Curtains for the greenback?

The mighty greenback is slowly but surely losing its pre-eminence as the world's reserve currency. Consider the evidence:

1. The US dollar has fallen by more than 10 per cent against the euro and 14 per cent against the pound this year.

2. Asian central banks have been steadily diversifying their holdings away from USD-denominated assets into the euro, yen and pound.

3. Key petrodollar economies such as Iran, the UAE, Indonesia and Venezuela have said  they are looking to shift their reserves into euros or to price oil sales in the currency.

4. Today's Financial Times reports that Euro notes have overtaken the dollar:

The US dollar bill’s standing as the world’s favourite form of cash is being usurped by the five-year-old euro. The value of euro notes in circulation is this month likely to exceed the value of circulating dollar notes, according to calculations by the Financial Times. Converted at Wednesday’s exchange rates, the euro took the lead in October.

The figures highlight the remarkable growth in euro notes since their launch on January 1 2002, three years after the start of Europe’s monetary union, which in January welcomes its 13th member – Slovenia, the former Yugoslav republic.

“After the launch, we expected growth to stabilise – but it has continued over five years,” Antti Heinonen, head of the European Central Bank’s bank notes directorate, told the Financial Times.

Although the ECB does not deliberately promote the international use of the euro, it has become popular in official foreign exchange reserves – even if it is far from challenging the dollar’s lead as the most popular reserve currency.

Individually, these might be dismissed. Together, they point to a gradual erosion of the greenback's long standing dominance of global currency markets and central bank reserves.

I don't see this gradual diversification as a problem for markets - though there will be the odd exchange rate and asset class dislocation as large holdings shift. Nor does it augur the greenback's imminent collapse; more like a gradual weakening.

In time I expect it will be the yuan - rather than the euro - which comes to rival the dollar as the world's most traded currency (though clearly we are still a long way from that).

UPDATE: Felix Salmon of Economonitor offers five main reasons why there are more euros in circulation than greeenbacks. Meanwhile Dean Baker has this to say:

First, the dollar is not essential to world finance. People are happy to hold euros and other currencies, no one needs to hold dollars. Second, the euro passing the dollar is not some sort of cataclysmic event.

As long as people still have faith in the basic soundness of the dollar, they will be happy to hold it, even if it slides to number 2 by some measures. Of course, if investors become convinced that the currency is on a downward path, then it could lead to a serious run.

In short, the world does not need the dollar, but it is also not anxious to throw it in the toilet, or at least not yet.

Comments

[Gabriel M.]

Well... eggs and baskets I say. The era in which the dollar was alone was the aberration. Previously, we had the British pound too but then it went away for obvious reasons.

What makes you say that about the yuan? -- My main concern there is that the yuan is not under the control of an independent central bank, credibly committed to inflation targeting. On the long run... maybe, but anything is possible. On the short run, the Chinese sit on a large enough pile of USD to make the scenario improbable.

[jon livesey]

"Previously, we had the British pound too but then it went away for obvious reasons."

Really? I must have missed that, and so did the FT, which recently reported that the Pound is currently the world's third reserve currency, behind Dollar and Euro, but well ahead of the Yen.

[Arthur Eckart]

The U.S. economy remains fundamentally stronger than the E.U. or Japan. However, to maintain overproduction, export-led countries need to shift away from dollars into Euros, Yen, gold, etc., since too many dollars have been bought. Lower prices induce demand. Conversely, higher prices reduce demand. The large U.S. trade deficits suggest consumer surplus of U.S. imports have been large. I suspect, a large quantity of foreign goods are sold slightly above costs. Also, there may be some dumping (i.e. goods sold below costs). So, it has been rational for U.S. consumers to spend rather than save. There are other factors contributing to the trade imbalance, e.g. relative income, interest rates, taxes, trade barriers, etc. It's possible much foreign wage growth is depressed to offset other input costs, maintain profit, keep employment high, and prices low. The danger is the longer the imbalances persist, the more likely they'll correct suddenly rather than slowly. So, if overproduction of export-led economies continue, those economies may eventually collapse.

