Tag Archives: foreign reserves

The Story of the Dollar: The Global Hedge

A recent Economist article, “The Once and Future Currency,” discusses some of the claims made in a new book, “The Dollar Trap,” written by Eswar Prasad of Cornell University. Prasad argues that the dollar will remain the reigning reserve currency of the world for years to come due to three main reasons: (1) Foreign attraction to the dollar during financial crises, (2) the size and sophistication of the U.S. economy, and (3) the growing population of pensioners in the U.S.  I’ll elaborate on each of these three points below and then give my own take.

1.    Foreign Attraction to the Dollar During Financial Crises

One would think that after the 2008 financial crisis, the dollar’s strength and future as a foreign reserve currency would be put into question, however, Prasad argues that the crisis actually did the opposite– the crisis cemented the dollar’s importance as a global hedge against foreign currency risk. As the article states:

In the last four months of 2008 America attracted net capital inflows of half a trillion dollars… America’s slump forced the Fed to ease monetary policy dramatically. In response, central banks in emerging economies bought dollars to stop their own currencies rising too fast.

I find that quite surprising. Even when the financial crisis originates in the U.S., the dollar is still used as a safe harbor by foreign central banks.

Another interesting strategy the article brought up– a strategy the Fed actually already used at the end of 2008­– is the creation of currency swap lines between the Fed and other central banks. In these deals, the Fed offers to swap currencies with certain central banks at the current exchange rate under the agreement that the currencies would be swapped back later at the same rate. This allows the Fed to earn interest on the foreign central bank’s loans to domestic banks, but not bear any of the credit risk. The credit risk still lies with the foreign central bank. In its first swap of this kind with South Korea in late 2008, the Fed earned a return of 6.84%.

2.    The Size and Sophistication of the U.S. Economy

Another argument Prasad uses to defend his point about the future strength of the dollar is the combination of size and sophistication that the U.S. economy exhibits. Many argue that China’s currency, the yuan, will overtake the dollar as the main foreign reserve currency, but Prasad asserts that that is unlikely. Although China’s GDP is growing rapidly and is estimated to overtake the U.S. in 2020, China’s debt markets are still not nearly as big or as open as those of the U.S. There are large restrictions on the amount of Chinese debt that foreign investors can own. The fact of the matter is that China’s economy is still playing catch up with the U.S. and it will take many more years before its financial markets exhibit the same depth and variety as the U.S.’s.

Furthermore, due to the growth China has experienced, the yuan has been appreciating rapidly and this is not necessarily attractive from the perspective of a foreign investor:

The dollar’s depreciation over that period is, of course, bad for anyone holding American assets. But the dollar is not merely a store of value. It has also become a popular “funding” currency. Banks and multinational firms borrow in dollars, even as they accumulate assets in other denominations. Since no one wants to borrow in a currency that only goes up, this is not a role that China’s currency could easily play.

3.    America’s Growing Population of Pensioners

Although a growing amount of pensioners is not a good sign for the productivity growth of the U.S. economy, Prasad argues it makes the dollar more attractive globally. Not only do pensioners hold a majority of U.S. debt that is not owned by foreigners, but also, old, wealthy individuals act as a powerful political influence. These individuals will go to great lengths to ensure that the dollar retains a stable value.

I would agree with Prasad that the dollar is unlikely to lose its status of global prominence anytime soon. Even in the wake of a rapidly growing Chinese economy, the dollar still has a number of clear advantages to the yuan that will not dissipate until China’s economy matures.