Supremacy of US Dollar


The Supremacy Of US Dollar


This assignment briefly discusses the supremacy of US Dollar. It includes suggestions and recommendations to its near future position, internationally. The proponents of the assignment are divided into the history of the US Dollar and its role as the dominating currency in the world. Ever since other currencies began to take part actively in the foreign exchange markets, they began to challenge the role of US Dollar. Arguments were put forward that the US Dollar would have to compete with the various emerging currencies to maintain its position as the most influential money dominator. The paper intends to discuss the currency contenders, which are the Euro, Japanese Yen Chinese Renminbi and the Russian Rouble and why are they the nearest competitors to challenge the US Dollar.

Chapter 1


The United States emerged from World War II not only as military victor but as an economic victor as well. It was by far the strongest economic power in the world. Under the Dollar standard, the Dollar standard, agreed to make the Dollar “ as good as gold” redeemable on demand by any central bank at the rate of $35 an ounce in 1933. This meant that the dollar became the accepted medium of exchange for international transactions. This seemingly routine event was to have far reaching implications for the international financial system, certainly beyond what anyone would have imagined.

According to James Grant the US dollar is the greatest monetary achievement in the history of the world. In year 1792 the first US dollar issued by the United States Mint which same in size and composition to the Spanish dollar. The US dollar was created and defined by the Coinage Act of 1972. The Coinage Act 1792 set the value of at 10 dollars, and the dollar at 1/10th eagle. It also called for 90% silver alloy coins in denominations of 1, ½, ¼, and 1/10.

The timeline of US dollar currency will be discussed which as follows:

I. Colonial Bills 1690

The Massachusetts Bay Colony, one of the Thirteen Original Colonies, issued the first paper money to cover costs of military expeditions. The practice of issuing paper bills spread to the other Colonies.

II. Franklin’s Unique Counterfeit Deterrent 1739

Benjamin Franklin’s printing firm in Philadelphia printed colonial bills with nature prints—unique raised impressions of patterns cast from actual leaves. This process added an innovative and effective counterfeit deterrent to bills, not completely understood until centuries later.

III. British Ban 1764

Following years of restrictions on colonial paper currency, Britain finally ordered a complete ban on the issuance of paper money by the Colonies.

IV. Continental Currency 1775

The Continental Congress issued paper currency to finance the Revolutionary War. Continental currency was denominated in Spanish milled dollars. Without solid backing and easily counterfeited, the bills quickly lost their value, giving rise to the phrase "not worth a Continental."

V. The Bank of North America 1781

Congress chartered the Bank of North America in Philadelphia as the first national bank, creating it to support the financial operations of the fledgling government.

VI. The Dollar 1785

Congress adopted the dollar as the money unit of the United States.

VII. First Central Bank 1791

Congress chartered the Bank of the United States for a 20-year period to serve as the U.S. Treasury’s fiscal agent. The bank was the first to perform central bank functions for the government and operated until 1811, when Congress declined to renew the bank’s charter. Recognizing that a central banking system was still necessary to meet the nation’s financial needs, Congress chartered a second Bank of the United States in 1816 for another 20-year period.

VIII. Monetary System 1792

The Coinage Act of 1792 created the U.S. Mint and established a federal monetary system, set denominations for coins, and specified the value of each coin in gold, silver, or copper.

IX. Greenbacks 1861

The first general circulation of paper money by the federal government occurred in 1861.Pressed to finance the Civil War, Congress authorized the U.S. Treasury to issue non-interest-bearing Demand Bills. These bills acquired the nickname "greenback" because of their color. Today all U.S currency issued since 1861 remains valid and redeemable at full face value.

X. First $10 Bills 1861

The first $10 bills were Demand Bills, issued in 1861 by the Treasury Department. A portrait of President Abraham Lincoln appeared on the face of the bills.

XI. The Design 1862

By 1862, the design of U.S. currency incorporated fine-line engraving, intricate geometric lathe work patterns, a Treasury seal, and engraved signatures to aid in counterfeit deterrence. Since that time, the U.S. Treasury has continued to add features to thwart counterfeiting.

XII. National Banking System 1863

Congress established a national banking system and authorized the U.S. Treasury to oversee the issuance of National Banknotes. This system established Federal guidelines for chartering and regulating "national" banks and authorized those banks to issue national currency secured by the purchase of United States bonds.

XIII. Secret Service 1865

The United States Secret Service was established as a bureau of the Treasury for the purpose of controlling the counterfeiters whose activities were destroying the public’s confidence in the nation’s currency.

XIV. Bureau of Engraving and Printing 1877

The Department of the Treasury’s Bureau of Engraving and Printing began printing all United States currency.

XV. Paper Currency with Background Color 1905

The last United States paper money printed with background color was the $20 Gold Certificate, Series 1905, which had a golden tint and a red seal and serial number.

XVI. Federal Reserve Act 1913

The Federal Reserve Act of 1913 created the Federal Reserve as the nation’s central bank and provided for a national banking system that was more responsive to the fluctuating financial needs of the country. The Federal Reserve Board issued new currency called Federal Reserve Notes.

XVII. The first $10 Federal Reserve Notes 1914

The first $10 Federal Reserve notes were issued. These bills were larger than today’s bills and featured a portrait of President Andrew Jackson on the face.

XVIII. Standardized Design 1929

The first sweeping change to affect the appearance of all paper money occurred in 1929. In an effort to lower manufacturing costs, all currency was reduced in size by about 30 percent. In addition, standardized designs were instituted for each denomination across all classes of currency, decreasing the number of different designs in circulation. This standardization made it easier for the public to distinguish between genuine and counterfeit bills.

XIX. In God We Trust 1957

The use of the National Motto "In God We Trust" on all currency has been required by law since 1955. It first appeared on paper money with the issuance of the $1 Silver Certificates, Series 1957, and began appearing on Federal Reserve Notes with the 1963 Series.

Chapter 2

Characteristic of US Dollar Currency


The U.S. dollar is the currency most used in international transactions. It is also used as the standard unit of currency in international markets for commodities such as gold and petroleum. There are also some Non-U.S. companies dealing in globalized markets, such as Airbus, list their prices in dollars cause of the international acceptance and the value of the dollar. At the present time, the U.S dollar remains the world’s foremost reserve currency. In addition to holdings by central banks and other institutions there are many private holdings which are believed to be mostly in $100 denominations. The majority of U.S. notes are actually held outside the United States. All holdings of US dollar bank deposits held by non-residents of the US are known as Eurodollars (not to be confused with the euro) regardless of the location of the bank holding the deposit (which may be inside or outside the US). Economist opinion said that demand for dollars allows the United States to maintain persistent trade deficits without causing the value of the currency to depreciate and the flow of trade to readjust.

Strong arguments do exist for why the dollar remains strong and still remain for world currency. There are (at least) three sources of demand for dollars that exert an exogenous force on normal balance of trade dynamics:

* A demand for dollar liquidity for transaction needs;

* A foreign desire for asset security found in the dollar’s role as a reserve currency; and

* Developing country attempts to accelerate economic growth through an export dominated economy.

To date all three factors have increased the incentive for foreigners to collect dollars (by selling goods and services in exchange for dollars) and decreased the incentive to dishoard dollars (by buying goods and services with the dollars). If these dynamics were to reverse, they would exert pressure to devalue the dollar above and beyond pressures exerted by the balance of trade dynamics.

Before discuss further about the characteristics of US Dollar that makes it the world’s foremost reserve currency, a better understanding regarding the basic function of money is crucial. The main basic functions of money are:

a) Medium of exchange

When money is used to intermediate the exchange of goods and services, it is performing a function as a medium of exchange. It thereby avoids the inefficiencies of a barter system, such as the ‘double coincidence of wants’ problem.

b) Unit of account

A unit of account is a standard numerical unit of measurement of the market value of goods, services, and other transactions. Also known as a "measure" or "standard" of relative worth and deferred payment, a unit of account is a necessary prerequisite for the formulation of commercial agreements that involve debt.

c) Store of value

To act as a store of value, money must be able to be reliably saved, stored, and retrieved. The value of the money must also remain stable over time. In that sense, inflation by reducing the value of money diminishes the ability of the money to function as a store of value.

d) Standard of deferred payment

Standard of deferred payment is distinguished as an accepted way to settle a debt – a unit in which debts are denominated, and the status of money as legal tender, in those

jurisdictions which have this concept, states that it may function for the discharge of debts. When debts are denominated in money, the real value of debts may change due to inflation and deflation, and for sovereign and international debts via debasement and devaluation.

