Global Currency Endnotes
“Annual income twenty pounds, annual expenditure nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pound ought and six, result misery.”
Economic forces help me keep my expenditures within my income over time. Companies that are not able to generate revenue greater than their expenditures over time are forced to close.
Governments and countries must ultimately live within their means as well. Governments can spend more than they receive in taxes by borrowing, but purchasers of their debt will stop lending to any government whose debt they think is growing too large for the government to service. Governments can and have defaulted on their debts. Countries as a whole can ultimately only buy from the rest of the world what they pay for with what they sell to the rest of the world. The economic forces that operate, and that need to operate, to keep whole nations within their means take us to the heart of the current debate about the international monetary system and the role of the US dollar in that system.
Like any other economy, the Cayman Islands must ultimately live within its means as well and the fact that its currency is exchangeable for US dollars at a fixed exchange rate means that the behaviour of the US dollar is particularly important for Caymanians.
A country (all of its people, companies and government taken together) must live within its means in the same way that individuals do. Its expenditures abroad must not exceed its income from abroad in the long run. Like individuals, countries can finance some foreign spending by borrowing, but only as long as their capacity to repay their foreign debts remains credible. And, like prudent individuals, most countries also build up reserves (savings) that can be drawn upon when their foreign income falls temporarily short of foreign expenditures.
Virtually the only aspect of transacting abroad that sets it apart from transaction at home is that most countries have their own currency. Generally we expect to receive our own currency when we sell abroad and foreigners expect to receive theirs when they sell to us. Thus a country’s foreign reserves, usually owned by its central bank, must be held in a currency acceptable abroad. Almost two thirds of the world’s official government-owned foreign exchange reserves of 6.7 trillion dollars are held in US dollars, predominantly in the form of US Treasury securities. The only other important currency in foreign exchange reserves is the Euro with 27 per cent of the total.
A country’s expenditures abroad are largely for imports and it generates foreign income by exporting and from the return on foreign investments or gifts. When the outflow of money from importing exceeds the inflow from exporting, the foreign trade deficit is financed from the country’s foreign currency reserves (a currency that is accepted abroad) or by borrowing foreign currency if it can1. To build up foreign currency reserves in the first place the country must export more than it imports (have a trade or current account surplus).
The United States, as the reserve currency provider, is unique among nations because it needs no reserve of foreign currency. The rest of the world will accept the US dollar. It needs only to print more of them to satisfy any demand. When China or other countries want to increase their reserves of dollars, they must export more than they import and the US must do the reverse. A key issue is how this system maintains the desired balance between these flows and adjusts them when deficits and surpluses are excessive. Related to that issue is whether the approximately 4.5 trillion US dollars held in official reserves are potentially destabilising, given serious concerns about the future value of the dollar and dollar interest rates in the face of huge prospective US government deficits. Would externally produced reserve assets, such as gold or the Special Drawing Rights (SDR) of the International Monetary Fund, be better or helpful?
Regulation by markets
The balance of payments adjustment mechanism.
When my budget is out of whack I can draw down my savings or borrow for a while if the imbalance is temporary. Once I have used up my savings and cannot borrow more, I am forced to either work harder to generate more income in order to sustain the level of my consumption or cut back on my expenditures. The same is true for countries. The counterparts to working harder or reducing consumption for a nation as a whole are to export more and/or import less.
The economic force that brings about the adjustment of unsustainable trade imbalances is what economists call the terms of trade. The terms of trade, or real exchange rate, is the price relevant for international trade. The price to me of an IBM/Lenovo PC produced in China depends on its price in Chinese renminbi and the exchange rate of renminbi for dollars. At the same time the price of American exports in China depend on their US dollar prices and the exchange rate.
When the exchange rate of the dollar depreciates (buys less of other currencies), imports into the US become more expensive and exports become cheaper to foreigners and thus more competitive. Collectively the US will import less and export more. But a change in the terms of trade can also result from changes in the Chinese or American prices of traded goods. If the Chinese do not want to accumulate more dollar reserves, economic pressure will change the terms of trade so as to make Chinese goods more expensive in the US and American goods cheaper in China in order to reduce the trade deficit and thus the need for China to accumulate as many dollars. The depreciation in the REAL exchange rate needed to reduce the large US trade deficit can result from a depreciation of the renminbi/dollar exchange rate, from a deflation in the US or inflation in China. Focusing on the nominal exchange rate only can be misleading.
