This seminar paper focuses on the issue that United States may have to face in future due to fall in the value of dollar.US has been gaining due to this , but that is for short term, but it is definitely a threat in long term period. It has been observed hence, that ever since peak time till 2000-2001 the US dollar has been on a significant decline ever since. The paper also focuses on a need for the global currency and whether further weakening of dollar may lead to introduction of a new global currency which will trap US treasury.
The United States has enjoyed the status of being the global superpower for more than half a century because of two unassailable pillars – military and financial superiority over the rest of the world and having Dollar as the international currency of choice for global trade. Due to the political, financial and economic reasons the dominance is inclining to an end . Recent events like the financial crisis and the widening fiscal deficit of America have challenged the supremacy of the mighty dollar. Its been more than a decade,U.S. has been running huge external deficits and today its among the world’s biggest debtor. In compression to global balance the size of the US economy has become relatively smaller . The account deficit for U.S. had widened (because of the requirement to supply large quantities of the currency) from $ 98 billion in second quarter in 2009 to $ 108 billion in third quarter in 2009 and is speculated to touch $ 1.35 trillion by fourth quarter. To add to the woes, the developing nations are maintaining lower fiscal and external deficits. It has been observed hence, that ever since peak time till 2000-2001 the US dollar has been on a significant decline ever since. This has got foreign bankers into talking about advancing towards other global currencies like the Yuan, Euro, or a medium which can used to exchange is being prepared by the International Monetary Fund. Under these circumstances the only question that arises is:
Before we go into finding answers to the above question it is important to understand the source of strength and monopoly of Dollar. The Dollar Supremacy story started with the Bretton Woods system established in 1944. By the end of World War II, a vacuum was created in the international financial system due to the downfall of pound sterling. A requirement of a new global currency to rejuvenate the world economy got 44 allied nations to gather in Bretton Woods where dollar took over the role played by pound sterling/gold in previous international financial system. However, in 1971, the Bretton Woods system was revoked by U.S. By this time also, there was no other currency that was as powerful as US dollar to become the international currency of choice. Hence, the global economy moved towards a free floating regime with dollar continuing as the dominant currency. Post Bretton Woods, U.S got into an unofficial pact with Saudi Arabia and rest of OPEC who were the world’s largest oil producers. US provided military cover and political support to the House of Saud in exchange for trading oil denominated only in US Dollars with all the countries. A country that did not have geographical oil reserves had the only option of procuring the only acceptable currency in cross border oil transaction – DOLLAR. Hence, with increasing demand for oil across the globe, the demand for Dollar was artificially inflated by this strategy of US and this is how the earlier system of exchanging dollar to gold was changed to dollar exchange for oil.
Some prominent reasons of concern of the weakening dollar and the threats are:
U.S had controlled the global markets for over half a century because of the faith, the rest of the world had in the “robust” financial system of USA. The recent financial turmoil however has been an eye-opener for countries that have been maintaining huge reserves and securities issued by the US Government. There have been few significant signs of economic retrieval. The housing market still remains In trouble. In the labor market, jobs are still being shed and not enough jobs are being added. The creditworthiness that U.S has lost because of this crisis is for years to stay now.
Keeping out the CCB (Chinese central bank), which doesn’t report its stake to the International monitory fund, around 39% of global reserves are in dollars as compared to 56% a years ago, with the remainder lost to a range of currencies such as the sterling and euro. That fall in importance as a reserve currency is much more than just symbolic.
The United States government is bankrupt. The account deficits have been widening since the second quarter of 2009, with the overall 2009 budget deficit estimated to be around $ 2 TRILLION Also, the national debt is now reaching towards $ 12 TRILLION.
Japan, under the prime minister ship of Yukio Hatoyama is leading the charge to form a regional currency partnership based on closer ties between itself, China and South Korea. At the Association of Southeast Asian Nations (ASEAN) discussions in late November, 2009, the trilateral meeting unanimously concluded saying – “until now we have been too reliant on the United States” and “we would like to develop policies that focus more on Asia”. This is coming to be a potential threat to the US Dollar’s supremacy.
Middle Eastern nations and OPEC members are increasingly getting inclined towards non US Dollar trading baskets. There have been sure talks between Chinese and Gulf Arab representatives in Hong Kong of oil trade in non-dollar appellation. Brazil along with India has shown interest in collaborating in non-dollar oil payments.
