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| Source: McKinsey Global Institute |
Being a major reserve currency has been termed an "exorbitant privilege" but it is also a barrier to competitiveness and proposals for a global reserve currency are only currently at hot air stage.
The dollar is a major form of cash currency around the world. The share of US dollar banknotes estimated to be held outside the United States is substantial according to Linda Goldberg, an economist at the Federal Reserve Bank of New York. Roughly 75 percent of hundred-dollar notes, 55 percent of fifty-dollar notes, and 60 percent of twenty-dollar notes are held abroad, while about 65 percent of all US banknotes are in circulation outside the country. Approximately $580 billion in physical US currency outstanding was circulating overseas at the end of March 2009.
In 2009, dollar assets accounted for about two-thirds of the reserve assets of industrialised and developing countries. Among industrialised countries, a sharp jump in the dollar share occurred between 1995 and 2000. The rise can be explained primarily by changes in the reserve holdings of euro area countries. With the introduction of the euro, the legacy currency reserves of euro-area countries—the deutsche marks, francs, lira, and other currencies replaced by the euro—were reclassified as local currencies and therefore were no longer considered foreign currency reserves; this shift in the composition of the countries’ reserve portfolios meant that the dollar assumed a much larger share of the remaining reserves. Subsequently, the dollar share declined only modestly in the portfolios of industrialised countries.
McKinsey Global Institute (MGI) says some observers assume that the United States continues to enjoy an "exorbitant privilege" because of the dollar’s reserve currency status, as former French Finance Minister Valéry Giscard d’Estaing charged in the 1960s. But MGI finds that the United States may not enjoy much of a privilege at all. In 2007–2008—a "normal" year for the world economy, the net financial benefit to the United States was between about $40 billion and $70 billion—or 0.3 to 0.5 percent of U.S. GDP. In a "crisis" year—such as the year to June 2009—MGI estimates that the net financial benefit fell to between -$5 billion and $25 billion because the dollar appreciated by an additional 10 percent due its status as a "safe haven."
The research finds that reserve currency status has two benefits. The first benefit is seigniorage revenue—the effective interest-free loan generated by issuing additional currency to nonresidents that hold US notes and coins—that generates an estimated $10 billion. The second benefit is that the United States can raise capital more cheaply due to large purchases of US Treasury securities by foreign governments and government agencies. MGI estimates that these purchases have reduced the US borrowing rate by 50 to 60 basis points in recent years, generating a financial benefit of $90 billion.
The major cost is that the dollar exchange rate is an estimated 5 to 10 percent higher than it would otherwise be because the reserve currency is a magnet to the world's official reserves and liquid assets. This harms the competitiveness of US exporting companies and companies that compete with imports, imposing a net cost of an estimated $30 billion to $60 billion.
MGI says this raises an interesting question. Mindful of the only modest benefits of reserve currency status, will the United States continue to prioritize its domestic growth and jobs agenda over its implicit responsibility to maintain global financial stability, causing greater volatility that threatens the competitiveness of economies and corporations? MGI's analysis suggests that the United States may not be inclined to tighten its fiscal and monetary policy to safeguard its dominant reserve currency position, even if it perceives that status to be at genuine risk.
And yet MGI finds that there is no realistic prospect of a near-term successor to the dollar. Although the euro is already a secondary reserve currency, MGI finds that the Eurozone has little incentive to push for the euro to become a more prominent reserve currency over the next decade. The small benefit to the Eurozone of slightly cheaper borrowing and the cost of an elevated exchange rate today broadly cancel each other. But if the euro came to equal the standing of the dollar as a reserve currency by 2020—an accelerated path from today’s trajectory—there would be a net cost of 0.1 percent of Eurozone GDP. The renminbi may be a contender in the longer term—but today China’s currency is not even fully convertible.
This analysis suggests that it is likely that we will continue to see an unmanaged reserve currency system in which both the United States and the Eurozone prioritize their respective domestic economic agendas over supporting the global system. Given the pressures on the exchange rate system, and the scale of capital flows, this could pose significant risks to the stability of global currency markets and represent a threat to the competitiveness of economies and corporations.
A December 2009 McKinsey global survey of executives found that both the level of exchange rates and exchange rate volatility have a large, and growing, negative effect on profits and investment decision making. Some 21 percent of respondents report that exchange rate uncertainty has reduced their planned investment over the next two years. And 29 percent of respondents report that exchange rates have an "extremely" or "very" significant effect on company profits.
MGI says companies may argue that grand schemes about global financial architecture are the preserve of politicians and none of their business. But exchange rates that are substantially out of line with economic fundamentals coupled with currency volatility will generate real economic costs. Whether the world resolves the reserve currency issue or not is therefore very much the business of businesses.
Linda Goldberg says the dollar is a leading transaction currency in the foreign exchange markets and a key invoicing currency in international trade, besides trade with the United States. With an 86 percent share of FX transaction volume—more than twice the share of the euro—the dollar continues to dominate these markets. Turnover volumes in the foreign exchange markets have more than doubled in the past decade, implying large numbers of transactions measured in reference to, or involving, the dollar.
Goldberg says the euro is used extensively for invoicing trade of the sixteen countries that have adopted the currency—both in transactions among themselves and with other markets—but not broadly in other regions.
Fred Bergsten, who served in the Treasury Department during the Carter administration and is now head of the Peterson Institute for International Economics think-tank, has argued that the dollar’s days are numbered as a reserve currency. Writing in the magazine Foreign Affairs, he said last year that the dollar’s position as the default international currency had made it “much easier for the United States to finance, and thus run up, large trade and current account deficits with the rest of the world.” But the US trade deficit, along with the huge US budget deficit, laid the groundwork for the current financial crisis. So he said it is now time for Washington to realise that “large external deficits, the dominance of the dollar, and the large capital inflows that necessarily accompany deficits and currency dominance are no longer in the United States’ national interest.” It’s time to start creating an international currency system that does not rely on the dollar, he concluded.
MGI paper on dollar
New York Fed article by Linda Goldberg
Finfacts article, Feb 2010: Euro's role as a reserve currency is growing