Based on the explanation above, there are some main characteristic of the currency shall have to be the main player. In this paper, we will discuss from the various aspects.

a) Currency and asset substitution

Currency and asset substitution are typically induced by past inflations, devaluations, currency confiscations and the growth of underground economies. The effective money supply is much larger than the domestic money supply and is, moreover, less easily controlled by the monetary authority because of the public’s propensity to substitute foreign for domestic currency. To peg the exchange rate to the US dollar, authorities have to intervene and purchase foreign exchange, hence the accumulation of holdings of US foreign exchange reserves,

US currency has many desirable properties. It has a reputation as a stable currency, and is therefore a reliable store of value. It is available in many countries, is widely accepted as a medium of exchange, and protects foreign users against the threat of domestic bank failures, devaluation and inflation. Cash usage preserves anonymity because it leaves no paper trail of the transaction for which it serves as the means of payment and is therefore the preferred medium of exchange in underground transactions. Indeed the very characteristics that make the US dollar a popular medium of exchange also makes it difficult to determine the exact amount and location of US notes circulating abroad.

Nevertheless, there is a direct source of information that can be used to determine the approximate amounts of US cash in circulation in different countries. Currency substitution also has fiscal consequences that are particularly salient for transition countries. Foreign cash transactions reduce the costs of tax evasion and facilitate participation in the unreported or “underground” economy. This weakens the

government’s ability to command real resources from the private sector and deepens fiscal deficits. The shifting of economic activity toward the underground economy distorts macroeconomic information systems (Feige, 1990, 1997), thereby adding to the difficulty of formulating macroeconomic policy.

b) International Reserve Currency

Furthermore, another characteristic of US dollar as world currency is because of the international reserve currency. Over the past three decades, academic and financial analysis that argued the US would suffer dollar devaluation due to national consumption exceeding national production has been largely wrong. That such an intuitive argument has been so consistently wrong is the source of much frustration and consternation. What has become clear is that when discussing exchange rates and determinants of exchange rates, there is a necessary delineation between the dollar and the rest of the world currencies. Because the dollar is the world reserve currency, special dynamics exist for it in addition to the normal trade and monetary dynamics one would expect.

The euro inherited this status from the German mark, and since its introduction, has increased its standing considerably, mostly at the expense of the dollar. Despite the dollar’s recent losses to the Euro, it is still by far the major international reserve currency; with an accumulation more than double that of the euro.

In August 2007, two scholars affiliated with the government of the People’s Republic of China threatened to sell its substantial reserves in American dollars in response to American legislative discussion of trade sanctions designed to revalue the Chinese yuan. The Chinese government denied that selling dollar-denominated assets would be an official policy in the foreseeable future.

c) Usage of the US Dollar

Other characteristic of US Dollar as a main currency is when there are a few nations besides the United States use the US Dollar as their official currency. For example,

Ecuador, El Salvador and East Timor all adopted the currency independently; former members of the US-administered Trust Territory of the Pacific Islands (namely Palau, the Federated States of Micronesia and the Marshall Islands) decided that, despite their independence, they wanted to keep the U.S. dollar as their official currency. Additionally, local currencies of several states such as Bermuda, the Bahamas, Panama and a few other states can be freely exchanged at a 1:1 ratio for the U.S. dollar.

d) Secure the Safety Trade

As the so-called “safety trade” turn into dollars that occurred in the second half of 2008, made ironic event in two ways. The dollar represents security to foreign entities is partly due to historical good behaviour and partly due to wishful thinking on the part of foreign entities. Certainly through 1960, the US had a virtually unblemished record in paying its debts and honouring its obligations. This historical precedent combined with geopolitical considerations and force of habit has created the foreign perception that exists to this day that the US dollar is “as good as gold.” Thus, historically when a country suffered from a balance of payment crisis, the most common alternative to the home currency was the dollar. The list of countries whose private citizens hoard dollars as an alternative to the home currency is long.

The reason for this hoarding is fairly easy to understand. If a country pegs its currency to the dollar and the peg is kept too high, citizens of the country will consume more than they produce and the country will run a current account deficit. Mirroring this current account deficit, a country will run a financial account surplus which decreases its supply of dollars. As the supply of dollars approaches a critical point, citizens will speculate that the peg cannot be maintained and will “make a run” on the currency, trading all of their domestic currency for dollars in anticipation of the devaluation. This is referred to as a balance of payments crisis, and results in a devaluation of the national currency.

Examples of recent balance of payment crises include the Argentine economic crisis

(2001-2002) and the Asian financial crisis (1997). Citizens in countries who have suffered balance of payment crises will often hold a portion or even a majority of their wealth in dollars in anticipation of currency devaluation.

As an additional demand, it is commonly considered good practice for a developing country to carry reserves in excess of what is necessary for transactions as a preventative measure against balance of payments crises. Thus, there is actually an incentive to peg a currency too low, as a method for accumulating a protective supply of dollars to prevent balance of payment crises.

e) Exchange Rate Dynamics

While all other countries have two primary mechanisms that determine their exchange rate, the US dollar has five. The two mechanisms present for all currencies are: the relative supply of the currency (determined by the central bank); and the terms and attractiveness to foreigners of domestically produced goods and services. All else equal, the greater the supply of currency the higher the exchange rate (depreciated), and the more attractive the terms of domestically produced goods the lower the exchange rate (appreciated). Both of these mechanisms are reflected in the current account: if a country devalues its currency through an increase in money supply, it will have higher interest payments on foreign denominated assets. In this circumstance, a net debtor will generally see a deterioration in the current account, and a net creditor will see an improvement. If a country increases the attractiveness of terms on its production to foreigners, it will improve the current account.

f) US Role As Most Develop Country In The World

Financial and currency news are not just the only stories of news but interests to all. As for example, Foreign exchange (Forex) traders also have a lot of interest in political news that may have an impact on different countries currencies. Political events, such as the U.S. presidential election cycle has substantial consequences on the valuation of currency. The essence of money is purchasing power and power is at the heart of politics. Power goes to those who create money, those who receive it, those who spend it, and most of all, those who control it. Money, in other words, is anything but neutral. Money can be controlled or governed in very different ways; these systems of governance are described as monetary regimes.

Chapter 3


In order to understand the current international monetary system and its problems, one must realize that, for practical purposes, all international financial transactions are inextricably linked to the US Dollar. As the dollar goes, so goes the international financial system.

Recently, as been mentioned earlier, the US Dollar remains the world’s foremost reserve currency. The US Dollar has been referred as the standard unit of currency in international markets for commodities such as gold and oil. Some non-U.S. companies dealing in globalized markets, such as Airbus, list their prices in US dollars. US Dollar has a value based on supply and demand of the market. As demand of US Dollar increase and more people willing to pay more to buy the US Dollar, then US Dollar will increase the value. We can also know the performance/value of US Dollar by using the benchmark in US Dollar. Benchmarking of the US Dollar means that we measure or evaluate the performance/value of US Dollar with another similar item in an impartial scientific manner. The US Dollar Index (US Dollar X) is type of index used as a benchmark in US Dollar.

US Dollar Index is an index (or measure) of the value of the United States Dollar relative to a basket of foreign currencies. It is a weighted geometric mean of the dollar’s value compared only with

Euro (EUR), 57.6% weight
Japanese yen (JPY), 13.6% weight
Pound sterling (GBP), 11.9% weight
Canadian dollar (CAD), 9.1% weight
Swedish krona (SEK), 4.2% weight and
Swiss franc (CHF), 3.6% weight.

(Source: Wikipedia)

Like declining real estate or stock prices, the diminishing dollar is neither uniformly beneficial nor harmful. In an article written by Karen (2008), the author provided an example of Accor North America, Inc., a division of Paris-based Accor, a global hotel operator. She added that when the company needs extra funds, perhaps to make an acquisition, the declining dollar comes in handy. "Taking advantage of the dollar devaluation means that it’s cheaper to borrow from our parent than a bank," says Stephen Manthey, senior vice president and treasurer with the Carrollton, Texas-based firm. This is because the parent company’s Euros now are more valuable than they were a year or two ago (Karen, 2008).

