05 May 2011
If you take a look at the major dollar crosses then the decline in the greenback has been a multi-year event. If the dollar remains on this downward path then the natural question to ask is how long can it maintain its position as the world’s reserve currency? This is a potent question at the moment as the world tries to recover from the 2008/2009 financial crisis and, most importantly, starts to re-balance so the binge spending in the West and hoarding of savings in the East finds a more comfortable equilibrium.
To answer this question it is worth considering what a reserve currency should be like. Firstly, it must be relatively stable and secondly, it must be immune from political intervention. Looking at the second point first, since late last summer when Federal Reserve chairman Ben Bernanke first touted the idea of a second round of quantitative easing the US has been accused of manipulating its currency lower.
Of course a weak dollar is good for the US export industry, but it also has repercussions across the rest of the world in terms of commodity price inflation. Although prices have moderated slightly across the Middle East, inflation is still at a high level and countries such as Saudi Arabia, Kuwait and the United Arab Emirates will not want to see prices continue to rise because of a weak dollar.
On this basis it would make macroeconomic sense if the dollar was no longer a reserve currency. While the US economy is going through its rebalancing process away from consumption and towards exports then the dollar needs to be weak. This will keep upward pressure on commodity prices for the foreseeable future.
So what should replace the dollar as a reserve currency? Obviously there is the world’s reserve currency. But the single currency has many drawbacks. It is the currency of a monetary bloc not a political entity and the sovereign debt crisis has highlighted the limitations of its structure. The other contender is the Chinese renminbi; after all, China is set to become a bigger economy than the US in a few years’ time.
But this looks unlikely. It will take years before the Chinese currency will be fully flexible and it is dubious whether the Chinese authorities would want the renminbi to become the world’s reserve currency. Beijing is at pains to stress it wants the renminbi to appreciate in a slow, steady fashion, which essentially rules out it becoming a reserve currency any time soon.
So what about gold? There is no one to bemoan its appreciation, it is a universal store of value and it isn’t controlled by any single central bank or linked to a particular economy. This sounds perfect, right? Indeed gold does have many advantages to becoming an honory member of the FX club as stated above, but there are also many drawbacks.
The problem with gold is that there is a limited amount of it and production takes years and in some cases decades to come on board. If gold became the new reserve currency then it would most likely take another leap higher. If commodities were priced in gold then prices would collapse and the threat of deflation would grip the world’s economies.
Added to this the structure of the precious metals market would need to be completely overhauled. Last week we saw margin requirements for silver raised by multiple commodity exchanges making it more expensive for speculators to hold a silver position. This caused a sharp move lower in the price. Gold is also traded on various global exchanges, thus changes to margin requirements and other contractual obligations have the potential to disrupt smooth trading in the precious metals market.
So before people call time on the dollar as a world’s reserve currency they should consider the limitations of the alternatives. While the dollar has its challenges, Federal Reserve President Ben Bernanke has said that quantitative easing is healing the US economy, which will eventually feed into a stronger currency. We will have to wait and see if his prediction comes true, but changing a reserve currency is an extremely tricky business and something that is probably best avoided at this important juncture of the global economic recovery.
Kathleen Brooks is research director at Forex.com.