Dollar’s Role as Reserve Currency in Jeopardy

I concluded my last post by promising to discuss the implications of a change in the status quo, regarding the Dollar’s role as the world’s reserve currency. As it turns out, the last few days have witnessed a few developments on this front.

First of all, the G7 concluded its latest round of talks. Despite previous indications to the contrary, the organization continued its practice of releasing a communique. in which it noted that global economic balances persist and that policymakers should work together to mitigate them. While seemingly benign and desirable, the proposition couldn’t have come at a worse time for the Dollar.
The only reason why the Dollar hasn’t collapsed completely is because economies largely continue to recycle their surplus wealth and trade surpluses back into Dollar-denominated assets. One columnist connects the dots with regard to the forex implications: “Less Chinese intervention to prevent yuan strength would mean China, slowly over time, would build up fewer dollar reserves.” In other words, economies no longer concerned with pegging their currencies would have very little reason to build up large pools of reserves.


In fact, China is fully on board with this notion. Following the G7 talks, Chinese officials announced that it would support a stronger Yuan as soon as the global economic crisis resolved itself. By its own reckoning, this would facilitate a shift in its economy, from one dependent on exports for growth to one focused around domestic consumption. Still, obstacles remain, and “It is far from clear how China can engineer a shift up for the yuan against the dollar, which analysts note would almost certainly translate into a gain against other currencies as well.”

Speaking of China, it is also among the most vocal of nations laboring for alternatives to the Dollar. Towards this end, it has reportedly formed a secret coalition with the other BRIC countries (Brazil, India, and Russia), as well as Japan. The goal is to end the pricing of oil in Dollars by 2018. That the group has given itself nine years to complete this task speaks to its extraordinary ambition.

The implications for the Dollar cannot be understated. A handful of oil-producing nations in the Middle East hold a combined $2.1 Trillion in Dollars, which are solely a product of selling oil in exchange for Dollars. Already, the government of Iran has mandated that in the future, all of its reserves be held in non-Dollar-denominated assets. Thus far, no other countries have followed suit. China is aware that pushing for further developments could roil the US, which would be unlikely to sit on the sidelines and watch its currency be summarily jettisoned. “Sun Bigan, China’s former special envoy to the Middle East, has warned there is a risk of deepening divisions between China and the US over influence and oil in the Middle East.”

Robert Zoellick, president of the World Bank, doesn’t harbor any illusions, and announced during a recent speech that the a decline in the role of the Dollar is inevitable. “He said the United States ‘would be mistaken to take for granted the dollar’s place as the world’s predominant currency. Looking forward there will increasingly be other options to the dollar,’ ” such as the Chinese Yuan and the Euro.

Zoellick’s warnings were prescient, when you consider that the IMF just announced that the share of Dollars in global foreign exchange reserves declined significantly in the most recent quarter, perhaps to its lowest share since the Euro was introduced in 1999. [The latter, however, has yet to be confirmed]. “The dollar’s share in global reserves declined to 62.8% from 65.0%…The euro’s share increased to 27.5% from 25.9%.”

JP Morgan’s research team has discovered a similar trend- that accumulation of US assets accounts for only half of the global increase in global forex reserves. “Quantifying this trend is always imprecise. But the circumstantial evidence — official buying of U.S. assets runs at only half of the pace of global reserve accumulation — suggests that diversification has accelerated since June.”

So, there you have it. The Dollar’s demise (to borrow a characterization by one of the columnists featured in this post) is no longer theoretical. It may have already begun…