[John Booke]

12/29/06 "The mighty greenback is slowly but surely losing its pre-eminence as the world's reserve currency." "Not true" according to today's IMF's report. In fact USD has been gaining Global Reserves shares since Q1 2005. The dip in Q2 2006 falsly cheered USD bears into thinking that Euro-Pound-Yen were gaining.

[Lafayette]

AE: "So, it has been rational for U.S. consumers to spend rather than save."

Not as regards the chronic current account deficit. Remember it has been "chronic" for over half a century.

Though ominous, the trend away from the dollar as a reserve currency is not yet perilous. However, if Americans wish to disregard the handwriting on the wall, which is thier prerogative however foolish it might be, then the they will also have to assume that holding fewer dollars in international reserve will not afford America the clout it once had in financial circles.

Frankly, it is about time. America has had a run at conspicuous consumption that is far beyond its means (since those means are afforded by those who retain reserves in T-notes).

The paradigm is shifting. It will take a while, but America (and Americans) will have to learn to live with a less than rosy economic climate of lower i-rates.

It’s time to pay the piper.

[brad setser]

New Economist -- First, congrats on a very successful year blogging; your capacity to find interesting material conistently amazes. Second, I wonder if you could spell out 2) a bit more. There are no shortage of rumors of Asian diversification, but I at least haven't been able to find great hard evidence of diversification in general(apart from a surge in euro denominated deposits from central banks in the BIS data for q2), let alone hard evidence of Asian diversification. It seems to me that the evidence of oil state diversification (led by Russia) is a bit stronger than the evidence of Asian diversification. Korea may have reduced its $ exposure somewhat, as may Japan -- but i would be surprised if Korea has less than 70% dollar reserves and Japan (couting the MOF's holdings) less than 80%. The COFER data (IMF) is incomplete, but it suggests (once adjustments are made for valuation) that dollar reserve growth picked up in 2006 v. 2005. The US BEA data is also flawed, but it too shows stronger official inflows in 06 than 05 (though both 05 and 06 inflows seem too small to me relative to the overall growth in central bank/ oil fund assets). It certainly would have been far easier for Asian central banks managing their reserves against the dollar to have diversified in 05, when the $ was strong, than in those periods in 06 when the $ was weak. Russia gained a bit more freedom by managing its currency v. a basket, and korea had a bit more freedom as well when it was willing to let the won rise (but not right now, I suspect). A diversification story would suit me personally -- a desire not to be left holding $ was a big part of the Setser/ Roubini story for how BW2 might end -- but I haven't been able to find good evidence that it is happening ... setting Russia and to a lesser degree Vennie (whose reserves are small and still 80% in dollars) aside.

Lafayette -- large (meaning more than 2-3% of GDP) US current account deficits are a fairly recent phenomenon. Think post 1997. Ten years, not fifty. Go back 50 years and the US was still running current account surpluses (and building up a stock of European assets whose rising value has really helped the US recently!)

The pound is back in style as well. But overtaking the yen (which doesn't pay interest) is easy; catching up with the euro/ $ will be hard. Third place isn't bad, and it is a big change from where the pound was in say the early 90s, but it still isn't a return to the turn of the last century int. monetary system where the pound was (I think) almost as dominant as the $ is now ...

[Arthur Eckart]

Lafayette, if you look at the BOP of interest and dividends of U.S. assets abroad and foreign interest and dividends of assets in the U.S., it shows the U.S. made large foreign investments since WWII, while foreigners began to invest more in the U.S. after 1980. Also, current American overconsumption will be offset by future American production, i.e. Americans will work longer. Moreover, I may add, there's a political component trading with OPEC. The big OPEC savers seem more comfortable dealing with the U.S. than with the anti-oil and anti-war E.U. Nonetheless, most OPEC countries are in business to make money (rather than using oil for politics). The E.U. response to a world oil price in Euros would be interesting. I suspect, the U.S. market would remain more open. So, OPEC would make less money. Overproduction of export-led countries should fall. However, export-led countries will attempt to keep their currencies weak to produce well beyond what's needed for oil. No matter what currency OPEC chooses, most countries still have to pay OPEC. Consumption is paid whether OPEC buys U.S. Treasury bonds or Eurobonds.