Animesh Ghoshal, a Professor of Economics at DePaul University, Chicago, once mentioned that exporters typically do well when their currency drops, as their products become more competitive outside their home markets. Conversely, importers take a hit, as the costs of their goods or materials rise. Karen (2008) also quoted a statement from Dean Baker, a co-director of the Center for Economic and Policy Reseach, an independent research group in Washington, D.C. Dean mentioned that "people think of a strong dollar like a strong body, but, there’s no particular virtue in having a strong dollar." In November 2007, prices for imports from the European Union rose for the seventh consecutive month, increasing 0.2 percent, while prices for goods coming from Canada jumped 4.7 percent. For the year ending in November, the prices of imports from Canada were up 12.9 percent, while imports from the EU were up 3.3 percent. The rises can be attributed to higher fuel prices and the declining dollar, reports the Bureau of Labor Statistics.

From 4 below, we can see that the US Dollar’s relative strength compared to Euro had been declining over the 2007. The declining US Dollar may bring more harm than benefits to the US importers.

Chapter 4

Factors Affecting US Dollar Currency

a) Trade Deficit

A trade deficit occurs when a country imports more than the exports. This leads to a net outflow of a country’s currency. Countries on the other side of the transaction will typically sell the importing country’s currency on the open market. As supply of the country’s currency increases in the global market the currency depreciates. As a net importer, the US has seen its trade deficit grow rapidly over the last decade. In last year (2008), the United States had a record of trade deficit of $816 billion dollars. This trade deficit weakens the US dollar relative to other currencies since foreign goods are denominated in foreign currency. Thus raising of demand for foreign goods increases the demand for foreign currency and decreases the demand for US dollars. This causes the US dollar to depreciate.

b) Budget Deficit

Chart below show that US Public debt has grown substantially over time. When a country’s government spends more than it earns from taxes or other sources of revenues, it is forced to borrow from its citizens and/or from foreign entities. As a country’s debt load increases, the value of its currency may decrease as result of fears within the international community over its ability to repay the debt. In addition, by borrowing money from foreign countries, the US increases the demand for foreign currency in exchange for US Bonds. The US is the world’s largest debtor with approximately $12 trillion dollars in debt in total debt. Over half of this debt is owned by foreign countries and lenders.

(Source: Wikipedia)

c) China, Japan, and India may stop holding large US Dollar Reserves

Japan ($349B) and China ($643B) are two of the largest purchasers of US debt. China in particular has exhibited a voracious appetite for US debt. Its rapidly growing economy is heavily dependent on exports, and the US is one of its largest trading partners. In any given year, the US imports much more from China than it exports to China. As a result there is a net flow of dollars to China. Normally, one might expect China to sell these dollars on the global market, causing the dollar to weaken. Instead China reinvests its dollars in US debt. In doing so, China strengthens the US dollar and limits the appreciation of its own currency. Chinese exports remain cheap to American consumers.

However, due to large deficits many countries, China and India in particular, have begun to reconsider diversifying their reserves to protect themselves from a devaluation of the US Dollar. In November 2009, the Indian Central Bank announced that it would purchase $6.7B worth of Gold to diversify its reserves. China, which is the single largest purchaser of US Securities, has similarly increased its reserves of gold by 76% since 2003 and has hinted at further purchases. The decision of these large countries to shift increasingly towards Gold as a reserve currency greatly decreases the demand for US Dollars and weakens the US Dollar.

d) Monetary Policy & Inflation

Demand for a country’s currency is highly dependent on the relative value of holding it, ie. the real, relative return of U.S. government bonds. Fear over higher inflation erodes the real value of bonds,

which in turn decreases demand for US dollars. Similarly, tighter monetary policy raises the real interest rate on U.S. Gov. bonds, at which demand for US dollars increases until the relative, risk adjusted return on those bonds is equivalent to the return on bonds for another country.

e) The Federal Reserve Rate

The Federal Open Market Committee, comprising of the Chairman, Vice Chairman, and three other members, along with the chiefs of the regional branches of the Federal Reserve System, come together regularly to determine the Federal Funds Rate, which is the rate at which financial institutions with deposits at the Federal Reserve lend to each other. The release of the decision is usually accompanied by much media fanfare, analysis and commentary, and with good reason. Lending at the federal funds rate is the normal channel for banks with financing needs, and it represents the wholesale market for large financial institutions.

The Federal Reserve Rate also determines the Dollar Libor rate which is the basis of many different types of financial transactions from complex derivative contracts, to credit card and mortgage interest rates. Libor is the cost of short-term unsecured interbank lending (where there’s no collateral exchanged between counterparties). As such, it is one of the building blocks of the modern financial system. Although most transaction in the unsecured market are limited to a single month at most, the benchmarks themselves are regularly quoted and taken as a basis for contracts and agreements.

f) Equity Market

The equity market can impact the currency market in many different ways. For example, if a strong stock market rally happens in the U.S., with the Dow Jone and the Nasdaq registering impressive gains, we are likely to see a large influx of foreign

money into the U.S., as international investors rush in to join the party. This influx of money would be very positive for the US DOLLAR, because in order to participate in the equity market rally, foreign investors would have to sell their own domestic currency and purchase U.S. dollars. The opposite also holds true: if the stock market in the U.S. is doing poorly, foreign investors will most likely rush to sell their U.S. Equity holdings and then reconvert the U.S. dollars into their domestic currency – which would have a substantially negative impact on the greenback.

Chapter 5

The impact of US Dollar

a) Dollar Hegemony (Domination of the Dollar)

The Bretton Woods negotiations at the end of the Second World War paved the way for establishing the dominance of the dollar as international money. This role was sustained by the confidence that the United States with its vast reserves of gold would honor the commitment to provide gold to foreign central banks in exchange for dollars at a fixed rate of $35 per ounce. By the end of the sixties, the growing trade deficit and the burdens of its military interventions in Vietnam created a huge dollar overhang abroad. In the face of increased demands for gold in exchange for dollars the United States unilaterally abandoned gold convertibility. This, however, did not lead to the dismantling of dollar hegemony. Instead, the refashioning of the international monetary system into a “floating dollar standard” in the post-Bretton Woods period was associated with the aggressive pursuit of liberalized financial markets in order to encourage private international capital flows denominated in dollars.

In the 1970s the Eurodollar markets served as the principal means of recycling oil surpluses from the oil exporters to developing economies, particularly in Latin America. This process became a tool of resurgent U.S. political dominance. The 1970s military dictatorships in Chile, Indonesia, and Argentina, and the “Chicago School” free market regimes that followed, were bolstered by repression and supported by the readily available loans from U.S. banks flush with oil funds. Once this cheap bonanza of credit came to an end with the debt crisis in 1982, a new wave of neoliberal reforms and financial liberalization was imposed through the IMF-World Bank rescue packages. The crisis was deployed to further entrench the dominance of the dollar and U.S. imperialist agenda. In country after country the IMF and World Bank imposed “structural adjustment” policies during the crisis phase that destroyed all attempts at independent economic development while engulfing their financial systems in the ambit of dollar hegemony. This set in motion another surge of dollar denominated private capital flows to emerging markets and a fresh round of crisis in the 1990s when capital flowed back to the United States

From 1973, up until about 2003 (the run-up to the present crisis) the periods when flows to emerging markets surged were also periods with a net efflux from the United States. As the surge comes to an end in the wake of capital flight and crisis, as in the Latin American debt crisis in 1982-83 and the Asian crisis in 1997-98, private capital flows are sucked back into the United States (see chart 2).

The privileged role of the dollar provided the United States with an international line of credit that helped fuel a consumption binge. Cheap imports allowed consumption to be sustained despite stagnant or declining real wages. The export-led economies of Asia (first Japan, later East Asia and China) in turn depended on mass consumption in the United States to drive their economies. But the dependence on cheap imports precipitated growing trade deficits. Unlike other deficit countries the United States could, because of the dollar’s role as international money, finance its growing deficits by issuing its own debt in the form of the holding of reserves and U.S. Treasury bills (T-bills) by the creditor countries.

The United States has played the role of the banker to the world, drawing in surpluses from Asia and the oil exporting countries, and recycling these in the form of private capital flows to emerging markets in the periphery. The countercyclical pattern of the private flows to emerging markets, noted above, was critical to the mechanism by which the dollar’s role was preserved. These private capital flows served as a safety-valve mechanism, enabling the export of crisis to the debtor-

periphery. While the United States has not been immune to episodes of financial fragility in this period — such as the 1987 stock market crash, the savings and loan crisis of the late 1980s and early ’90s, the collapse of Long-Term Capital Management in 1998, or the dot-com bust at the turn of the century — the corresponding financial crises were far greater in the periphery. By 2007 however, this mechanism had begun to lose some traction.

