The King of all Trades

For years, pundits and market participants have stubbornly predicted the demise of the dollar as the premier reserve currency in the world. The dollar has defied all skeptics. Even as chatter from market participants has grown louder with every contemporary financial crisis, the demand for dollars has become nearly insatiable. First, the yen, then the euro, were predicted to become reasonable alternatives to the dollar. Despite these predictions, the demand for dollars has only increased in global financial markets. The Chinese renminbi (RMB), whose roll-out as a new international currency was patiently planned by Beijing’s policymakers, has been listed recently as a long-term viable alternative to the current status quo. So what are the prospects for the RMB, current market turmoil aside? And what is the likely fate of the dollar?

For all involved in bond and currency markets, the concept of “reserve currency” status is nearly metaphysical and very hard to define.

But why was the dollar not the preferred currency prior to the summer of 1914? The answer is not a mystery. First, prior to the formation of the Federal Reserve, the US was prone to numerous financial crises. In addition, a mere 50 years before the start of WWI, the US had been embroiled in civil war; this was not an encouraging state of events, nor did it inspire confidence in international investors. Second, prior to the summer of 1914, there had been little or no reason to question or doubt the pound’s convertibility into gold. Simply put, the British government had not given the world a reason to seek a new preferred currency. 

The formation of the Federal Reserve, and the Treasury’s enhanced credibility during the summer of 1914, made the US dollar a tolerable substitute for the pound. However, it was the third event, the decisions made at Bretton Woods, which finalised the role of the dollar as the world’s reserve fiat currency, turning the de facto relationships of the war into the de jour relationships codified in the international monetary system. The decisions at Bretton Woods codified the dollar as a near substitute for gold, acknowledging the reality that had taken place over the long years of war. 

Starting from the 1960s onwards, US monetary liabilities held by foreigners began to exceed US holdings of gold.9 The paradox of being the world’s reserve currency required the US to supply the world with an adequate number of dollars. However, the more dollars it supplied the world, the more the US diminished its credibility regarding its ability to convert those dollars to gold on demand. This paradox is known as the Triffin paradox after Robert Triffin, who identified the problem in the 1960s. From 1965 onwards, in part for political reasons, France demanded its gold and the continuation of this “on-demand” conversion process precipitated in the ending of the gold standard in 1971. Coming off the gold standard, the dollar stayed the reserve currency. However, that did not occur without a substantial devaluation. Indeed, if one reads the minutes of the conference call of the FOMC in 1973, one can sense the palpable alarm among the participants regarding the dollar’s depreciation. Nevertheless, the dollar continued to be the world’s reserve currency for lack of any other substantial alternative.

Defining a reserve currency
The line blurs between currencies that are considered “international” and those that are considered “reserve.” A reserve currency needs to be an international currency. An international currency requires that the currency be used in a significant portion of invoicing/trade transactions, and used in the financial markets. In other words, an international currency is really a transaction currency, one that is easily accepted by a number of market and trade participants. A reserve currency goes a level above that and becomes the currency of choice during flight-to-quality scenarios.

There are two necessary, but not sufficient, conditions for a currency to be considered an international or transactional currency, both of which are associated with capital account convertibility. 

Condition Rs.1 – A Trading and Invoice Currency: Trade and invoicing must take place in a currency for it to be considered international. Goods and services must be purchased with these currencies. The reason is obvious: Fiat money exists to facilitate some type of exchange between counterparties. A primary invoicing currency determines which currency is used when a good or service is exchanged between two countries.

Condition Rs.2 – A Liquid and Investable Currency: To invest in a currency, one actually needs a deep and liquid marketplace for securities. A short-term, high-quality securities market is critical to the development of an “investable currency.”

There are also several criteria for a currency to be considered “liquid.”

Short-term, high-quality commercial paper and bills market. The importance of this market cannot be overstated for the functioning of a reserve currency. It allows investors to purchase securities that they consider “cash-like” with limited credit risk. For banks, this market creates a liquid place to deposit cash as an alternative to depositing cash in a central bank account (remember, until recently, the commercial banks did not earn a return on their excess central bank deposits). 

A liquid and developed government yield curve. A well-built-out, risk-free curve will serve as a benchmark for liquid borrowing by private issuers. Some participants would argue that a liquid swaps curve would suffice, and they would point to the phenomena of negative swap spreads as an indication that swaps are now the preferred benchmarking vehicle due to their lower balance sheet costs relative to government cash securities. 

An effective and tested bankruptcy code. The concept of “predictable outcomes” is required for a private credit market that is not backstopped by government guarantee. Private credit markets are more likely to flourish when there are more predictable outcomes in bankruptcy. 

What really matters
The ability to have the preeminent reserve currency, without it being locked to a finite good such as gold, gives the US enormous advantages. For all intents and purposes, US dollars (and Treasuries) are gold. As my colleague James Montier has suggested, the US is like Rumpelstiltskin spinning out gold at will. The current account deficits that the US runs most years mean that the world is willing to give the US goods and services for the privilege of owning pieces of paper (indeed as a friend noted, they are not even pieces of paper, they are electronic credits). 

However, others argue that the preponderance of the dollar is a core point of global financial instability. The IMF has suggested that a more multilateral currency framework, or enhanced use of SDRs (special drawing rights), would be beneficial to global financial stability, including utilizing the Fund to act as a lender of last resort to those requiring flight-to-quality liquidity. In short, if the dollar is the reserve currency of the world, how does the Federal Reserve set appropriate monetary policy for the US? It’s a question that is under debate during this current phase of Federal Reserve monetary policy tightening. 

While there are a number of concerns regarding the world’s dependence on dollars, as noted in the IMF paper, US policymakers should remain cautious toward divergence away from the dollar. While currency regime changes appear to be generational, to date it has been hard to find an example where a change in the reserve currency status was not a zero sum game for the country that held that status.

In the second instalment of the article we will address the growth and utility of RMB usage, the failure of other developed market currencies such as the yen and the euro to fully achieve dominant reserve currency status, and the odd development of alternative currencies such as bitcoin.

Edited excerpts from GMO’s white paper titled: The Reserve: The Dollar, the Renminbi, and Status of Reserve