Reserve Currency Roulette
by Annaly Capital Management
Following up on our post from Friday, in which we illustrated the currency reserve and GDP market share of a number of different countries, a kind reader asked a question: “I wonder what percentage of the world’s foreign exchange reserves the dollar had when it was redeemable among central banks in gold?”
Our source for the graph, the IMF, only showed data going back to 1995, so we dug a little more and found the answer in a paper written by Barry Eichengreen of the University of California in 2005. The answer: The dollar’s status as a reserve currency was even more dominant back then. In 1973 it accounted for 84.5% of the world’s foreign exchange reserves. (Today it stands at 62.1%.)
In Eichengreen’s paper, “Sterling’s Past, Dollar’s Future: Historical Perspectives on Reserve Currency Competition” (the paper can be purchased here, and it’s worth the $5), he argues that the hegemony of the dollar during the second half of the 20th century has some obvious roots: America’s dominance of global trade and payments in a period when Europe and Japan were still licking their wounds, the liquidity of the US financial markets and the capital controls put in place by other potential reserve-currency competitors. Britain’s sterling was the reserve currency of choice in the first half of the 20th century, largely for the same reason (between 1860 and 1914, according to Eichengreen, about 60 percent of world trade was settled in sterling), but this status waned as Britain’s economic prowess declined.
As his paper’s title suggests, Eichengreen is concerned about the future of the dollar’s status. He concludes that the dollar may end up sharing reserve status with another currency, likely the euro, but that the yen and the renminbi probably wouldn’t make the cut—the yen because of Japan’s poor demographics and the yuan because of China’s capital controls and its lack of credible political/financial infrastructure.
What could possibly tip the world away from the dollar? In a word, inflation.
“[W]hether the dollar retains its reserve currency role depends, first and foremost, on America’s own policies. Serious economic mismanagement would lead to the substitution of other reserve currencies for the dollar. In this context, serious mismanagement means policies that allow unsustainably large current account deficits to persist, lead to the accumulation of large external debts, and result in a high rate of U.S. inflation and dollar depreciation. Clearly, this would make holding dollar reserves unattractive. This is a lesson of British history in the sense that an inflation rate that ran at roughly 3 times U.S. rates over the first three quarters of the 20th century, in conjunction with repeated devaluations against the dollar, played a major role in sterling’s loss of reserve currency status.”
Absent sustained periods of inflation, says Eichengreen, the stability, liquidity and vibrancy of the US economy should enable the dollar to maintain its reserve currency status.
So, is the US engaged in prudent economic policies or “serious economic mismanagement”? We probably won’t know the answer to this question for some time. In the meantime, the market has been re-pricing the yield on sovereign debt around the world. The graph below looks at selected sovereign rates since Ben Bernanke’s speech in Jackson Hole last August, in which he first suggested the possibility of another round of quantitative easing. Ever since, market participants have been deliberating about the possible ramifications—including the inflationary prospects—of this policy decision.