Furthermore , during recession, the US Dollar typically appreciates in value and the price of commodities such as gold, oil, silver, platinum and palladium decline, keeping true to the inverse relationship (negative relationship).While most of the recent rise in oil prices is due to increasing demand, particularly from developing countries, the declining dollar plays a role, as well. As the dollar drops, producers of petroleum and other commodities demand more greenbacks for their wares. In general, a 1 percent drops in the dollar pushes the prices of commodities up by 1 percent (Karen, 2008).

So far, volatile energy prices don’t appear to have significantly affected most companies’ operations or performance. This could change, of course, if prices skyrocket. And, energy costs are driving up other prices. The Consumer Price Index rose by 0.8 percent in November 2007, the largest jump since September 2005, reports the U.S. Bureau of Labor Statistics. 70 percent of the jump was due to rising energy prices, reported the Bureau. The big question, and one that is impossible to answer, is just how long it will be before the current economic landscape shifts. At least some economists and currency experts predict a rising dollar in 2008. Chandler at Brown Brothers Harriman estimates that it will rise by about 10 percent against the euro this year."Currencies always come back into balance. They go to extremes and revert to the mean," says Boris Schlossberg, senior currency strategist at He notes, however, that the dollar probably won’t return to its previous levels, given America’s changing role in the world economy. The U.S. is still substantial and a key player, but no longer the dominant player. Moreover, while the declining dollar has its benefits, it prompts some longer-term concerns, says Mike McDonald, president of the investment advisory firm Dollar Crisis and Recovery Partners, LP, La Quinta, Cal. For starters, rising import prices eventually will strain consumers’ wallets.

In addition, the currency reflects the relative value of a country, McDonald notes. As demand for commodities and energy grows around the globe, the U.S. will have to compete for these goods. This becomes more difficult with a weakened currency. Prudent national economic policies will be the key to a sustained stronger currency, McDonald adds.

b) US Dollar Index and Gold Price Relationship

We can see the very bullish in the gold price chart, and very bearish picture painted by US Dollar Index chart as below. Gold is trading up strongly up to approximately $1200/lb, while the US DOLLAR index which is an index (or measure) of the value of the United States Dollar relative to a basket of foreign currencies, is down sharply to approximately 75.

From two charts below, we know that Gold and US Dollar Index have an inverse relationship. The US Dollar increased then the price of gold went down and vice verse. Gold acts as an effective hedge against future possible dollar depreciation and rising inflation. The research conducted by Eric J. Levin, confirms the long-term measurable relationship between the price of gold and the US index, which substantiates gold’s importance as a long-term hedge against inflation.

The bullish of gold was due to decreasing gold supply and its increasing demand. The first is that gold output has declined in present year. The amount of gold per global capital (ration between gold in circulation and global population) has been decreasing. There is less and less gold per person in the world every year. This is amidst a growing global demand for the yellow metal.

Also, many other countries could release a gold fund in this few years. As Japan released a Gold ETF which it would be released on the Osaka Securities Exchange (second largest Japanese stock market). And also the Street tracks gold trust (GLD) has done in the U.S., this should increase the demand for gold, being that it makes it much more convenient for investors to add gold to their portfolios. (Report by the International Herald Tribune). The researcher suggests that dollar depreciation will lower the price of gold to investors outside of the USA, which will in turn increase demand for gold and raise the US dollar price of gold. Since gold is proven as an inflation hedge, US wealth holders will benefit from gold exposure during a period of sustained dollar depreciation.

Also, the wedding season is expected to bring more demand as jewellers increase their orders for the yellow metal due to more people buy the gold jewellery to keep for their descendent, especially people from India and China. Sovereign demand also will increase the demand of gold. Besides that, they buy the gold for inflation hedge.

US Dollar Index (Year 2001 to 2009)

Gold Price (Dec 1999 to Dec 2009)

c) US Dollar Index and WTI Crude Oil Price Relationship

US Dollar Index (Oct 2007 to Sept 2009)

WTI Crude Oil Price (Oct 2007 to Sept 2009)

West Texas Intermediate (WTI), also known as Texas Light Sweet, is a type of crude oil used as a benchmark in oil pricing and the underlying commodity of New York Mercantile Exchange’s oil futures contracts.

The first thing that should stand out is the tight, inverse correlation between oil and the US Dollar. From both of the chart, we saw the reversal of trends that had held for almost eight years. As the US Dollar has declined, the price of oil risen. This inverse relationship exists because global oil prices are denominated in US Dollar. Thus, as the US Dollar declines, oil producers are paid fewer quantity of foreign currency in exchange of oil. They must compensate for this decline in real revenues by raising the price of oil (in US Dollar). The same relationship holds in reverse, albeit for a different reason. The United States consumes a disproportionate large amount of the global oil supply. Thus, as the price of the oil rises, stock market capitalization and economic growth suffer. This can also be accompanied by a decline in the US Dollar.

d) US Dollar Index and Stock Index Futures Relationship

One of the reasons that equity index prices have been so strong is because of the persistent weakness in the US Dollar. Overseas investors have an incentive to buy US dominated assets due to favourable exchange rates that allow them to purchase more US assets with their appreciating home currency. Currently, foreign investor enjoy when investing in US because that the comparative exchange rate differential advantage. The US dollar index and the S&P 500 charts above clearly show that strong inverse relationship between the movements of US dollar index and stock index futures.

Adding to that, the dollar remains reserve currency of choice. The IMF estimates that 64% of the world’s official foreign-exchange reserves are held in dollar-denominated assets. The euro, the second most widely held international reserve currency, lags well behind, followed by the British pound and Japanese yen. These currencies’ official reserve rankings parallel their status in international commerce more generally. This correlation should be of no surprise. According to a 2007 BIS survey, roughly 88% of daily foreign exchange trades involve dollars. Again, the euro is a distant second, with the British pound and Japanese yen trailing.

The world reaps substantial economies from using dollars.

a) Many foreign-exchange transactions, even ones not directly involving US residents, are denominated and undertaken in dollars.

b) International trade in fairly standardised commodities and in products that sell in highly competitive markets is typically conducted in US dollars. Invoicing in a single currency helps producers keep their prices in line with their competitors and simplifies price comparisons across the different producers. Naturally, these invoicing gains rise with the number of producers.

In contrast, international trade in heterogeneous manufactured goods, where price competition is not as crucial, tends to be denominated in the exporters’ currencies, but even in these cases importers or their banks will often acquire the exporters’ currencies by first trading their home currencies for US dollars and then trading dollars for the exporters’ currencies.

The dollar has maintained this role over the years, despite substantial fluctuations in its exchange value, because the size, sophistication, and relative stability of the US economy generally render the costs of transacting in US dollars lower than the costs of transacting in currencies that do not equally share these characteristics. In large part, the widespread use of the dollar developed and continued because the US has been the largest, most broad-based exporter and importer in the world. With a lot of Americans trading globally, a lot of dollars will naturally change hands. Because traders must finance a large portion of their business in US dollars, they maintain accounts, seek loans, and undertake myriad other financial arrangements in dollars.

A strong and open US financial system helped facilitate the dollar’s international use. While a high degree of feedback naturally exists between the dollar’s expanding role in trade and the growth of an accommodating financial structure, US financial markets have always been innovative and relatively free of cumbersome regulations. Their breadth and depth enhances the liquidity of dollar-denominated assets. Moreover, as dollar trade expands and US financial markets grow, more and more foreign financial firms – even ones not located in the US – offer dollar-denominated products. All this makes holding dollars convenient and transacting in dollars relatively easy.

As the global network for dollars expands, the benefits of using the dollar in exchange rise. The process is self-reinforcing. Moreover, once the network benefits of a particular currency become substantial, people are prone to continue using it, even if viable competitor exists. The debate on the SDR’s possible challenge to the dollar echoes many of the points made in the dollar versus euro debate. The euro matches many of the dollar’s qualities, and its use continues to expand. Making the jump to a new international currency, even one as widely used as the euro, requires a substantial proportion of people to make the jump in close concert. Otherwise, the network benefits are lost. For that reason, the world is not likely to shift quickly away from dollars even if the SDRs become a new international-reserve option.

