In discussing the future of the U.S. dollar, it is important to examine its perceived benefits and drawbacks vis-à-vis other monetary reserves. When Japan was growing rapidly in the 1980s, some scholars thought the yen would rival the dollar as the key currency. However, rivalries and suspicions among Asian states, and Japan’s economic problems since the 1990s have precluded this possibility. In accordance with its growing economic influence, China has moved to promote its yuan (or renminbi) globally. For example, China has signed currency swap agreements with South Korea, Malaysia, Argentina, and other states to inject the yuan into foreign banking systems; and China is spreading the yuan’s influence through its loans and investments in other countries. However, the lack of development of China’s financial markets, China’s exchange restrictions and capital controls, and concerns about domestic political stability will limit the yuan’s influence in the short to medium term. Proposals to develop an Asian Currency Unit are also only in the planning stage for several reasons, including the competition and mutual suspicion between China and Japan. Thus, scholars generally agree that the euro is currently the only alternative to the U.S. dollar as the key international currency.56 Others
will also have a role in determining the future of the dollar, especially China, Russia, and Middle Eastern countries that have large dollar reserves. This section begins with a discussion of the dollar versus the euro, and then examines the possible role of actors outside the EU and the United States.
The Dollar Versus the Euro
In comparing currencies, it is important to look at their three main functions. In 2005, the dollar was used as a medium of exchange in 89 percent of all for- eign exchange transactions, compared with 37 and 20 percent for the euro and Japanese yen. Almost two-thirds of all countries that peg their currencies today peg them to the U.S. dollar as a unit of account compared with one-third
to the euro. The dollar is also used as a unit of account in the invoicing or pricing of almost half of all world exports. The share of dollars as a store
of value in central bank holdings declined from 70.9 percent in 1999 to
65.7 percent in 2006, while the share of euros rose from 17.9 to 25.2 percent; but the dollar still accounts for almost two-thirds of official foreign exchange reserves. Thus, the U.S. dollar continues to be the key currency today.57
In assessing whether the dollar’s dominance is likely to continue, economists look at three factors: the position of U.S. financial markets, the level of confidence in the U.S. dollar, and the importance of U.S. transactional networks.58First, the dollar is more likely to retain its key currency status if
the United States continues to have the most developed and open financial markets. Although European financial markets could pose a challenge to U.S. dominance, decentralization and fragmentation in the eurozone is a disadvan- tage relative to the more unified U.S. financial structure. The ECB has less supervisory capacity over EU financial markets than the U.S. Federal Reserve; and Britain, which has the most well-developed financial markets in Europe, has not adopted the euro. Confidence in U.S. financial markets was seriously tested in September 2008, when the subprime mortgage crisis expanded into a full-blown financial crisis. The U.S. role in the global financial crisis raises new questions about the dollar’s future as the key currency, but Europe’s difficulty in dealing with the financial crisis shows that the euro remains an uncertain alternative to the dollar. The EMU’s current difficulties in dealing with the financial problems confronting Greece and other weaker member states shows that the EU “has a long way to go before becoming the continent-wide economic and political authority it has set out to be.”59
Second, the U.S. dollar is more likely to remain the key currency if there is confidence that its value will remain relatively stable. The U.S. deficit and debt problems have led to a dramatic decline in the dollar’s value and in the confidence level in recent years. Although the value of the euro initially fell from $1.18 (U.S.) on exchange markets in 1999 to 86 cents (U.S.) in January 2002, its value then recovered and rose to $1.59 (U.S.) in July 2008. The declin- ing value of the dollar gives governments and investors an incentive to diversify their portfolios from dollars into euros and yens. However, the stronger EMU financial position overall masked the great differences among EMU members, and fears that Greece’s economic problems could spread to other weaker EMU countries such as Portugal, Spain, and Ireland have raised questions about the future of the euro. In crisis situations such as the world has experienced since 2008, investors tend to opt for the U.S. dollar as the world’s reserve currency despite the serious U.S. deficit and debt problems. Third, in regard to U.S. transactional networks, the size of the U.S. economy and its share of global trade have ensured that the dollar is widely used in global transactions. The widespread use of the dollar outside the United States tends to be self- perpetuating, because its use by so many others decreases transaction costs. The larger the size of a currency’s transactional network, the greater are the economies of scale in using the currency. The transactional network of the euro is limited by the fact that only 16 EU members have adopted it. If the eurozone
What Is the Future of the U.S. Dollar as the Key Currency? 157 expanded to include all 27 EU members, the euro would pose a greater challenge to the dollar; but the current problems facing the poorer EMU members make this an unlikely possibility. In sum, in terms of economic criteria, the U.S. dollar should continue to be the key currency in the short to medium term, but its dominance in the longer term is by no means certain.60
Political as well as economic factors will affect the standing of the dollar. In some respects, political factors give the dollar an advantage over the euro. For example, U.S. military power and political stability contribute to confi- dence in the dollar; there is less confidence in the euro because of the EU’s lack of political unity and the difficulty EU members have in asserting their power collectively on international political issues. The difficulties the EMU has had in confronting the financial problems of its weaker members also shows the problems of monetary union without political union. The eurozone requires a crisis resolution system, better fiscal policy coordination, and policies to reduce the economic imbalances among the member countries. However, the EMU member states may lack the political will to implement such policies.61
Although the United States has the advantages of being a single country, it also faces major problems with governance. The U.S. political system of checks and balances combined with the strongly held differences between the Democratic and Republican parties today may prevent U.S. government leaders from taking the difficult political decisions to follow more fiscally prudent policies. In sum, the roles of the dollar and the euro will depend on whether the United States addresses its current account and debt problems, and on whether the EU takes a more assertive and unified position (both internally and externally).