The market forces that produce the terms of trade adjustment just described operate differently, but to the same effect, when countries have freely floating, market determined exchange rates or fixed exchange rates, as they do if they use the same currency and as it was the case with the gold standard.. A trade deficit (actually the more comprehensive current account deficit) in one country has its counterpart in surpluses in other countries.
When governments play by the rules of the gold standard or any other fixed exchange rate regime, the gold or foreign exchange reserves of the deficit country fall reducing its money supply (its importers sell their currency to the central bank for foreign reserves/gold). The opposite happens in the surplus countries. Foreign exporters sell the gold/foreign exchange to their central banks for their national currency, the supply of which increases. Prices fall in the deficit country and rise in the surplus countries. This market process changes the real exchange rate (terms of trade) in the direction that adjusts imports and exports so as to reduce trade deficits and surpluses. With market-determined exchange rates and (let’s assume) domestic inflation targets for the national currencies, foreign exchange markets experience a surplus of the deficit country’s currency and a shortage of the surplus country’s currencies. The excess supply of the deficit currency results in the depreciation of its exchange rate, which has the same effect on the real exchange rate (terms of trade) described above for the gold standard.
This rule-based system has suffered two problems. Countries often did not play by the rules, eg they might sterilise the market effects on their money supplies. Even if they did, when an external asset like gold is replaced by a national currency as the international system’s reserve asset, the country that supplies it, such as the US in the currency system, must run a current account deficit in order to supply the dollars the rest of the world wants. As it is supplying its own currency, it will never run out of ‘foreign exchange reserves’.
The US can supply its dollars to the world as long as it wants them. It is not forced to ‘adjust’ to large deficits in the way other countries are. The system rests on the rest of the world’s confidence in the stability of the value of the dollar in all of its dimensions. Neglect of this reality and responsibility by the United States could result in a catastrophic flight from the dollar.
World demand for dollars
For a variety of reasons, many countries in the last few decades chose to keep their exchange rates low enough relative to the US dollar to facilitate the growth of their export sectors or to accumulate larger foreign exchange reserves. Many developing countries following the earlier example of Japan have adopted an export lead strategy for development. For some this strategy took the healthy form of removing trade restrictions that allowed the growth of both imports and exports, subjecting their economies to greater competition and promoting greater efficiency and productivity. But some, such as China, promoted exports at the expense of imports as their strategy for growth. These countries set their exchange rates (explicitly or via foreign exchange market intervention by their central banks) below levels that would produce balance between imports and exports. To prevent the resulting inflow of surplus dollars from depreciating their currency’s exchange rate in the market, the central banks of these countries intervened to buy the excess dollars (often sterilising the domestic monetary consequences of such intervention to prevent inflation, thus violating the rules of the game). The result was an increase, and often a very large increase, in their foreign exchange reserves (ownership of US dollar assets).
In some cases, countries wished to increase their foreign exchange reserves for sound prudential reasons. Following the Asian financial crisis of 1997, many Asian countries thought that the conditions imposed by the IMF for its temporary balance of payments financial assistance were too harsh. In order to avoid them in the future, they determined to increase their reserves to levels that would avoid the need to borrow from the IMF when their exchange rates were under attack.
For these and other reasons many countries ran international trade surpluses that greatly increased their foreign exchange reserves. Their surpluses were necessarily matched by the deficits of others, largely the United States. Twenty years ago, as the Berlin Wall came tumbling down, the United States imported US$580bn worth of goods and services from the rest of the world. This was about 11 per cent of US domestic production (GDP). The US paid for most of that by exporting US$487bn worth of goods and services. The shortfall (trade deficit) of US$93bn was more than paid for by the net income received by American’s from their investments abroad. This modest trade deficit of 1.7 per cent of GDP rose to an unsustainable 5.7 per cent of GDP by 2006. Thus the result of the build up of reserves in China and other surplus countries has been a huge inflow of capital into the deficit countries (most investments in the United States and largely US government securities).
