Dollar Reserve Status -- Who Cares?

Dollar Reserve Status – Who Cares?
The U.S. dollar has been the world’s reserve currency since the end of World War II. With the dollar's 45 percent decline against the euro during the past six years and its 37 percent drop on a trade-weighted basis, there is a growing concern that the greenback's six-decade reign as the world's most important currency may be ending.
Why care? The standard argument is that reserve currency status allows the U.S. government to borrow in its own currency and helps the government and American companies to fund themselves at low interest rates. It makes it easier for U.S. companies to do business and increases the international demand for U.S. assets. Perhaps most importantly, the reserve currency status provides interest-free loans to America from the hundreds of billions of dollars held overseas and hoarded. In other words, the reserve status has enabled the U.S. to live well beyond its means.

The US dollar is currently the world's reserve currency, but that status is being threatened by China, America's biggest creditor, which is becoming "concerned" about the safety of the $1trn in US government debt it holds. American national debt, including social security obligations, has grown to more than $11trn, above 80% of GDP and will rise in the coming years. That's likely to see US Treasury yields forced higher to attract investors willing to fund this soaring deficit, which will hit bond prices, hurting the value of China's existing holdings. On top of this, the Federal Reserve has expanded the money supply tremendously over the last two years. Between January 2007 and January 2008, the base money expanded by about 750%. Ultimately, many more greenbacks in circulation means the price, that is, the exchange rate, will fall. That's bad news for anyone outside the US who is holding on to dollar assets.

Right now China’s currency – the yuan, also known as the renminbi – is tightly controlled and not freely tradeable in international markets. But China is starting to use the yuan to settle trade accounts between some of its provinces and neighbouring states, starting with Hong Kong. Chinese officials recently moved to promote the yuan’s influence overseas. China has signed deals with six countries, including South Korea, Malaysia and Argentina, for currency swaps that would inject Chinese money into foreign banking systems, and allow foreign firms to pay for goods they import from China in yuan.

Is the declining status of the dollar a serious worry? Perhaps it is actually a blessing. Ordinarily, a country’s central bank faces sharp limits to a policy of monetary expansion since if a country expands its currency, other countries will not want to hold that money. Its currency is devalued against less expansionist monetary systems. But when a country’s currency is dominant, the situation is different. Because other countries find it convenient to hold this currency, they are reluctant to rid themselves of it, despite inflation. The dominant country thus has much more leeway to conduct an expansionary policy. Surely, though, far from being an advantage, the ability to expand the money supply more than other countries is a liability. Although the fiat money system is the true problem, anything that limits discretionary expansion has to be seen as constructive.