Countries with Large Foreign Reserves and the Future of the Dollar
The growing U.S. deficits have been financed by foreigners. Of particular concern is the large volume of cashlike dollar assets held by central banks or other government-controlled bodies. China and non-Chinese Asia each have about $1.2 trillion of dollar assets; the OPEC states have $600 billion; and Russia has $400 billion due to its growing revenues from energy exports. Thus, total foreign-held U.S. dollar reserves by the end of 2006 amounted to about $5 trillion.62Countries with large U.S. dollar reserves will have a majoreffect on the future of the currency, and both economic and political factors affect their behavior. Although China, Japan, and South Korea are shifting some of their reserves from U.S. dollars to euros, it is not in their economic interests to cause a rapid decline in the value of the U.S. dollar. They are highly dependent on the U.S. market for their exports, and U.S. consumers with a cheaper dollar would purchase less. The value of their dollar reserves would also decline along with the falling value of the dollar. Political factors also play a role in countries’ support for the dollar; for example, Japan and South Korea continue to depend on U.S. military support.
However, there are also economic and political reasons that countries have begun to shift more of their dollars to other reserve currencies. Russia and the OPEC exporters are large dollar holders; they have priced their
oil trade in dollars and have invested their surpluses mainly in dollar- denominated assets. However, the United States is not their main trading partner. Russia trades primarily with Europe, and the largest markets for Middle Eastern oil producers are in Asia. China has also been diversifying its trade, and almost half of its exports now go to countries other than the United States, Europe, and Japan; other important export markets are mainly in Asia, but also in the Middle East and Latin America. Indeed, the United States now accounts for only about 20 percent of China’s exports, and Europe recently surpassed the United States as an importer of Chinese goods. As for East Asia in general, its dependence on the dollar was viewed as an important cause of the 1997 Asian financial crisis (see Chapters 10 and 11), and Japan is promoting the use of the yen and considering an initiative to develop an Asian regional currency. Two of the largest holders of U.S. dollar reserves—China and Russia—are also geopolitical rivals. U.S.–China relations are marked by economic tensions over China’s large trade surplus with the United States, China’s reluctance to float its currency freely against the U.S. dollar, and competition for scarce resources around the world. Political tensions relate to differences over Taiwan and over China’s support for a number of regimes that the United States opposes. China is aware that the United States prevents it from being the dominant power in the western Pacific, and it may choose to cooperate in developing an Asian currency to weaken the United States in geopolitical and economic terms. U.S.–Russian tensions have been marked by Vladimir Putin’s efforts to strengthen the state and re-establish Russia’s economic and political influence.
Unlike China, Russia has only a limited amount of trade with the United States. Thus, Russia was one of the first countries to begin shifting its reserves from dollars to other currencies after Putin launched an antidollar campaign in April 2006. For several years Russian purchases of U.S. dollar assets had increased along with its growing surpluses from energy exports; but its purchases of U.S. dollar assets declined sharply in the latter part of 2006. Although Kuwait has been a close U.S. ally, it has shifted from pegging its currency to the U.S. dollar to pegging it to a basket of currencies; and by the end of 2006, more than 20 percent of Saudi Arabia’s official assets were in nondollar currencies. OPEC members that are openly hostile to the United States such as Venezuela and Iran are taking more forthright actions to decrease their dollar reserves. China has also begun to diversify its foreign exchange holdings, and the governor of the People’s Bank of China has proposed that SDRs should replace the dollar as the major global monetary reserve. As discussed, the top global currency must be backed by a strong economy, and it is highly unlikely that SDRs would replace the dollar. China is likely to act cautiously on this issue, because of its large dollar holdings and its dependence on the U.S. market for its exports.63
In sum, the dollar continues to be the key international currency, and the only major challenger (the euro) has its own sources of weakness as well as strength. However, large holders of U.S. dollar reserves are shifting more of their reserves to other currencies, and the dollar as the key currency faces