Is the Renminbi Challenging the Dollar’s Reserve Status?
Since its inception in 1999, the euro has gained ground against the dollar as an official reserve—a currency that foreign governments hold to facilitate their transactions in foreign-exchange markets. The dollar emerged after World War II with key official reserve status, but persistent trade deficits since 1982, coupled with a broad-based depreciation of the dollar after 2002, encouraged a marked shift out of dollars and into euros.
Most of the reshuffling has occurred within the developing countries, which hold particularly large portfolios of foreign-currency reserves. The Great Recession and the European sovereign debt crisis have recently stalled the euro’s ascent as the key reserve currency, but not the diversification out of dollars. The intriguing, but unanswered, question is: what currencies are now replacing the dollar, the euro, and the other traditional reserve currencies in these portfolios?
Although it has lost ground, the dollar remains the world’s key international reserve currency. At the end of last year, it constituted 58 percent of developing countries’ official reserves, according to preliminary IMF data. The euro remained a distant second, at 27 percent of the total, with the British pound and Japanese yen making up 6 percent and 2 percent, respectively. After accounting for all of the traditional reserve currencies, however, the IMF lumped 7 percent of foreign-currency reserves in an “other currencies” category—an eye popping amount. Usually, this “other currencies” category amounts to only 1 percent or 2 percent of the total.
A currency’s ranking as an official reserve typically parallels its broader—public and private—use in the foreign-exchange market. Every day, foreign currencies equivalent to roughly $4 trillion change hands. Of these transactions, 84 percent involve U.S. dollars. The euro accounts for slightly less than half of that, even after double counting trades of euros against dollars.
The sticking power of the dollar as the world’s key currency, despite the arrival of competitors, stems from its widely established use. International trade in both standardized commodities and products that sell in highly competitive markets—including many financial instruments—is typically denominated in dollars, because a common currency facilitates price comparisons. In contrast, international trade in heterogeneous manufactured goods, where price competition is less important, tends to be denominated in the exporter’s currency. Even so, importers—or their banks—will often acquire an exporter’s currency by first trading their home currency for U.S. dollars and then trading dollars for the exporter’s currency. The world has found significant cost savings from these arrangements.
The dollar has maintained this role because of the size, sophistication, and relative stability of the U.S. economy. The United States is one of the largest and most broad-based of exporters and importers in the world. With all this trading, a lot of dollars will naturally change hands. As a consequence, foreign traders often finance a large portion of their business in U.S. dollars, so they maintain accounts in dollars, seek loans in dollars, and undertake myriad other financial arrangements in dollars.
A strong, open, and liquid U.S. financial system accommodates their needs. U.S. financial markets have always been innovative and relatively free of cumbersome regulations. They offer many different types of financial instruments and well-developed secondary markets, all of which enhance the liquidity of dollar-denominated assets. The expansion of dollar trade and the growth of U.S. financial markets foster and complement each other.
To be sure, the euro enjoys many of these same attributes, and that is why it is rapidly gaining reserve currency status. Euro area gross domestic product and population are on par with that of the United States, implying a domestic euro market comparable to the domestic dollar market. In addition, euro area trade with the rest of the world last year was slightly larger than U.S. foreign trade. European financial markets are comparable to the U.S. market save the notable lack of a single European government security. Still, a lot of euros naturally change hands.
The dollar’s continued dominance owes much to the inertial effects of its network benefits. As more and more people came to use dollars in international commerce over the years—as the global network expanded—the benefits of using the dollar in exchange rose. Moreover, once the network benefits became substantial, people were prone to continue using it, even after a viable competitor—like the euro—existed. Making a jump from the dollar to a new international currency requires a substantial portion of people to switch in close concert; otherwise the network benefits are lost. This does not mean that a competitor, like the euro, will not gain ground on the dollar, but it suggests that the diversification process will probably remain slow.
In 1998, the year before Europe launched the euro, its constituent currencies collectively accounted for 16 percent of developing countries’ official foreign currency reserves, compared with 75 percent for the dollar. At the end of 2006, just prior to the Great Recession, the euro and dollar shares had changed to 28 percent and 64 percent, respectively. Since then, the euro share has fallen to 27 percent. The dollar, however, has not benefited from the euro’s decline. Its share fell 6 percentage points to 58 percent. A rise in the “other currencies” category gained almost as much as the dollar lost. The IMF does not report the currencies in the category, but the Chinese renminbi seems a likely candidate. China’s economy is developing, and the country is important in global trade. The Chinese government would like to promote the use of the renminbi, at least regionally.
Although the dollar has lost ground relative to other currencies in the collective portfolio of developing countries, it has not done so in an absolute sense. Developing countries are not dumping dollars; they held more dollar reserves at the end of 2011 than in any previous year. As their portfolios have been expanding, however, developing countries have been acquiring euros and the mysterious “other currencies” much faster than they have been adding dollars.
Where all this is headed is anybody’s guess, but it seems clear that the dollar will share its status as key international reserve currency with the euro and, maybe, some other currency.