By Ken Austin[1]
When I was in grad school, the dollar’s reserve currency status meant something very specific – foreign central banks bought and sold dollar assets to fix (manipulate) their exchange rates. They accumulated dollars when they wished to keep their currencies depreciated to favor their export industries. Let’s call this role “Central Bank Reserve Currency”(CBRC).
Today, the term “reserve currency” has become an umbrella term for any international role played by a currency. The term now has so many definitions that it has no meaning at all. Using the term is a game of three-card (or ten-card) monte. This allows people to change the subject even if everyone is looking (same as three-card monte). Some of the US$’s most important international roles are:
- Central Bank Reserve Currency (CBRC)
- Private store of value for foreigners who want to hold their savings in dollar assets
- Safe-haven currency (shelter in a financial storm)
- Tax-haven currency
- Kleptocrats’ and drug dealers’ means of hiding the loot
- Means of cross-border payments, especially bank payments (Singapore pays for NZ lamb chops with US$)
- Measure of value (contract for Singapore purchase of NZ lamb chops is denominated in US$, IMF statistics in US$)
- Vehicle currency: If a Swede wants Australian dollars (A$), she first buys US$ with Swedish crowns and then buys A$ with the US$.
- A convenience for American tourists who don’t have to exchange their dollars as often or ask, “How much is that in real money?”
- A source of prestige
Most of the other roles are sub-variants of these roles. Only the first five are important contributors to the US trade deficits, especially the first two. They work by allowing foreigners to accumulate dollars. Trade is balanced when foreign countries or their citizens earn export revenues and use them to buy US exports of goods and services. However, if they keep their export revenues as dollar savings, rather than spending it on goods and services imported from America, they run a trade surplus, the counterpart to a US deficit.
Since the beginning of the modern fiat currency system (money created and backed by governments) until the early 1970s, most countries, especially industrialized ones, were on the gold standard or some variant. Each country fixed the value of its currency in the amount of gold it would buy and generally tried to maintain that price. The relative value of different currencies (their exchange rates) was proportional to the amount of gold they would buy. If the United States said $20 is worth one ounce of gold, then the United States had to sell an ounce of gold to anyone who offered to pay $20. If an ounce of gold was worth $20 or £4, then £4 = $20 or £1 = $5. The catch was that each country’s government or central bank had to have enough gold to sell to make good on its promise. So, countries kept reserves of gold.
Alternatively, countries could keep reserves of other countries’ money, which could also be exchanged for gold. Better yet, central banks learned they could keep interest-bearing financial assets denominated in those currencies. Central banks are sophisticated institutions, and to minimize risk, they wanted to keep their reserves in currencies that were less likely to default or devalue (countries best able to honor their financial promise to redeem the currency for gold). Especially in a crisis, it’s important to get one’s money quickly and surely, which generally happens in larger and more liquid markets. So, certain large economies evolved over time into the most prominent suppliers of foreign exchange reserves. In the 19thand early 20th centuries, that major reserve currency was the British pound. After WWII, it was the US dollar.
Being a CBRC reflects a reputational advantage as the biggest and best in the financial world. It confers prestige and provokes envy. However, on a practical level, it reflects, indeed requires, indebtedness. If, for example, India’s central bank, the Reserve Bank of India (RBI), holds $10 billion worth of US Treasury securities as Central Bank reserves, who does that make rich? It means that the US Government owes the RBI, (an Indian Government entity) $10 billion. Many analysts use the proportion of global central bank reserves to measure the US dollar’s standing as a reserve currency. The good news is that the rest of the world regards the United States as a good credit risk. The bad news is that it means that the United States owes lots of money.
Of course, the more debt one has, the less creditworthy one is generally. This principle is known in economics as the “Triffin Paradox” or “Triffin Dilemma.” It was first described by Belgian-American economist Robert Triffin in 1960. The post-WWII Bretton-Woods system was designed with the dollar’s role as reserve currency established by formal agreement. Other currencies were denominated in terms of US dollars, and the dollar was backed by gold at the rate of $35/oz. Each dollar was, in effect, a promissory note that could be redeemed by foreign governments for 1/35 ounce of gold. Triffin noted that if the reserve issuer supplied all the reserves that the rest of the world needed or wanted, the accumulating external debt would eventually exceed its ability to repay. The whole system collapsed in the early 1970s when some governments, notably France, began to cash in their dollar foreign exchange reserves, which exceeded American gold reserves.