Chapter 6

The Challenges to US dollar

The Credit Crisis in the article entitled “Is the International Role of the Dollar at Stake?” authored by Ramaa Vasudevan suppresses as the first tremors of the looming financial crisis ripped through Wall Street, with the meltdown of the subprime mortgage market in the summer of 2007, the dollar plunged sharply. Perversely however, even as some financial pundits were foretelling its collapse, the deepening of the crisis following the bankruptcy of Lehman Brothers in September 2008 actually saw the dollar gain ground sharply (for the first time since the steady decline that began in 2002; see 7).

For any other country a financial crisis of this magnitude would have sparked a full-scale currency crisis. Why then has the deepening of a crisis centered in the United States actually seen the reverse, the strengthening of the dollar? The answer lies in the continuing role of the dollar as international money.

In “Finance, Imperialism, and the Hegemony of the Dollar,” in the April 2008 issue of Monthly Review, Ramaa Vasudevan argued that the privileged role of the dollar as international money has been critical to U.S. imperialist hegemony. The explosion of private financial flows globally helped the United States preserve and establish its pivotal place at the center of the international financial markets and impose a “dollar standard.” However, this process also created the conditions for its own unravelling. The present crisis, an outcome of this unfettered growth and rising dominance of finance, lays bare the contradictions of the mechanisms of the dollar standard.

Two developments summarize the process so far: (1) when panic hit, the U.S. dollar’s status as “international money” asserted itself and the dollar rose against all currencies other than the yen. (2) The implosion of the financial system, however, has threatened the foundation of dollar hegemony—its central role in the proliferating web of global private capital flows. The current crisis is thus also potentially a crisis of dollar hegemony.

Generally, the leading or dominant currency is usually being issued by the country that had the biggest and strongest economical strengths at that time. The Dutch guilder was the world leading currency in the 17th and 18th centuries. Then after the First Industrial Revolution, it was overtaken by the UK pound sterling. Soon after World War Two, the US dollar took the dominant position from the sterling and sustained it position under today. All three currencies have one thing in common; they are all issued by the country that has the strongest economic influences and strengths at that time.

2008 GDP by World Bank



GDP (million of US DOLLAR)




United States











2008 GDP of various countries by World Bank


United State as the issuer of the dollar have maintained as one of the countries that contributed a large share of the World GDP. According to the above GDP ranking by World Bank, in 2008 alone, US had contributed US$ 14,204,322 which is around 20% of the World GDP with the total of US$

69,697,646. Base on the GDP contribution, US economy is considered as the strongest as compare with other countries in the world. However, when there is a champion, it position will always be challenged by someone else. This is how the sterling took over guilder and then overthrown by the dollar in the first place. Now the dollar is again challenged by other international currencies such as European’s Euro, Chinese’s Renminbi, Japanese’s Yen and etc. Beside the competition of other currencies, there are also other factors such as economic, politic, military and etc. which also affecting it current leading position as an international currency.

Meanwhile, in news entitled Russia challenges dollar’s role as global currency dated June 16th 2009, China and Russia sought greater international clout at a summit on Tuesday promising a $10 billion loan to Central Asian Countries, while Russia challenged the dominance of the US dollar as a global reserve currency. Political concerned dramatically involves as Russia also gave a prominent platform to Iranian President Mahmoud Ahmadinejad amid massive protests in Iran over his disputed re-election and questions in the West about the vote.

Then, Chinese leader Hu Jintao said China would extend a $10 billion loan to a regional group that includes Russia and four Central Asian states. The move adds muscle to China’s role in the Shanghai Cooperation Organisation, a six-nation group Russia and China use to counter the Western influence in resource-rich, strategically placed Central Asia. The other members of the organisation are Kazakhstan, Kyrgyzstan, Tajikistan and Uzbekistan. The leaders of Afghanistan, Iran, India and Pakistan were also at the table, underscoring Russian and Chinese reach for regional clout and global influence.

The loan was intended to shore up the struggling economies of its members amid the global financial crisis. President Dmitry Medvedev pushed his call for new global reserve currencies to complement the dollar. No currency system can be successful if we have financial instruments denominated in just one currency and we must strengthen the international financial system not only by making the dollar strong, but also by creating other reserve currencies. Mr Medvedev’s economic adviser, Arkady Dvorkovich said Russia might put part of its currency reserves in bonds issued by Brazil, China and India. He told that Russia could make the move if the other three BRIC members reciprocated as part of efforts to diversify financial instruments.

The Russia’s Rouble, Chinese’s Yuan and gold should be part of a revised basket of currencies to form the valuation of the IMF’s special drawing rights, or SDRs where the dollar’s status as the world’s main reserve currency wasn’t likely to change soon. The emergence of new reserve currencies would be a gradual process reflecting shifts in the global economy. It can’t happen fast but the creation of new reserve currencies should help distribute global wealth more fairly and also encourage economic leaders to pursue a more balanced economic policy. The talk about the new global currency has been prompted by concerns in China and Russia that soaring US budget deficits could spur inflation and weaken the dollar, debasing the value of their holdings.


a) Chinese Yuan (Renminbi)

In December 1, 1948, the Chinese Communist Party’s People Bank of China (PBC) issued the Renminbi (RMB). It was issued to stabilize Communists held areas during the civil war with the Chinese Nationalist Party which has its own currency. In its early history, the RMB was pegged to the U.S dollar at an unrealistic exchange rate which reached 1.50 Yuan per US DOLLAR in 1980. During the China’s economic reform in the 1980, the RMB was devalued in order to improve the competitiveness of Chinese export. Thus, the official RMB/US DOLLAR exchange rate declined from 1.50 Yuan to 8.62 in 1994 which was the lowest ever on the record. On July 21, 2005, the PBC announced that it would lift the peg to dollar, which the RMB was revaluated to 8.11 per US DOLLAR and the exchange rate against the euro stood at 10.07 yuan per euro. From the RMB exchange rate graph below, we can see that since after peg was lifted, the value RMB has appreciated slowly.

In the last three decades, China has successfully transformed itself from a poor developing country to become the world’s leading manufacturing economy entity. China is currently in a stage of economy rapid growth and it has emerged as a major power in the world economy, thus, naturally its currency will be expected to have a major role as well. However, as to date, the RMB has served none of the purpose of an international currency. It is not used significantly in invoicing China’s imports and exports, nor does it circulate abroad (Dobson & Masson, 2008).

Generally, a world dominant currency is the most preferable currency to be use in international trading, settling external obligations and as currency reserve. The greater quantity it is used and variety of functions a particular a currency can perform, the more useful it is as an international currency. The US dollar has successfully achieved such status since after World War II where majority of the assets traded internationally are denominated in dollar. However, a dominant international currency must not only be capable to perform the functions mentioned above, it must be required to do so. Because if you can perform the same functions using your own currency, or the currency of another leading economy, then there is no reason to consider that country’s currency as a dominant internationally currency and this is the same case RMB facing today.

During the 19th century, Britain was practically the world’s sole source of industrial products and capital for industrialization. Since the world came to London to buy and borrow, Britain could insist on being paid either in its own currency, or in a currency fixed, like the Pound, to gold. Then after

World War I, the US ended up with most of the world’s gold and took over Britain’s role as lead creditor. It then was in the position to demand payment in its own currency. Thus, if the world wanted to do business with America, it will need dollars. In contrast, China dependence on exports, which 40% of its GDP, leaves it in no position to dictate payment term. It has no choice but to continue accepts dollars, Euros, and yen or cease to grow. Also, because China accumulates so many dollars it has no use, it lends those dollars back to the US and to be repaid in dollars. Thus, nobody requires RMB to purchase Chinese goods or repay Chinese loans. Dollars will simply do just fine.

Some of the major factors for the almost complete lack of use of the RMB currency internationally are due to the restriction placed by the Chinese authorities on the use of the currency and the underdevelopment of Chinese financial and capital markets. The two factors are inter-related as due to the underdevelopment of the financial and capital markets, the Chinese authorities have no choice but to impose strict control in order to protect its fragile financial system. This has created an off-limits situation for the foreign investors in the China’s capital markets.