[Lafayette]

AE: "The big OPEC savers seem more comfortable dealing with the U.S. than with the anti-oil and anti-war E.U."

Just what have you been smoking that provoked this revelation?

It is so off-base that it does not merit a rebuttal.

As for the rest of your assesment, it is pure pie in the sky.

"current American overconsumption will be offset by future American production"

What future production? This is sounds like a campaign promise of some Republican candidate desperate to be relected in 2008.

The dislocation of jobs from the US has meant that, within certain economic classes, people have reduced consumption due to, first, unemployment and, second, re-employment at lower paying service jobs.

The US has known disastrous depressions before and it is risking one again. Nothing predetermines the US for special treatment. And, its deficit almost guarantees that one WILL happen unless measures are taken very soon to prevent one.

It's a new ball game ... most Americans simply have not realized the profound reallocation in terms of exchange related to international trade. And, Dubya wasted a tax reduction to spark an expansion that simply has not brought about the level of new jobs that had been hoped for.

THAT is the reason there will be change of power in Washington.

[Arthur Eckart]

Lafayette, if the U.S. didn't exist, Kuwait would likely still be Iraq's 19th providence, because the Europeans would be less likely to eject Iraq's military (the U.S. also had the will to intervene in Bosnia, which is in Europe). An intertemporal model shows if there's overconsumption in the first period, then there would be underconsumption in the second period. However, Americans have shown to be adept at maintaining autonomous consumption. So, they may produce more in the second period. The U.S. will produce $13.5 trillion of output in 2006 and consume over $14 trillion. So, U.S. consumption hasn't been reduced. Export-led economies are more likely to collapse than the U.S. economy. The U.S. is in a strong fundamental position, where rising exports will prevent an economic contraction.

[Lafayette]

BS: "Go back 50 years and the US was still running current account surpluses (and building up a stock of European assets whose rising value has really helped the US recently!)"

You go back 35 years. Go here: http://en.wikipedia.org/wiki/Balance_of_payments#History

The CA deficit has been an American hallmark since the seventies. Kennedy had tried to staunch the capital exode to Europe in the 60s with in interest equalization tax ... to no avail.

It seems disingenuous of those who cannot read the handwriting on the wall. America likes to give lessons to other countries on how to run not only internal affairs but foreign policy as well. (It cheered the demise of communism as vindication of capitalism, which was certainly not the same conclusion obtained by most European countries, already heavily socially democratic.) But, it is not such a good student when it regards Uncle Sam's own matters of importance.

I don't think that the CA deficit will torpedo the American economy, but it will make it ever more difficult for America to be as resilient in the past, since this resilience has depended largely on comparatively inexpensive money rates, a factor that may not be at the rendezvous when most necessary.

America is living on borrowed time (whilst burrowing itself in a stupidly costly foreign war.) Pooh-poohing the gravity of the situation is NOT the solution.

Whenever is Uncle Sam going to learn? Answer the question.

[Arthur Eckart]

Lafayette, I wouldn't assume the world's only superpower is a failure. The U.S. must be doing some things right. Nonetheless, some continue to ignore the elephant in the room.

[Lafayette]

AE: "Lafayette, I wouldn't assume the world's only superpower is a failure."

Now that's a rich bit of hubris ...

I wouldn't assume it either. But, neither would I presume that God accords it any particular preference in terms of divine protection.

[angry economist]

Doesn't the devaluation do the US domestic economy a few favours? like making domestic producers and goods more price competitive next to imports or in competition with other markets for example? Personally I think US Govt is happy to see the dollar's value decline, and to erode its place as the World's no. 1 reserve currency.

I think there's lots of mistaken views in the comments about the relationship between trade deficits, the dollar, and the US domestic economy here. Anyone read Krugman's stuff?!

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