The old Attitude of Americans ‘shop till you drop’ is showing signs of change with personal savings rate hypes upto about 7% from less than 1% a year before. As people spending accounts upto 70% of USA spending, the economy is undergoing contract in the short term as increased savings rate and hence reduced spending. Leading economists call it “the paradox of saving”.
The US inflation rates have been declining from 3.8 % in 2008 to 2.6 % in Jan, 2010. This causes higher demand in the market thereby increasing the imports in US and weakening the dollar further.
Countries like China, Russia and Japan hold vast amounts of reserves in USD. If USD continues to fall, then nations who hold USD as foreign reserves might sell it and replace it with another nation’s currency, or even gold, thus further weakening the dollar. China, which has the world’s largest foreign exchange reserves at $ 2.3 trillion, has doubled its gold reserves in the last 6yrs to 1054 tones.
A look at the recent figures shows that the U.S current account deficit increased to $ 108 billion in the third quarter of 2009 and as per the estimate by the Budget office, the federal budget would show a deficit of $1.35 trillion for the fiscal year 2010. On the other hand, many developing countries are showing rapid growth rates and are maintaining lower fiscal and external deficits and over the long term their currencies are expected to appreciate against the dollar.
There would be an impact even on the commodity prices as the dollar weakens. There exist an inverse relation between the two i.e the U.S dollar and commodity prices Oil prices rise with the weakening of dollar. Due to this, the purchasing power of oil producing nations fall since crude prices are dollar – denominated. Gold prices also follow the trend and rise with the weakening of dollar as dollar based currencies become cheaper to buy in other currencies. This is indicated by the fact that the central banks of India, China and Russia have chosen to boost their gold reserves in preference to dollar denominated securities.
The weakening of dollar would lead to an increase in the cost of foreign goods for U.S (it is the largest importer in the world). This would lead to widening of the already federal budget deficit. The fall of dollar might also lead to another financial crisis by causing panic in the financial markets. But on the positive side, the depreciating dollar can lead to increased foreign investments in the U.S markets. This increased capital inflow would lead to creation of more jobs in the economy. It would also make the U.S exports more competitive, thereby increasing the demand. Tourism industry is one of the largest in U.S and hence the weakening of dollar would be beneficial as the tourists would find travel to U.S cheaper.
The emerging nations are in no way insulated from the losses associated with the dollar’s losing value, as they are restricted by the dollar monopoly in oil trade. For example, China has a forex reserve of $2 trillion. 1% loss in the dollar’s value translates into a loss of $2 billion of Chinese forex. Also, emerging markets are facing the threat of decline in exports as their currencies appreciate. India: The depreciating dollar has a major impact on the Indian economy as most of its trade is done through U.S dollars. It erodes the profit margins of our exporters are the prices are no longer competitive in the world market. This can even have an adverse impact on the employment rates. The services sector constitutes 50% of our GDP and any impact on the software exports sectors will have a huge impact on the economy. The FDIs and the FIIs inflows would increase due to high growth rate expectations. China: China holds the largest amount of U.S Treasury bills followed by Japan. According to the approximations till the late 2008 the CCB ( Chinese central bank )held 72% of its reserves in US $ . This heavy place is not going to be for a longer appropriate given concerns about the stability of the dolaar. Changing direction will take time for China but there is already some evidence that China is adding gold holdings as an alternative to the dollar. China would obviously not continue to buy US debt endlessly. However, in the short term such a move would be counterproductive because of fear of losing value of its own substantial investments but there is a possibility in the long run.
In decision making about the choice of a currency there are components which are majorly considered – macroeconomic stability ,share of world output and trade, development and network, externalities, degree of financial market .
The big challenger euro is often seen as the threat. It is a well-managed currency with a better inflation record than the dollar. Nearly 42% of the trading in the London market takes place in Euro. The GDP of European Union is within sniffing distance of that of America and is poised to surpass it by 2015. The growth of London markets stands as a threat to that of New York. Recent performance of the Euro against Dollar have showed that the euro have strengthened against dollar. Although the European Union has a central bank, there is no single European treasury. Instead, there are 27 European treasuries. Investors cannot easily track or influence fiscal policy on the continent. Also the ECB does not have a goal of Internationalization of the Euro. Similarly, Euro lacks depth and liquidity in capitalmarkets.UK is still not part of the Euro zone which leaves London, a major financial centre still without Euro monetary controls.
