A gentle warning from the BIS about the US dollar's status as reserve currency.
I have long tracked foreign investment - particularly that of foreign central banks and foreign official sovereign wealth funds - in US dollars, and its impact on US financial markets. This is why the recent article in the BIS Quarterly Review, December 2014, "Currency movements drive reserve composition," peaked my interest.
The BIS piece essentially questions why the US dollar has maintained its global reserve currency status - as US dollar assets account for 60% of foreign exchange reserves - despite the weight of the US economy being less than 25% of global GDP. Among their conclusions (and I'm paraphrasing here) are that:
- Currencies that tend to be highly correlated to the dollar maintain higher shares of dollars in their official reserves. This "dollar zone" of currencies keeps the overall weight of the dollar in reserves higher and helps the dollar maintain its reserve status.
- Should the co-movement of currencies change rapidly, the shift away from dollars in the composition of reserves could also quickly erode the dollar's weight as a reserve currency, perhaps in favor of the Chinese renminbi.
I'm going to go on record as saying that their projection that the renminbi will move to global reserve status is both way too early and not really supported by the evidence that they site in the paper, other than that they seem to want to see the US dollar pushed aside. No countries that report the currency breakdown in their FX reserves currently have enough renminbi that it rises to the level of being significant to report as a category (less than 1% of allocated reserves are held in renminbi). Granted, most renminbi is probably held by nations that don't disclose that information, but still, it's an incredible stretch to project that such a position would go from being presumably negligible to "global reserve status" in, what, a period of a few years?
Many international economists have been claiming since before the euro was created in 1999 that it would rise to reserve currency status, challenging or overtaking the dollar (we site some more recent pieces along that vein later in the post). And I'm sure that it will - or could - occur, if the monetary union begins to function more as a fiscal and regulatory union, and the current destabilization problems are worked out. Fifteen years is certainly much too early to begin to judge. Britain had the reserve currency of the world for a couple of centuries, and many others functioned that way at times over the past two thousand years.
Part of the persistence of the US dollar's reserve status is its role in the global oil trade, the strength and size of the US economy, and the safe haven status its securities have due to the trust and faith people all over the world ascribe to the intent of the government to make good on its debts. Like us or not, we're the best credit going. As the US dollar continues to strengthen against the euro, yen and renminbi and the oil market crashes, I don't quite know what to make of all this. History can tell us a lot, and the history of money tells us that it's just as much about faith, governance, financial and monetary stability as it is about the size of the economy. Currency crises and financial chaos have been occurring with surprising frequency for millenia. There is a trade here, it's probably in FX and energy (ha ha ha, brilliant deduction, Watson) but I'm not sure know what it is. If you have some time, give this a read and send me some suggestions.
A brief history of money.
Bartering - e.g. trading cattle for seasonal harvests for cloth for labor - being a rather cumbersome and inefficient form of economic exchange, most ancient societies developed some primitive forms of money. In ancient China it was cowrie shells, in modern day prisons it's cigarettes. Due to its durability, convenience of transport, and eventually the ability to standardize weights, most ancient civilizations had incorporated the use of various metals as proto-money by around 2000 BC.
It is worth noting that banking preceded the development of true coinage. From Glyn Davies, Origins of Money and of Banking,
Banking originated in Ancient Mesopotamia where the royal palaces and temples provided secure places for the safe-keeping of grain and other commodities. Receipts came to be used for transfers not only to the original depositors but also to third parties. Eventually private houses in Mesopotamia also got involved in these banking operations and laws regulating them were included in the code of Hammurabi.
In Egypt too the centralization of harvests in state warehouses also led to the development of a system of banking. Written orders for the withdrawal of separate lots of grain by owners whose crops had been deposited there for safety and convenience, or which had been compulsorily deposited to the credit of the king, soon became used as a more general method of payment of debts to other persons including tax gatherers, priests and traders."Tax gatherers," ha. Who knew the ancient Egyptians were Democrats? Anyway, manufactured, stamped coins first appeared independently in India, China and cities around the Aegean sea from 700 to 500 BC. Gold and silver, along with various metal alloys, were commonly used for money and later coinage. The Egyptians used gold bars as a medium of exchange as early as 4000 BC. The first gold coins of the Grecian age were struck around 700 BC.
Once coinage became widespread, the minting of money - along with standardizing the weights and compositions of metal coins - was rapidly taken over by governments worldwide, after which inflation, debasement and counterfeiting immediately became problems.
