Rules of the Game: Examining the Reserve Currency Status of the US Dollar

The US dollar has remained the world's currency for nearly 80 years. A global reserve currency is a currency accepted for trade globally and is a stable means of holding foreign reserves. According to the International Monetary Fund (IMF), 60% of all central bank reserves worldwide are held in US dollars. Close to 40% of the worldwide trade is dominated by the dollar, with the US responsible for 10% of the global business and 40% of the worldwide debt issued. Not to mention that the daily average volume of US dollars being traded is $2.9 trillion, with the Euro being second to the dollar at $1.1 trillion. There is no doubt that the US dollar is the global reserve currency, and no official title is needed to justify that. There have been discussions going on for a long time about the relevance and ability of the US dollar to hold up its position as the reserve currency and whether the Euro, Yuan, Yen or even cryptocurrency are on the verge of becoming the next big thing. Even after all this discourse, myriad implications and aspects still tilt towards the US dollar being the ultimate winner. However, I still wanted to take a plunge into the prospects of some other currency becoming the next global reserve currency and the shortcomings of the US dollar when it comes to the notion of being the currency that holds up its value during all times. 

HISTORY OF THE GOLD STANDARD AND THE US DOLLAR

We have to go back to the late nineteenth century, the year 1871, and the international gold standard was at its full flow. It emerged as a means of enhancing the global global global global global financial system. The gold standard was a system under which almost all the countries fixed the value of their currencies in terms of a specified amount of gold. The domestic coins were redeemable in gold on demand, primarily to stabilize the whole monetary system. In 1871, the newly unified Germany received payments from France and took further steps to put itself on a gold standard. This decision of Germany and the accessibility to the financial markets in Great Britain proved to be enough for other countries to take up this system. Almost every country barring China and some of Central America, was on a gold standard in a few decades. This all went well until the First World War, before the war demolished the gold standard. The countries following the bar did not demonetize or refuse to buy gold at a fixed price, but the countries did not adhere to the gold standard. All the abrupt changes made to the system were perceived to be temporary but bought instability to the global financial system. In the US specifically, the gold standard was just not working, and the unstable European markets made it even more unmanageable for the US. Due to the inability of the US to pay off its debt to the European debtors, the Dollar-Sterling rate soared to $6.75 from $4.86. The US was entitled to export enormous quantities of gold to pay off the debt and the premium incurred on the Sterling. The Sterling was also the primary reserve currency worldwide as Great Britain was a prosperous economy and had the global economy circulated this currency. Britain wanted sufficient financial resources and supplies to fund the war, and they had to import enough gold to fund the operations. The US turned up and became the biggest buyer of gold from Britain. When the US went through its neutrality stage, the supplies and resources kept coming in, but they never proved to be enough and the only option that Britain had then was to devalue the Sterling against the dollar to boost the exports. The US didn't enter the war till 1917 and kept recovering the economy before that, also transforming the US into a creditor nation, as the US had made net cash advances to Britain and other countries in Europe.

Post the World War; the global economy was not in the same state as it was a few years back. The political systems and the alliances changed, the international debt levels shifted, indebtedness rose significantly, and the finances of governments around the world deteriorated and fluctuated consistently. Another thing that happened was the diminished confidence in the gold standard. The system didn't work well during the war, gold was not considered stable enough, and something more flexible was needed in such a catastrophe. It was challenging to maintain the gold standard after the war, as the event brought extreme uncertainty and several changes in the system's financial structure and fiduciary nature. Before the war started, countries following the standard had definite trust in gold and those not following the gold standard depended on the Sterling and the Bank of England to have a point of reference. By 1919, the gold standard was perceived unchanged; only the US could follow the system. Almost all the countries barring the US, couldn't keep up with the changing political and economic environment. They decided to wait for some time for the Sterling to be stabilized.

Meanwhile, all of this was happening; the US economy was going through an entirely unstable phase and had uneven money supply, discount rates and overall credit levels. Even the gold reserve ratio and the available reserves started declining over time in the US. On the eastern side of the US, Britain was facing its issues while recovering from the effects of the war. The prices started soaring and became a reason they decided to drop the system for some time and wait for Sterling's appreciation and the price levels to deflate. The Sterling plummeted during this time and was no longer a reliable currency for countries that were not under the gold standard and looked at the money as a benchmark. After that period, several countries re-adopted the system, but things were never the same as before, and it all became much worse after the Great Depression started in 1929. It was not only the 1929 crash that affected the world because half of Europe was still struggling to keep up with the post-war currency misalignments and their war debts. When the Great Depression seemed to end, the Second World War had already started, and maintaining the gold standard was not the priority. The countries could not rush toward gold when maintaining stability was concerned. Most economies immediately realized that maintaining the reserves and adjusting the cash reserves while keeping the unstable economic environment in mind was nearly impossible. Even the US abandoned the gold standard for a brief period and eventually repurchased it. Not many people know this, but in 1934, the US simply changed their monetary system and potentially the global financial system. The Gold Reserve Act kicked in and heavily undermined the influence of the gold standard. It was decided that gold would primarily be used for international settlements and that the people could not exchange the paper currency for gold. 