Special Drawing Rights (SDRs) were created by the International Monetary Fund in 1969 in an effort to stabilize the international foreign exchange system. The basic definition of SDRs given by the IMF is as follows – “The SDR is 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 – US Dollar, Euro, Yen and British Pound. The US Dollar itself makes up almost half of the value of the SDR. The exact amounts of currency making up SDRs are determined by the IMF Executive Board in accordance with the relative importance in international trade and finance every five years. The currency compostion of the SDR for the period 2006-2010 is 44% USD, 34% Euro, 11% Yen and 11% Pound. The IMF’s so-called Special Drawing Rights could be used as the basis for a new currency. Arguments against making SDR the world’s reserve currency include the fact that the US dollar, the Euro and the Pound – which make up the large majority of SDRs – have all lost value since late 2007 when the recession began. Why replace a falling dollar by an index which so heavily includes the dollar? Also, SDRs do not contain the Chinese Renminbi, Indian Rupee, Australian Dollar or Canadian Dollar, all of which are important benchmark or secondary global reserve currencies. However, even if the dollar is replaced by the SDR, the IMF does not have the financial prowess to safeguard the exchange risk. SDRs would have to be delinked from other currencies and issued by an international organization with equivalent authority to a central bank in order to become liquid enough to be used as a reserve. To make SDR the principle reserve asset, close to $3 trillion in SDRs would have to be created (Currently, it comprises 4% of world reserves). There is a need for a wider basket of currencies in SDR in order to be accepted as a global currency. It would provide a more efficient, fairer and more stable basis for our globalised economy. But however, this is not a quick or a short or easy decision and if at all it happens it would be quite revolutionary.
Some currencies like Yuan are likely to achieve international status as it is issued by a large growing country. However, Yuan as a replacement is a very long proposition. For this to happen not only the Chinese economy has to grow considerably bigger (which it very likely in the near future) but also it must develop large financial markets, fully integrated in world exchanges, and the Chinese government must issue top-rated public debt instruments. Currently, Yuan is not fully convertible, the Chinese markets are not integrated and for various reasons, the financial credibility of local authority is limited. If China makes its currency convertible to make it a reserve currency, the consequence is that importing countries must have reserves of Yuan for trade. To buy Yuan, central banks around the world will have to divest from U.S. assets and Treasury bonds causing USD prices to crash and Yuan Prices to rise drastically, resulting in paper losses.
The copious factor that favour the dollar as the set aside choice includes the quality, stability and size of the dollar asset market, particularly the short term securities market where the central banks tend to be the most active. The high liquidity of these financial markets makes the dollar an excellent medium for exchange. Dollar dominates as a currency for international trade invoicing and payments. US organiztation has plus point that they are able to carry out transactions in their home currency. But it is not true that it shields the U.S from fluctuations in commodity prices. As dollar set commodity prices are formally or informally indexed to the dollar . The foreign exchange reserves of central banks around the world mostly in treasury bills and not in cash. $4.4 trillion, is ten times the value of greenbacks held external of the United States. The share of dollar’s of foreign exchange reserves is about 60% and any change in the global currency would have a huge impact on the economies of all countries holding dollar as their reserve currency. OMI’s Conclusion (Russian President Dmitry Medvedev has recently presented an interestingly different perception about the state of the world stating that the artificially maintained unipolar system was based on one big centre of consumption financed by a growing deficit and thus growing debt, one formerly strong reserve currency and one dominant system of assessing assets and risks. He went on to castigate the US military presence across the world stating that it survives on what is effectively a massive subsidy by the rest of the world while the US continues to appropriate the exports, companies and real estate of the rest of the world in exchange for paper money of questionable worth.) It is worth recapitulating the process by which the global economy currently finds itself in dire straits. (Unbridled consumption by US citizens, US buyouts of foreign companies and the massive US military spending across the World, all paid for in the domestic currency of the US, find their way ultimately to the foreign central banks of the countries that have balance of payment surpluses. These dollars are effectively recycled by the central banks back to the US when they invest in “safe” financial assets like US treasury bonds.) (The standard prescriptions under ‘structural adjustment programmes’ are tax and interest rate hikes, currency devaluation, reduction in trade and fiscal deficits, pruning social safety nets, selling government-owned enterprises and natural resources, etc., to the satisfaction of pressing creditors. However, it is surprising to note that the US response to the financial crisis over the last two years is at complete variance to the “standard” operating procedure in a structural adjustment programme.)
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