Biggest Threats to Dollar’s Global Supremacy are at Home
The US dollar will almost certainly remain the world’s most important reserve currency for the foreseeable future.
The US dollar will almost certainly remain the world’s most important
reserve currency for the foreseeable future, as no other offers the same
set of advantages to money managers, including central banks, or is as
deeply embedded in the global financial system. The primary cost to
the US is surrendered competitiveness due to dollar appreciation, but
lower interest rates and unrivalled government access to funding bestow
considerable benefits, ultimately supporting the sovereign’s ‘AAA’ rating.
As the Fed tightens, expect calls for an alternative to US dollar dominance, but no real change. Congress is the most plausible medium-term threat.
The dollar dominates global bond markets, central bank foreign reserve
holdings, international trade invoicing and cross-border lending. It is
the standard currency used for commodity and other prices, and is the
preeminent safe-haven asset and preferred store of value in times of
financial turmoil. Crucially, the dollar is underpinned by the fact that the
US Treasury market is the world’s largest and most liquid for risk-free
assets, and the Federal Reserve operates independently of government
with respect to the market, and in implementing policy more broadly.
The dollar’s role is so widespread that its supremacy is self-reinforcing. The
additional costs and/or inconvenience of switching to another currency
for transactions normally conducted in dollars create a high degree of
inertia, making it difficult for other currencies to gain traction.
Calls for the dollar’s displacement were relatively infrequent — though
not entirely absent — when US monetary policy was exceptionally
accommodative in the aftermath of the global financial crisis. That changed
in mid-2013 when the Federal Reserve announced it would begin to slow
its asset purchases, causing considerable turmoil in emerging markets
(the “taper tantrum”) and appeals to the Fed for greater consideration to
be given to the international implications of its policy decisions.
The Fed now appears poised not only to continue with policy interest
rate hikes that began in December 2015, but also to consider the pace
and magnitude of eventual balance-sheet reductions. Dollar funding
is already costlier in markets outside the US, and has been for several
years, as reflected in elevated cross-currency basis spreads for several
currencies versus the dollar. If they rise further, as they may when Fed
balance-sheet reduction draws nearer, there will again be concerns about
global stresses associated with Fed tightening and inevitable suggestions
that the dollar’s hegemony be somehow curtailed.
Realistic, immediately available alternatives to the dollar are limited. It is
important to note, however, that the dollar is not alone either as a reserve
currency or in many of its other global roles; it is just the biggest player.
Other recognised reserve currencies (tracked by IMF data) are the euro,
Japanese yen, pound sterling, Swiss franc, Australian and Canadian dollars
and Chinese renminbi.
In most instances, financial markets in countries that have reserve
currencies are far too small to pose a threat to the dominance of the
dollar. The most obvious candidate to replace the dollar is the euro, given
the size and depth of euro-denominated capital markets as well as the
credible focus of the European Central Bank on controlling inflation.
However, for at least as long as the currency zone is plagued by lingering
existential risks amid questions over possible member withdrawals, it
will not be in a position to overtake the dollar. The renminbi is growing
rapidly in trade settlement, but neither it nor the yen offer truly risk-free
assets given their sovereign ratings, and China seems some distance from
having an open capital account and fully internationalised currency even
if it were rated higher.
The lack of a ready substitute, however, does not mean the dollar’s current
position is entirely assured. Perhaps the most plausible scenario for the
dollar being meaningfully displaced does not begin with the emergence
of a viable alternative, but rather it being undermined at home.
Two pieces of legislation currently working their way through Congress
are the Federal Reserve Transparency Act (FRTA) and the Financial Choice
Act (FCA). The first would allow the Government Accountability Office to
audit the monetary policy decisions of the Fed and make subsequent
recommendations for administrative or legislative actions. The second
would restrict the Fed’s ability to provide financial sector support to avert
or address a crisis, and empower a commission to review and recommend
changes to the Fed’s operations, as well as to consider a rules-based
rather than discretionary monetary policy framework.
It is the unambiguous intention of these legislative initiatives to curtail the
independence of the Fed and allow for greater congressional oversight of
monetary policy as well as the Fed’s regulatory decisions and interventions
related to financial stability. If implemented, the proposals would diminish
the appeal of the dollar as a reserve currency over time. Investors
considering dollar assets and other dollar exposures would weigh the risk
of political interference in monetary policy decisions and the possibility
of the Fed’s remit being broadened to include congressional priorities
such as indirect funding of infrastructure investment. There may also be
concerns about episodes of financial sector stress being deeper and more
prolonged if the Fed’s policy response options were explicitly limited.
Parties in favour of the FRTA and FCA might argue that the risks identified
by those concerned about the Fed’s independence — and, incidentally, the
dollar’s global role — are, in fact, the purpose of the proposed legislation,
and that the overall economic interests of the US would be better served
by their implementation. The debate is unlikely to end soon no matter the
fate of the FRTA and FCA. Either way, the dollar is set to remain the world’s
most important reserve currency, a position it is likely to hold for some time.