It was in 1944 when the Bretton Woods Agreement was agreed upon to become the following framework for the global currency system. Under this system, the currencies were supposed to be pegged to the US dollar, which was pegged to gold. This happened because the US was possibly the only country that was able to maintain its reserves and, by the end of the war, held nearly 75% of global monetary gold. This happened when the importance of the US dollar started rising immensely, as every powerful nation had to hold reserves in US dollars to maintain the stability in the exchange rates. One point that needs to be highlighted here is that the gold standard was not really a gold standard in absolute terms but always a quasi-one. In the late 1950s, the system started facing issues as the gold standard did not cut across all the nations. It was difficult for countries to continuously keep the relative value of the local currency closer to the dollar. This gave rise to several short-term currency crises and thus, led to instability in the gold price due to mismatched supply and demand. The US started devaluing the dollar to keep it in terms with the price of gold, and inflation started rising in the US for some time. This also meant that the US dollar was overvalued in the global market and that there was a need for other countries to hold on to their US dollars for some time. It also gave rise to the Eurodollar market, which made investors in the US deposit their funds in European banks or securities. The US's balance of payments trade deficit kept increasing, and more money started flowing into Europe, primarily because of the high demand for US dollars by non-residents and the fact that Europe offered better interest rates. There are also opinions on the Eurodollar becoming the next global reserve currency. Back in the US, inflation was a bit shaky, and the reserve was also very close to racing the limit of the money that could circulate, keeping in mind the gold reserves they held. Not to mention that the US intervened in the Vietnam war in 1965, and things never looked suitable for the country after that.

The US was sucked into an inflationary cycle due to the high costs of war, the inability to raise taxes, and the loss of life. All this led to a lack of trust in the US dollar, and countries started exchanging their US dollars for gold, leading to an absolute disaster for the US and the system. In 1971, it was announced that the gold standard system was no longer in place and the US dollar would not be pegged to gold and that now, it is a fiat currency. Despite significant economic downturns, the US dollar saw a meteoric rise after the first world war. The standard was never supposed to work because it had several shortcomings, the biggest one being the inability of several countries to maintain the exchange rates and control the money supply. The system also favoured countries that were already economically prosperous, and the smaller countries suffered. The end of the gold standard was not the end of the US dollar's domination but the beginning of maintaining the status of being a global reserve currency for over 75 years. After the gold standard ended, most countries invested their US dollars in US treasuries, and the economy started stabilizing. It was questionable, but the US dollar had reigned supreme for the past 40 years. Despite making multiple failed efforts to link itself back to gold, the fact that most of the world held the US dollar for decades made it stable and economically sound. Several countries peg their currencies to the dollar, including Saudi Arabia, which still raises the question of the Petro-dollar system. Replacing the US dollar as the next global money is nearly impossible as the historical effect and economic output play a big part. However, looking at a few other currencies and examining the cross-border flows and stability levels might be a compelling discourse. 

A global reserve currency would usually have some characteristics that would solidify the potential of the money.

• First off, the global reserve currency needs to be backed by a solid legal infrastructure and needs to have deep and liquid financial markets.

• The currency also needs to have confidence in the form of private consumers, investors and the central banks worldwide. The trust has to be domestic as well as international.

• The currency needs to be in demand for cross-border trade, invoices and payments while widely being used as a means of exchange. Such a currency has to act as a unit of account and would essentially have commodities priced in that currency.

THE EURO

The Euro has been the primary contender to become the global currency for a long time. The Euro is the next most held currency globally by the central banks representing nearly 21% of the total reserves. Historically speaking, the Euro came into effect in 1999, and before that, different countries simply had their currencies. Pre-1999, the French Franc and the Deutsche Mark were the two most held currencies around the globe and were deemed to be more stable than the others. Over the past 2-3 years, however, the Euro's share in global transactions has equalled the US dollar and even went beyond the dollar for some time. In mid-2022, the US dollar and the Euro accounted for about 38% of the global transactions each. 

One fact to look out for is that the transactions denominated in the Euro are mainly within the Eurozone, and the transactions outside the Eurozone are significantly lesser. The Euro passes on the point of being a currency that has maintained the confidence of investors worldwide and the central banks. The money is also used for global transactions, particularly in the Eurozone. The one criticism about the Euro and the infrastructure backing it is that the Euro does not tend to have an expected value across different European countries, and there is undoubtedly an inadequacy of international assets in the form of government bonds. The issue, however, is the dichotomous nature of default spreads and credit ratings across different countries. Eastern Europe and Russia have an average default spread of 1.8%, whereas the default spread in Western European countries is much lesser at 0.7%. The default spread in countries like Switzerland, Germany and Luxembourg is 0%, which makes it identical to the US treasuries. Still, a country like Greece or Albania has a spread of close to 3.5-4%, making it much riskier. Due to this disparity, Europe suffers from international assets backed by the common currency, but the risk profile is different. Investing in Germany is not the same as investing in Greece. The Eurozone crisis from 2009-2012 also made it significantly tougher to hold on to the Euros and have faith in the currency. Investors tend to invest in safer countries, making the international debt market denominated in Euros smaller and more concentrated in a few countries. Even commodities are not paid enough for in Euros, and the US dollar has maintained its solidified position in the commodities market for a long time. There is no doubt that the Euro is the second biggest reserve currency globally. Still, the kind of policies and acceptance a currency requires at such a level, especially in the commodity markets, makes it tremendously tricky and implausible.