Though this huge accumulation of dollar assets abroad was in response to world demand for reserves, it has created a system that is dependent on the stability of the American economy and the value of its currency. The system is vulnerable to the successful conduct of American monetary and fiscal policies. But the arrangement complicates American macroeconomic policy. The desire of others to accumulate dollar reserves flooded American financial markets with liquidity, which lowered interest rates. If the Federal Reserve had tried to raise interest rates it would only have attracted even more foreign inflows thus appreciating the dollar and worsening the American current account deficit. These conditions, plus American housing policy and other factors5, fed the housing price bubble in the US.
The value of the dollar is now in doubt. Financing America’s huge current and even larger prospective fiscal deficits will be difficult and promises higher interest rate or higher inflation or both. Either of these developments will reduce the value of foreign exchange reserves held in dollars. Any slowdown in the accumulation of dollars abroad, much less any effort to reduce them by diversifying out of the dollar, would greatly accelerate the fall in the dollar’s exchange value. This poses a serious dilemma for countries with large dollar reserves. Should they try to diversify out of dollars and thus contribute to the further fall of the dollar or should they stick it out and suffer whatever losses are expected.
Both the Governor of the Peoples Bank of China, China’s central bank, and the President of Russia have recently called for the ultimate replacement of the US dollar as the world’s reserve currency with one issued by the IMF (the Special Drawing Right – SDR)7,8. The SDR was created in 1969, just before the collapse of the Bretton Woods international currency system, precisely for this purpose. With the abandonment of the gold exchange standard and the floating of the dollar’s exchange rate in 1971, the need for SDRs became less pressing. The G20 heads of state meeting in London in early April 2009 called for an additional US$250bn dollar allocation of SDRs, almost an eight-fold increase over the current stock of US$32bn. These were allocated 28 August 2009.
A future for the SDR?
The current system suffers from several weaknesses.
a) Currencies pegged to the US dollar need to have reserves of dollar assets to avoid the exchange rate risks associated with fluctuations in the dollar’s exchange rate with other currencies. Thus the value of the approximately US$4.5tr of official reserves held in dollars are exposed to whatever happens to the value of the dollar and the US has not always been a good steward of the responsibilities that come with being the supplier of the world’s reserve currency.
b) Market discipline of America’s policies that affect its external balance is weak because the United States, as the supplier of the reserve currency, is not subject to the restraining power of a loss of reserves when its monetary and fiscal policies are too lax.
c) The ongoing growth in desired reserves as the world’s output grows requires an American current account deficit large enough to supply them and the accumulated stock of external claims on the US can and has grown very large.
d) Changes in world demand for dollars (eg because of easier IMF terms for balance of payment support that reduce the need for reserves, or a loss of confidence in the dollar) may be hard to absorb and if abrupt could produce wide swings in the external value of the dollar.
The use of an external supply reserve asset such as gold overcomes the first three of these problems and reduces to the scope of the forth one, as a loss of confidence is unlikely. The pros and cons of and the historical experience with the gold standard have been extensively written about. The Special Drawing Rights (SDRs) of the IMF are more recent and less widely known.
The SDR has a very important advantage over dollars or gold. Its supply can grow, by allocation by the IMF on the basis of the decision of an 85 per cent weighted majority of its members, without the need for a balance of payments deficit by the US or any other supplier of a currency used as international reserves or the mining and refining coats of gold (or any other commodity that might be used). SDR allocations are distributed in proportion to member countries’ quotas in the IMF and growth in members’ reserve demand is not likely to exactly match such a distribution, although it is a reasonable first approximation given the economic basis for members’ quotas. Thus some marginal reallocations would occur that would have to involve balance of payments deficits and surpluses. However, these would be much smaller than are now required to supply the world with the dollars it demands.
An enhanced role for the SDR might be limited to providing some or all of the future growth in foreign exchange reserve desired by countries or might also replace some of the existing dollar reserves9. If all further increases in international reserve assets were in SDRs, any dollars purchased by the Peoples Bank, for example, to preserve its nominal exchange rate and/or to expand its reserves, as with the gold standard or gold exchange standard, would be sold to the US for SDRs. It would add SDRs rather than dollars to its reserves. The US could no longer print dollars (issue Treasury securities) to satisfy China’s demand for reserves. If the US holdings of SDR’s ran short, it would need to allow the upward pressure on its interest rates that would naturally result from its purchases of dollars, thus reducing the supply of dollars in the market, in order to increase the capital inflows needed to provide it with the SDR’s demanded by China.