Since 2003, China has achieved a remarkable success in undertaking a sweeping reform program to restructure and rehabilitate its banking sectors (Hu, 2008). The Chinese banks are continuously making improvement in term of capital adequacy, asset quality, financial market regulations and supervision which greatly increased the public and investor confidence. China has introduced the Qualified Foreign Institutional Investor (QFII) and Qualified Domestic Institutional

Investor (QDII) programs as carefully controlled experiments to allow greater two-way cross-border portfolio investment flows. Despite all the above, currently the process of getting money into China and back out is considerably lengthy and cumbersome. Nor can the securities be freely traded to other foreign investors, which severely limit their utility as foreign exchange. In the foreign invertors’ perspective, facing with so many capital controls, the Chinese capital market is simple not liquid. If you own a RMB asset, in most cases, you can do nothing with it outside of China.

One of the features of any international currency is that it has a high level of availability. This means its economy must export the currency. In the 19th century, Britain was a net exporter of goods, paid with gold, but it re-exported both pounds and gold by investing its capital around the world. After that from World War I to the early 1970s, the US performed the same role. At the point, it switched to become a major importer of capital, but continued supplying the world with dollars by running trade deficits. In both cases, the balance of payments made it possible for other countries to obtain access to Pounds (or gold) and Dollars. On the contrary, China does not export its currency. It runs a large and growing trade surplus and it is a net importer of capital if excluding the management of its reserves. This is partly because China effectively prohibits Chinese companies and individuals from investing abroad without government permission. Currency can flows into China through both the current and capital account, but leaving it no way to flow out again. As long as this situation continues, there is virtually no way for foreigners to get hold on sufficient quantity of RMB and even if they wanted to, the one-way flow of funds would make it impractical.

When holding sizeable amount of any foreign currency generally puts the owner at the mercy of another country’s fiscal and monetary policy. If that country were to undermine the value of its currency, either by defaulting on its debts or printing too much money, whoever held that currency would suffer a real economic loss as in the case of China.


Country/Monetary Authority

Billion US DOLLAR (end of month)


People’s Republic of China

$2273 (Sep 2009)



$1019 (Jun 2009)



$962 (Dec 2009)



$716 (Oct 2009)

(Source:, date: December 28, 2009)

As until September 2009, China foreign reserves had reached US$ 2.273 trillion, by far the largest holders of foreign exchange reserves and the first time a country had surpassed the $2 trillion benchmark.

Currency composition of official foreign exchange reserves











US Dollar






















Source:, date: December 28, 2009.

At the end of 2008, 64.0% of the identical official foreign exchange reserves in the world were held in US dollar and 26.5% in Euros.

From the above information, we can see that currently China held the largest portion of their foreign exchange reserve in US dollar. Now the question is whether China willing to suffer economic loss just to undermine the value of US dollar as a dominant international currency? The answer will most probably be “NO”. The Chinese authority is reluctant to increase the value of RMB by much as it will decrease the value of their investment assets which mostly denominated in US dollar. On the opposite, it will need to play a role in reinforce the dollar position to protect their own interest.

Beside all that, RMB also have the issue of credibility. One of the major concerns for countries to hold foreign exchange reserve is the credibility and responsibility of the issuing country. During the time of British Pound was still the dominant currency, the British solved this concern by linking

their currency firmly to gold. Americans also did the same until 1971. The gold standard ensured that neither Britain nor the US could arbitrarily inflate their currencies and damage their value.

After 1971, the US was no longer constrained by a fixed exchange rate with gold. Thus, there was effect on some of the investors confident toward dollar as a reliable reserve currency. But in the end, people decided to trust the US, at least for the time being. US maintained a good record of never defaulted on its sovereign debts. However, such trust was never unchangeable. In the face of today rapidly increasing budget deficits, many are wondering whether the dollar is still a “safe” currency. This is why people are starting to consider RMB as a potential alternative.

Furthermore, China experienced hyperinflation and defaults in the early 20th century, but that was under a different government. The US has a long track record as a leader in global economic affairs while China has only just stepped onto the stage. The controlling style of leadership and unclear decision making processes in China can sometimes inspire distrust. Over time, the world will have to decide whether it feels confident entrusting theirs to China.

In a matter of Dollar hegemony, it is quite clear that the U.S. imperial agenda of refashioning the post-crisis world in a way that preserves dollar hegemony depends critically on China, which has finally outpaced Japan as the biggest holder of U.S. Treasuries. China has in a sense been locked into dollar holdings because selling off its mountain of Treasuries would precipitate a crash of the dollar and a collapse of its (dollar) asset base. The slowdown in Chinese exports, which began to decline sharply in the last quarter of 2008, would mean a flagging demand for U.S. Treasuries at precisely the point when issuance is skyrocketing.

The above mentioned issues suggest that RMB is a long way off from being an attractive and viable international currency. But of course, this situation could change. China could reduce its dependence on exports to the point where it can start insisting on its own payment terms. It could expand its capital markets and open them to foreign investment. It could buy more imports and allows its citizens to invest abroad, letting currency flow out as well as in. And it can develop a positive track record of economic leadership that involves considering other nation’s interest as well as its own. But all these steps will involve a dramatic and sometimes painful restructuring of its economy, from an export led growth model to a more balanced and open system. For now, China’s policies and priorities portrait itself as a holder of currency reserves rather than as a supplier of reserve currency to the world economy.

b) Japanese Yen

The Yen was officially introduced in May 10, 1871 by the Japanese Meiji government. It is currently the third most traded currency in the foreign exchange market after the US dollar and Euro. Also, it is the fourth widely used reserve currency after the dollar, euro and pound sterling.

The table below shows that until year 2008, Japanese Yen obtained 3.3% share of the world total foreign reserves.







US Dollar














Pound Sterling







Japanese Yen







(Source:, date: December 28, 2009.)

During and after World War II, the yen lost most of its value. Then in 1949 in order to stabilize prices in the Japanese economy, the value of yen was fixed at 360 yen per US dollar through a United States plan. When the United States abandoned the gold standard and imposed a 10 percent surcharge on imports in 1971, the fixed exchange rate was no longer practical and eventually led to floating exchange rates in 1973. During 1950s and the first of the 1960s, the Japanese imposed restriction for foreign direct investment in Japan due to their heavy current account deficits. Through such method, the deficit had turned into large surplus in the 1971 and then the yen was undervalued together with several major currencies at that time.

In the 1970s, the Japanese government intervenes heavily in foreign-exchange market by buying and selling of dollars in order to protect their exports competitiveness and the country industrial base even after the 1973 decision to allow the yen to float. Despite the heavy intervention, the market pressure and large trade surpluses caused the yen to continue appreciating. Between the periods between 1970s until today, there were several ups and downs for the yen, but overall it is still on an appreciating trend. We can clearly see the trend of the yen exchange rate from the following graph:

(Data Source:, December 30, 2009)

One of the reasons why the Japanese became to the world fourth reserve currency is because of it is one of the world biggest net creditor. During 1980s, Japanese government have relaxed it control on the capital markets and cause a large investment capital outflow. The large investment capital outflow was largely caused by the Japanese foreign direct investment (FDI) activities abroad. Japan is a country that lacks many natural resources and this forced Japan to obtain the necessary raw materials from other countries to maintain their industrial economy growth. Thus, direct investments were one way to ensuring the supply. As such, Japan total outward FDI abroad have grown since 1983 from US$ 3 billion into US$130 billion during 2008 (from Japanese Trade and Investment Statistics). This heavily FDI strategy had cause a large volume of Japanese Yen to flow into the currency exchange market and increased the currency availability and liquidity in the international trade markets.

Since the end of World War II, the dollar was the “Top” currency for Japan and in East Asia. The Japanese external economic relations with the US and with the rest of the world operated through dollar. During that time, the dollar served an important political function of integrating the Japanese economy back into the world, thus making Japan a dedicated supporter for dollar. The undervalued yen and pegged exchange rate system at that time helped turn the country current account deficit into surplus. Then during 1980s, the Japanese government started to extend its currency power at least in the region. But there was a clear lack of motivation on the part of the Japanese government to shift from a supporter to a challenger of the dollar’s international role.

However, in the late 1990s, things started to change as Japanese monetary authority attempt to push towards internationalization of the yen in the means to increase the use of yen to overcome the dominance of dollar in East Asia. The actions were triggered by the fact that the dollar dominance in the regional monetary structure was blamed for the Asia Financial Crisis (AFS) in 1997. According on Katada (2008), the Japanese government at that time also realized the benefits that could come from the internationalization of the yen: easier for foreign exchange risk management for Japanese companies, enhancing Tokyo’s role as an international financial center and greater macro-economic stability in East Asia. Several actions were taken to make Japan’s short-term capital and money market more attractive, including a withholding tax exemption from non-residents and foreign corporations that earned interest income from Japanese government bonds, maturity diversification or government bonds and improvement of settlement systems to facilitate cross-border transactions. Even with such attempts, but there was not much of results.