The first foreign exchange traders.
Another excerpt from Glyn Davies (same reference as above):
The great variety of coinages originally in use in the Hellenic world meant that money changing was the earliest and most common form of Greek banking. Usually the money changers would carry out their business in or around temples and other public buildings, setting up their trapezium-shaped tables (which usually carried a series of lines and squares for assisting calculations), from which the Greek bankers, the trapezitai derived their name, much as our name for bank comes from the Italian banca for bench or counter. The close association between banking, money changing and temples is best known to us from the episode of Christ's overturning the tables in the Temple of Jerusalem (Matthew 21.12).
Both the Egyptians and the Greeks developed a sophisticated banking and finance system, which allowed for money transfers, extensions of credit, and lending to support shipping, mining and construction operations. Unfortunately, the fall of the Roman Empire resulted in most of the banking system being lost or forgotten. Back to Glyn Davies:
Coinage to paper money to the gold standard.
Like the development of coinage, several governments or financial centers in the first millenia independently developed some version of a paper guarantee. This was often due to a shortage of bullion used for making coins, the necessity of transferring large sums of money for international trade, or a drainage of coins to other countries due to payments for imports or protection from invaders (Vikings, all over Britain). However, it was China - where paper and printing were first invented - that was the first to make banknotes a common form of currency in about 960 AD. By 1020 China also suffered the world's first crippling bout of hyper-inflation, as financial authorities flooded the empire with banknotes, resulting in a dramatic devaluation of the currency.
Paper currency didn't really come into widespread use in Europe until the mid-17th century with the issuance of bearer receipts and banknotes. Again, the issuance of these instruments was quickly taken over by the government, in part to retain sole control of the money supply. Unlike metal coins, paper money obviously has no intrinsic value, and was originally backed by some physical commodity that it could be converted into or served as a claim against, usually gold or silver. Beginning in the 19th century, most countries - led by the then economic powerhouse Great Britain in 1817 - migrated from a silver or bimetallic standard to an exclusively gold standard backing their currency. That is, the domestic money supply in a country is directly tied to a country's stock of gold, held at their own central bank. Between 1870 and 1914, many countries, including Great Britain, the US and much of western Europe, were on a "classic gold standard" and the British pound was the reserve currency of the industrialized world.
By now, those of you still reading (you, dozing off at your monitor! thank you!), are wondering why I'm dragging you through this history lesson and what on earth it has to do with foreign currency reserves and the US dollar. Hang on, we're speeding up now (mostly because there are a lot of economic models and details that I'm outright skipping).
All countries that are on a gold standard fix the prices of their currencies to a specified amount of gold. Therefore, rates of exchange between currencies tied to gold also become fixed, the price levels between those countries move together, and it vastly facilitates international trade. If enacted correctly and "all countries play by the economic rules" then the virtue of the gold standard is that it assures long-term price stability - at the expense of highly unstable prices in the short run and a lack of discretion over monetary policy.
The gold standard may have been a good idea in principle. Unfortunately in practice - particularly through WWI, the great depression and WWII - it didn't work out at all well. Countries and central banks cheated, markets and international payment systems collapsed, people started hoarding gold - all the usual stuff that happens when academic theory collides with real human behavior. It was time to come up with something else. From Wikipedia:
*The politics on all sides surrounding this agreement were about as vicious and rife with self-dealing as you can imagine. At times - in hindsight - they are also very, very funny. If you have the time and the interest, you can read about it in Benn Steil's book, The Battle of Bretton Woods.
In 1971, Nixon takes the US off the gold standard, and currencies begin to be "free floating".
By the late 60s the US was no longer the dominant engine of world growth, public debt had increased, its gold supply was falling due to persistently negative balance of payments and the Federal Reserve was inflating the currency, resulting in the dollar becoming increasingly overvalued versus other currencies. Other countries were understandably furious at subsidizing the US spending spree, and threatened to convert their dollar reserves into gold (which the US could not afford to have them do, because it didn't have that much gold left) and exit the Bretton Woods system. West Germany did so in 1971 and promptly saw its currency and economy strengthen. Switzerland followed.
In August, 1971 President Nixon took the US off the gold standard: US dollars were no longer convertible into gold; fixed exchange rates became floating; the dollar devalued against other currencies (and the US fell headlong into stagflation).