The market adjustment mechanism that now applies to the rest of the world would apply to the US as well10. It would be more difficult for the US to undermine the global balance adjustment mechanism as it does now.
To replace some or all of existing dollar reserves with SDRs would require much larger allocations of SDRs or the creation in the market of significant quantities of private SDRs (SDR denominated bonds and other financial claims). The SDR faces a unique challenge because of its current official valuation as a basket of currencies. The official SDR allocated by the IMF must currently be exchanged for dollars or other national currencies at the official exchange rates calculated daily by the IMF on the basis of current market exchange rates for these currencies. Thus it may not be the case that China or some other holders of SDRs can find IMF member countries willing to buy them at that price on any particular occasion. Dollar reserves can always be sold because the price of dollar asset may fall if necessary until willing buyers materialise.
All fiat monies gained acceptance initially by being exchangeable for something else, such as gold. The US dollar’s acceptance internationally was bolstered by its convertibility into gold by the US Treasury until international claims on American gold so far exceeded America’s holding of gold that President Nixon was forced to end the dollar’s convertibility in 197111. Yet the world’s demand for and use of dollars continued to grow based on its ultimate convertibility into American goods and services and reasonably predictable prices.
While internationally traded commodities like oil, gold, copper, silver, diamonds etc might well be priced in SDRs and wholesale purchases settled in private SDRs, the official SDRs held in central bank reserves would generally need to be converted into a national currency to be fully usable, and as noted above would need to be exchanged at the IMF’s official rate for that day. To deal with this situation, IMF member countries judged to be in a sufficiently strong balance of payment position are required to accept SDRs when designated by the IMF to do so. This is not likely to be a significant burden in normal times as the global growth in reserve demand would produce sufficient opportunities to sell SDRs for those wishing to do so. In unusual periods in which the global demand for reserves including SDRs falls, the ‘burden’ of being designated to accept them in exchange for dollar, euros or some other freely usable currency could be reduced by a cancellation of SDRs, which like an allocation would fall on countries in proportion to their IMF quotas.
The key advantages of the SDR over the US dollar or any reserve currency issued by a national central bank are that its value is more stable relative to currencies in general being a currency basket12, its supply is determined by collective decision of the IMF’s member countries, it is added to each countries’ reserves (to the extent of each countries allocation) without cost (now countries must sell their goods and services to acquire additional net foreign reserves), and the global supply can be increased without the need for a current account or trade deficit by the issuing country. These are formidable advantages.
Getting from here to there will take more than additional allocations of SDRs, though that would be part of the evolution. Most central bank reserve transactions are not with other central banks. They are with the market. The Peoples Bank of China buys dollars in the foreign exchange market, ie from banks and other foreign exchange dealers, and uses them to buy US government securities in American markets and not from the US Treasury directly. Thus the acceptance and growth of the ‘official’ SDR (those allocated to central banks by the IMF) will require the development of private ones (private SDR denominated financial instruments) and mechanisms for linkages between the private and the official ones.13 This was the path followed by the Euro and its predecessor the Ecu.
The extent to which the world chooses to hold and deal in SDRs rather than dollars will reflect the extent to which individuals and governments are more confident in the valuation of the SDR than the dollar or other possible units and the convenience (cost) of dealing in the asset. The world has changed its reserve currencies from time to time to align with the dominant economic power of the time, but such changes have always been gradual. If the SDR catches on, its displacement of the dollar would also be gradual, taking place over many years of growing use.
An important advantage of an international currency like the SDR emphasised by People’s Bank Governor Xiaochuan is that the US would be subject to much stronger market pressure, in the form of exchange rate adjustments, that would maintain better balance between imports and exports than is now the case. The US would also face far less risk of the world’s central banks losing confidence in the dollar and sharply reducing their willingness to hold them. As the SDR does not and is not likely ever to exist in currency form, the US, and increasingly the EU are likely to continue to enjoy the seigneurage profits from selling their currency to the citizens of the rest of the world.