First of all, the continued dependence of Japan on the US for security and market was an important barrier. A lot portion of the Japan’s FDI was located in the US and thus making it relying heavily on the dollar to perform their transactions. The depreciation of dollar will severely impact their assets value. Secondly, there was various layer of domestic resistance against the internationalization the yen. For the Japanese private financial entities, they are concerned with the one-time transformation cost and the opportunity cost of lost business involved in replacing the dollar with yen. Also, the Japanese monetary authority was reluctant to lose its macro-economy policy autonomy by allowing the yen to move freely in and out of Japan. And there was also resistance against domestic financial liberalization. This led to the underdevelopment of short-term financial market that made the Japanese yen unattractive. Besides that, the country was unwilling to run a periodic current account deficit also contributed as difficulties for internationalize the Japanese yen. Running a periodic current account deficits are an unavoidable price of the internationalization of a currency. But as noted by Katada, Japan has never been prepared to accept this idea.

Also, the dollar served as the main currency for economic transactions in East Asia for the past few decades, as most of those economies closely pegged their local currencies to the dollar. Therefore, the Japanese business operations in the region didn’t needed complex transactions with the region’s local currencies, thus reducing the incentive to internationalize the yen. Finally, China emerged as a power whose dollar holdings equal or surpasses those of Japan but do not wish to see the dollar removed from its position as the dominance currency in Asia for the time being. As indicated by

Katada, there is a strong power rivalry between Japan and China, which the Chinese authorities wish to prevent Japan from suppressing China at a subordinate place, as the RMB cannot compete against the wider used yen in the region. But the Chinese authorities also in no hurry to make the RMB an international currency as that would require liberalization of China’s capital account and massive reform of the country’s financial system, where both are political risky.

The current Japanese government’s efforts in removing the dollar from the dominance currency position mainly focused in the East Asia regional economic exchange. But due to Japan’s dependence on large market and resources of the US, the bilateral transaction between US and Japan are likely to remain largely dollar-based. However, given the increased intra-regional trade and investment links, along with the AFC shock that shifted the preference of the East Asian leaders, the region is now in search for an alternative to dollar dominance. Additionally, uncertainty associated with the intensifying financial globalization will keep the regional members motivated to strengthened regional financial cooperation.

There exists lot of challenges, both internal and external, for Japan in construction support for their attempts to internationalize the yen and challenge dollar dominance position. The US would definitely oppose to such moves that would weaken the regional dollar dependency, especially during the time when US capital needs are very high. It is also not easy to gain regional consensus, when China would also need to make sure the Chinese interests in the regional currency arrangement are safe guarded. It is important also for Japanese private financial entities as well as large businesses to back up the government initiative and be willing to pay the costs (both the one-time transformation cost and the opportunity costs of lost business) of the fundamental currency policy change. Thus, for the time being, the Japanese yen will not be considered a strong contender to the dollar dominance position in the global stage. Nevertheless, it is still possible for the yen to challenge the dollar in the regional level but with a mountain of challenges to be overcome.

c) Euro

The Euro was introduced in January 1, 1999 as a replacement of national currencies for the 11 countries that joined the European Monetary Union (EMU). One of the main reasons for the forming of Euro is to create a single large common market in Europe that are free of tariffs and trade barriers (KaiKati, 1999). Now, after ten years since the birth of Euro, the member countries of EMU have been increased from 11 to 16. Euro zone which is the economic area of the 16 EMU members has became the second largest contributor to the world GDP with US$ 13,565,479 which is around 19.5% of the world GDP in year 2008 as reported by the World Bank. Together with the economy growth of the euro zone in the past ten years, Euro had gained a significant reputation and position as an international currency and being considered as a potential challenger to replace the dollar.

When the Euro was first launched, some predicted it will replace the dollar as the world dominant currency (Portes and Rey, 1998; Hartman, 1998; MacCauley, 1997). However, after 10 years of Euro existence, we can see the Euro is catching up but slowly with the dollar in the competition of international leading currency. The number of firms and sovereigns countries raising their external finance by issuing euro-denominated securities is growing year by year. Also, there is an important usage increase of the euro currency for settlement or invoicing of international trade transactions in the recent years (E. Papaioannou et al, 2006).











US Dollar























From the above currency composition chart of the official foreign exchange reserves, we are able to observe that the dollar is still consider as the most preferred reserve currency by firms and other countries in the world. The US dollar obtained 64.0% of the total percentage of world reserve currencies. On the other hand, we also observe that percentage is slowly decreasing since the introduction of the Euro. In 1999 when the Euro was first introduced, it had captured 17.9% of the total world reserve currency and in 2008, it percentage had grown steadily to 26.5%. From here, we can see that the US dollar is losing its attractiveness as an international reserve currency and euro is gaining grown in the international reserve currency competition. Although, the future for the euro seems potential promising, it is not without any obstacles in its path.

The euro currency is issued by EMU which is only a union of 16 independent countries that each with their own governance, banking systems and capital market. Under such circumstances, it is slow and difficult for the EMU to establish a proper integrated financial and capital market for the euro currency as compare with the dollar circulating in the US markets that runs under one federal state. This is affecting the efficiency of the markets and lowering the attractiveness of the euro currency toward those private economic agents that doing trading internationally.

The stability of the euro currency is one of the obstacles that related to the above problem that preventing it to take over the US dollar as the international leading currency. Although euro had been in the international market for ten years, but it is still be considered young in comparison with the dollar. It is natural for investors to be sceptical in judging the stability of the currency not only because of it age but also concerning the efficiency and liquidity of the markets.

This is making it more difficult for the euro to exploit the economy of scale and network externalities of the currency. The economy of scale and network externalities is some of the factors that affecting the liquidity of a currency. When a currency become less liquid, its stability will be lowered as it will be subject to higher risk when it is used in the international transaction and as a reserve currency.

Also the events in the first two weeks of September 2008 — the rescue of Fannie Mae and Freddie Mac, the bankruptcy of Lehman Brothers, the fire sale of Merrill Lynch, and the rescue of AIG — heralded the complete freezing of credit markets. Financial institutions hoarded cash and demanded ever widening premiums before lending to one another. The contagion effects of the credit crisis in the United States now spread globally, leading to capital flight from Eastern Europe, Latin America, and Asia. At a time of world crisis when markets do not have any confidence in the ability of debtors to honour their debts, and have frozen lending, T-bills—in other words international money—became the safest bet.

This had caused dollar began to rise against a host of currencies (excluding the yen) as U.S. investors repatriated funds, speculators turned increasingly averse to risk amid the growing turmoil, and market operators sought dollars to meet their lenders’ demands. Investors and banks also began to withdraw their money from investment banks and hedge funds. The result was the fire sale of assets; “deleveraging” created a sudden desperate need for cash in the form of dollars.

Before the credit crunch had taken hold of the global financial system, the surge of capital flows to emerging markets through 2007 might create the conditions leading to a fresh wave of financial

crises in the periphery and the revival of flows back into the United States. By the time the full force of the panic hit in September 2008 capital had begun flowing back to the United States, and outflows from emerging market bond and equity funds reached $29.5 billion between June and September 2008 (the highest level since at least 1995). The commodity bubble in developing countries also collapsed, as investors fled from all forms of risk, and export demand fell with the impact of recessionary forces in the United States, United Kingdom, and Europe. The accumulating surpluses and reserves in emerging markets began to erode. Stock markets crashed in Asia and Latin America as investors began pulling out and seeking the safety of the dollar.

Capital flight from the emerging markets has precipitated a fall in some emerging market currencies of as much as 50 percent, fuelling currency crises in Iceland, Hungary, and Ukraine. Eastern Europe has been particularly vulnerable. With current account deficits approaching 7 percent of GDP and private capital inflows amounting to 11 percent of GDP in 2007 — a level that exceeds that of developing countries in Asia and Latin America — it is not surprising that a severe financial crisis erupted in Eastern Europe. But where the crises of 1982-83 and 1997-98 in Latin America and East Asia were effectively deployed to further U.S. hegemony, the current economic collapse of the “shock therapy” neocapitalist regimes in Eastern Europe is a challenge to U.S. imperialism, not an opportunity.