THE CHINESE YUAN

The People's Republic of China has been attempting to dethrone the US dollar for a few years, but it has not happened because of China's policies and how opaque the economy is. The Chinese Yuan accounted for 2.7% of the global cross-border transactions in 2021, compared to 41% of the transaction value in the US dollar. Going back to the apt requirements for a global reserve currency, China fulfills the condition of being a currency used for payments across the globe, even though it lags substantially to the US dollar, Euro and even the Pound Sterling. The main issue lies in how China functions and the problems of trust in the Chinese economy concerning their debt levels and the constant devaluation of the Renminbi to make Chinese products appear cheaper in the global market. Another aspect relates to how non-transparent their capital markets are and how it affects the confidence in the Chinese economy, despite the massive growth in the last 3 decades. China would have to create a more free-flowing currency and stop pegging it continuously to the US dollar and devaluing it. Doing this makes China's economy grow significantly faster through a rise in export volumes but makes investing in and holding on to the reserves denominated in the Chinese Yuan. The People's Bank of China also has to be clear about its long-term policies and make them stable and transparent to some extent to appear and behave stably. The shadow banking system is a central issue in the Chinese economy that has had some severe ramifications. As of 2022, the shadow banking levels in China are close to $ 8 trillion, nearly 50% of China's GDP. All the debt within the shadow banking system is out of the official plan and does not reflect an accurate picture of the economy's health. Shadow banking is not particularly inimical for an economy, as it also widens the scope for credit distribution and makes credit more accessible, but it also increases the systemic risk. 

China also does not allow free movement of capital to different countries, and these restrictions have been going on for some time now. The Chinese government gives the reason that the funds might be helpful in terms of financial stress, but the consequences of such a decision are immense. Even if we look at the foreign portfolio investments (FPI) coming into China, the numbers are way too less considering the growth of the Chinese economy in the last few decades. Among the emerging markets, China has the second lowest foreign ownership in government bonds after India. It is not that foreign investors are more bullish on Peru or Indonesia, but the absolute lack of transparency of the Chinese government restricts capital inflows. If not for the restrictions, China would most definitely be up there, given the growth doesn't get affected and would also have led to central banks holding additional hundreds of billions of Chinese Yuan. Apart from this, the lack of a robust legal infrastructure, low levels of intellectual property rights and political events also play a significant part.

Nonetheless, FDI in China is still strong due to the government's heavy domestic investment, the market size, and lower production costs. 85% of the central banks hold the Yuan and are interested in maintaining that, which proves that the currency will rise when it comes to being a reserve currency. The Yuan might be able to devalue the dollar to some extent and find a place in the global central bank reserves. Still, the changes required to diminish the importance of the US dollar are irreversible and practically impossible for China.

CONCLUSION

The US dollar is almost an immovable force when it comes to being 'the' global currency, and there is possibly no contender for that. The dollar is the most widely accepted reserve and international currency, which are different things. It simply means that the economies around the world like to hold US dollars as reserves, and the dollar is also the most highly traded and circulated currency. Various hypotheses about the Euro, the Yuan or the Yen replacing the US dollar have floated, but none has fructified into a larger concept and doesn't even seem like it's going to be. Why the US dollar is so mighty is a question whose answer primarily lies in the past. The maximum power and value come from the trust in the economy and its ability to pay off its obligations on time. The first three decades of the 20th century made it clear that the US dollar is where countries would turn toward, and it proved to be true in the subsequent years. The Bretton Woods Agreement made it impossible to ignore the US dollar, and the demand and usage of the dollar kept increasing with the economy. By the time the gold standard ended, the world was accustomed to the US being a haven and had exchanged enough gold reserves for the US dollars and vice versa. There is also an argument about the power of the US dollar from the oil trade and how the Petrodollar system made the currency what it is, which is not valid. Almost every commodity is priced in US dollars, and most of the Middle East still pegs their currency to the US dollar because the US dollar is the primary currency in which oil trades. 

There is also a discourse about cryptocurrencies being the next dollar and serving the need for a single global currency, which is as far-fetched as possible. Blockchain systems might work with different currencies over time, but without the support of the economies and governments, having a decentralized global currency doesn't make any sense. Currencies that have been circulating for decades are still trying to find a place within the reserve system and have not been able to do so. In short, nothing changes till the absolute perception of the US economy and the dollar changes. The reason for the dominance of the dollar can be the way the currency is managed, the illusion of money and value or the lack of a better alternative, but the fact remains unchanged.