other for more than a year. Just a few months ago China signed an agreement with Japan that promotes the use of their own currencies in their bilateral trading. Moreover, leaders of the growth economies of the BRICS nations plan to use their own currencies when trading with each other. As a measure of size, China had already become Africa’s largest trading partner since 2009, with expectations of trade ties to reach at least $100 billion by 2015 – to be settled in Chinese renminbi.