When the advanced economies ditched Bretton Woods and replaced it with floating exchange rates among them, in theory, they had no need for a reserve currency. Their currencies would “float” against one another and didn’t need foreign reserves to intervene in foreign exchange markets. In reality, the new system just reduced their foreign exchange interventions. Another thing that did not change much due to the dollar’s reduced CBRC role is the dollar’s role in cross-border payments. That endured. The size and efficiency of the U.S. banking system and the advantage of incumbency maintained the cross-border payments role as a practical matter. Thus, the biggest benefits of the dollar’s international role never depended on the dollar being a Central Bank Reserve Currency.
Although the dollar’s formal CBRC role was diminished, the United States never tried to eliminate or restrict its use in that capacity. It was there for other countries to use as they saw fit, and during the exceptionally high-interest rate periods of the late 1970s and 1980s, it was likely useful for the U.S. economy. Things changed at the turn of the century. The East Asian Financial Crisis of 1997 began when financial flows into Asia suddenly reversed. Several of the hardest-hit countries had to accept politically difficult IMF austerity programs. Many countries decided to build up their foreign exchange reserves to prevent a repetition. If another financial inflow reversal occurred, the central bank could provide the necessary foreign exchange to maintain normal activity. Simultaneously, China, which had fixed a depreciated exchange rate to stimulate its exports, began running very large BoP surpluses. The upshot was a very large increase in global demand for foreign exchange reserves, mostly dollar reserves, creating another Triffin dilemma as global reserves increased six-fold, to roughly $12 trillion, from 2001 to 2014. This was the period of the “China Shock” and a major loss of U.S. manufacturing capacity and jobs. Global reserves (as compiled by the IMF) have been stable in the decade since, but there is no guarantee that it will not happen again. In fact, in China’s case, serious suspicions have been raised that China continues to increase its dollar reserves off the books.
Xi no more wants the RMB to replace the US$ as the major central bank reserve currency than he would want to shove an angry weasel down his trousers. Doubtless, China wants a small role as a central bank reserve issuer for the prestige. However, a major role, especially replacing the US$ CBRC role, would force China to replace the US as the world’s major trade deficit country. This would be good for US manufacturing but a disaster for Xi’s vision of China.
The dollar’s near-monopoly role as a means of cross-border payments (point 6), especially bank payments, is what allows the US to impose trade sanctions. China would probably like the whole payment role, but it won’t happen, both because of the US’s advantage of incumbency and because of China’s overly controlled financial system. Even if China established an effective cross-border payments system, it would not be able to enforce sanctions on its own because it would not have a monopoly on cross-border payments. But China and others would like to have a backup method of cross-border payments to evade US sanctions (sanctions violations and money laundering from a US perspective). The alternative may be a cryptocurrency or a Chinese-backed system, and these systems may be more expensive and/or cumbersome to use. The more the United States uses sanctions, the greater the incentive to develop an alternative payment system. Thus, using sanctions ultimately limits their further use. America must judiciously use sanctions on only the most important issues if it wishes to prolong that role. But not using sanctions at all means not taking advantage of a useful tool. It’s like inheriting $50K from your only aunt. She won’t die and leave you money again, so you should spend your inheritance wisely. But if you don’t spend it at all, you won’t derive any benefit from it.
Limiting the dollar’s use as a store of value (first two points above) does not directly affect the American ability to impose economic sanctions. But using economic sanctions will reduce the US ability to impose economic sanctions in the longer term.
While any international currency role confers a certain prestige (point 10 above), the various roles are often separable. The US dollar can continue to be a means of cross-border payments even if central banks stop hoarding the dollar as a Central Bank Reserve Currency.
[1] Ken Austin is a retired US Treasury economist. The views he expresses are his own and do not represent the views or position of the US Treasury Department.