Although the emerging markets are besieged by capital flight and confront the contradictions of their export-led development strategies, the unravelling in the periphery has not, in the much more serious world crisis of today, resulted in a renewal of the financial system at the centre. The inflows to the United States are largely in the markets for U.S. Treasuries rather than into the battered private financial system. The European Union has denied similar recourse since there is no comparable market for sovereign debt at the level of the European Union.

As a result, paradoxically liquidity in the U.S. markets remains at all-time highs. The real problem is that despite all this liquidity the credit machinery has refused to restart as banks and financial institutions remain wary of lending, and are simply stockpiling excess reserves. In other words the supply of money is way up but its velocity is even further down, keeping deflationary forces strong. Consequently, the international financial system shows no signs of revival.

Chapter 7



For half a century, the United States has garnered substantial political and economic benefits as a result of the dollar’s de facto role as a global currency. In recent years, however, the dollar’s preponderant position in world markets has come under challenge. The dollar has been more volatile than ever against foreign currencies, and various nations have switched to non-dollar instruments in their transactions. China and the Arab Gulf states continue to hold massive amounts of U.S. government obligations, in effect subsidizing U.S. current account deficits, and those holdings are a point of potential vulnerability for American policy.

In 2005, U.S interest payment on that foreign debt topped the $100 billion mark for the first time-coming in at $114 billion or about $310 million per day. And the rate at which the United States is going deeper into debt is accelerating: those interest payments are more than double the amount the United States paid to its foreign creditor’s decade ago.

Each of the dollar bear market periods has its own unique circumstances. But in the long run the dollar will continue falling because of simple supply and demand. Without a gold standard, the United States effectively can print as much new money as it wants. As the United States prints more dollars, it runs the risk that there will be a glut-that one day there will be more dollars than foreigners wish to hold. Maybe domination by one currency is just not meant to last for a superpower.

As the world’s first truly global currency, the dollar helped unleash a period of globalization never before seen, but it also changed the rules of the world economy in ways people are still trying to understand. It upended the relationship between states and created new opportunities and new traps.

Euro as the most challengers to US dollars

With the Euro as new rival, and another one potentially brewing in China, the US dollar is unlikely ever to command the same global market share it did in the post-Cold war 1990s, when there was no genuine competitor in sight and America enjoyed unrivalled authority as the winner of the Cold War and the unchallenged superpower. So, if the dollar’s spot on top of the mountain looks relatively secure, the distance between the mountaintop and its major rivals looks to be narrowing. Some of economist sees the world eventually dividing into three currency blocs: one using the Yuan, one the Euro, and one the Dollar, each within a sphere of influence of a regional power.

The euro was created legally in 1999 and began to circulate as currency in 2002. It has now replaced national currencies in 16 countries; it is widely used in EU members that have not yet formally adopted it but are committed to doing so and in a number of would-be members of the European Union. Debt outstanding in 1998 was converted into Euros, and since then participants in euro land have issued debt denominated in Euros. The euro-based capital market has evolved greatly in the past decade.

Economists’ biggest fear is of the damage a US recession would inflict on the world economy. With the economies of Europe and Japan growing at slower rates, many exporters have come to rely on US demand to sustain their businesses. That means a sudden U.S slow-down or collapse in the dollar would threaten sales for companies around the world and could spark a global recession.

The first conclusion is that one of the other leading currencies in the world today is ready to replace the US dollar in its international role. The international role of the Euro is likely to increase in the coming decade as non-eurozone members of the European Union and aspiring candidates increasingly use Euros in their transaction with the EU countries, for invoicing, for payment, and for holding international balances. But this increasing use of the Euro is not likely to displace the dollar at the global level. In a growing world economy, there is room for the Euro to increase its share in reserve holdings even while the value of dollar holding continues to rise.

The second conclusion is that synthetic currencies or basket arrangements such as the SDR will not displace individual, national currencies due to all the inherent problems of pricing and trading in composite currencies. With notwithstanding the current phase of weaknesses in the value of the US dollar unit, the RMB and the Chinese authorities have a mountain to climb before there is any possibility of the RMB becoming an international currency, let alone an international reserve currency on a par with the US dollar.

The above graph forecasted Euro as a potential challenger will appreciate against the dollar in the year 2010 as international traders will slowly reduce their dependencies on the dollar. One of the reasons is most probably out of the considerations of diversifying their risks of holding large amount of single currency. Also, because of the Euro is gaining strengths and weight in the international trading markets as it is currently still most potential currency to compete with dollar.

Chapter 8


In short, predictions for other currencies to take over the role of the US Dollar as the international currency began to look increasingly illusory. Even under the best of circumstances it would take years, if not decades, for the new currencies to overcome the dollar’s natural incumbency advantages.

The below shows the summaries of reasons why other currencies may still remain below par in challenging the position of the US Dollar as the world’s dominating currency.

Although Europe’s new money does offer many positive features for market agents, including especially a high degree of transactional convenience. Unfortunately, we know that the fact shows where progress to date, however, has been disappointing, and it is not at all clear that the euro’s promise in this respect can ever be converted fully into performance. As discussed previously, this is due to its standing as only a ‘union’ of 16 independent countries. This situation makes collaboration between each countries’ financial market system difficult. Thus, problem in integration which promotes inefficiency resulted in higher transaction costs, if the currency were taken as an international currency at the time being. In principle, the EU is firmly committed to financial integration under the Financial Services Action Plan first launched in 1999 but in practice, however, resistance to many market-opening measures remains stubbornly strong.

The second reason is simply inertia, a characteristic that is inherent in all monetary behaviour. As what numerous analysts have emphasized, switching from one money to another is costly due to the involvement of an expensive process of financial adaptation. Considerable effort must be invested in creating and learning to use new instruments and institutions, with much riding on what other market agents may be expected to do at the same time. Most countries may still prefer the use of US DOLLAR as they’ve been, for the past 30 years. Whereas, other currencies may be considered ‘young’ and need more adjustments to improve in terms of functionality and performance internationally.

The third reason that continues the tenure of US Dollar as the international currency is performance. Since the clearest indicator of the money’s international status is the amplitude of its use as a medium of exchange in the foreign-exchange market. This can be also measured in terms of the currency’s stability and security. The Americans has been the world largest, most broad-based importer and exporter. Likewise, the dollar remains the most favoured store of value in global capital markets, where the other currencies have yet to catch on significantly as an investment medium for international portfolio managers.

The fourth aspect which gives rise to the strengthen position of the US Dollar is governance. Political stability and cohesiveness, the structure of a country’s governance and a systematic and efficient implementation of political matters are needed to facilitate the role of an international currency. Other contenders with big issues like the government of China effectively prohibits the free flow of its current and capital account, resulting in shattered investors’ confidence in the country’s financial system, the lack of political coherence among the EU nations, the over-dependency on US Dollar of the Japanese policy makers for security and market and high political concern in Russia which gave a platform to Iranian President Mahmoud Ahmadinejad ponder questions in the minds of the people to whether accept other currencies internationally.

The fifth reason for the US Dollar’s strengthened position as international currency for the near future is the anti-growth bias by most currency competitors like the Japanese government. Japan’s dependence on large market and resources of the US, therefore, causing Japanese government to willingly accept the bilateral transaction between the US and Japan to remain largely dollar-based. On the other hand, Chinese authorities are in no hurry to make the Renminbi an international currency as it would require liberalization of China’s capital account and massive reform of the country’s financial system, where the acts are deemed to be both politically risky.

As a consequence of all these reasons, some have suggested that the US Dollar would remain its position unchallenged for a few years ahead and in the near future. However, as mentioned in the previous sections, issues like the rescue of Fannie Mae and Freddie Mac, bankruptcy of Lehman Brothers, the fire sale of Merrill Lynch, and the rescue of AIG shifted the nation’s attention into considering other currencies as either a substitute or complementary to the US Dollar internationally. Some financial experts suggested the creation of new reserve currencies that would help distribute global wealth more fairly and also to encourage economic leaders to pursue more balanced economic policy. Even if this idea is accepted, the emergence of new reserve currencies would be gradual process reflecting shifts in the global economy which would take even decades to be completely reformed. Hence, we would still accept the US Dollar as the supreme currency when the world is still unable to confidently answer this question “Can other currency or currencies rival the Dollar, effectively and efficiently?”

Chapter 9


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