Central banks begin to diversify their foreign exchange reserves.
Back to Wikipedia (Get off me. I send them donations every year):
Only a small portion of the foreign exchange reserves are actually held as bank deposits - that is, in currency form. Instead, most central banks invest their reserves in securities denominated in the targeted foreign currencies. Central banks being necessarily risk averse, these security portfolios are heavily weighted towards sovereign debt, highly rated asset-backed securities and investment grade corporate debt.
The US dollar is still the reserve currency of the world. For now.
FX reserves that are tracked by the IMF (International Monetary Fund) currently total ~$12 trillion, roughly 60% of which is estimated to be held in US dollar assets. A little over half of the countries report the size and allocation by currency of their FX reserves; others - including China, the world's largest single holder of FX reserves - report only the total size. Reliable estimates and limited self-reporting leads most analysts to conclude that the currency breakdown of the ~$5 trillion in unallocated reserves is similar to that of the allocated reserves, and most likely also held 60-70% in US dollars. Historical FX reserve data from the IMF broken down by currency for allocated reserves, plus the unallocated portion, is shown in the graph below.
The benefits of being a reserve currency - not to mention "the" reserve currency - are both tangible and meaningful: lower interest rates, cheaper financing of both public and private debt which results in improved economic growth, ease of international transactions for exports, and the prestige of being a financial world leader and a "safe haven" in times of upheaval. (Now everyone reach out and smack Ted Cruz in the head.)
Why is the US dollar still so dominant?
A clique of international economists have long projected (nee hoped) that the US dollar would lose its status as the reserve currency of the world - or at least be forced to share that status with the Euro, or perhaps China's renminbi. As an example of that faction, some Slovenian economists did an evaluation of foreign currency reserves similar to that in the recent BIS review. Their conclusions in 2007 were that the US dollar was likely to be "dethroned" as the leading reserve currency in favor of the euro. Excerpted from Compositional Analysis of Foreign Currency Reserves in the 1999-2007 Period - The Euro vs. the Dollar as Leading Reserve Currency (edited for brevity, emphasis added):
Unfortunately, due to recent events that are once again destabilizing the euro zone, I can't imagine that will contribute to a further FX diversification into euros at this time. It will no doubt happen that the US dollar will share "reserve status" - and eventually be completely supplanted - by another currency or basket of currencies.
Banking re-emerged in Europe at about the time of the Crusades. In Italian city states such as Rome, Venice and Genoa, and in the fairs of medieval France, the need to transfer sums of money for trading purposes led to the development of financial services including bills of exchange. Although it is possible that such bills had been used by the Arabs in the eighth century and the Jews in the tenth, the first for which definite evidence exists was a contract issued in Genoa in 1156 to enable two brothers who had borrowed 115 Genoese pounds to reimburse the bank's agents in Constantinople by paying them 460 bezants one month after their arrival.There you go - the first known recorded forward FX contract. Pretty cool.
Coinage to paper money to the gold standard.
Like the development of coinage, several governments or financial centers in the first millenia independently developed some version of a paper guarantee. This was often due to a shortage of bullion used for making coins, the necessity of transferring large sums of money for international trade, or a drainage of coins to other countries due to payments for imports or protection from invaders (Vikings, all over Britain). However, it was China - where paper and printing were first invented - that was the first to make banknotes a common form of currency in about 960 AD. By 1020 China also suffered the world's first crippling bout of hyper-inflation, as financial authorities flooded the empire with banknotes, resulting in a dramatic devaluation of the currency.
Paper currency didn't really come into widespread use in Europe until the mid-17th century with the issuance of bearer receipts and banknotes. Again, the issuance of these instruments was quickly taken over by the government, in part to retain sole control of the money supply. Unlike metal coins, paper money obviously has no intrinsic value, and was originally backed by some physical commodity that it could be converted into or served as a claim against, usually gold or silver. Beginning in the 19th century, most countries - led by the then economic powerhouse Great Britain in 1817 - migrated from a silver or bimetallic standard to an exclusively gold standard backing their currency. That is, the domestic money supply in a country is directly tied to a country's stock of gold, held at their own central bank. Between 1870 and 1914, many countries, including Great Britain, the US and much of western Europe, were on a "classic gold standard" and the British pound was the reserve currency of the industrialized world.
The development of the modern concept of a reserve currency took place in the mid nineteenth century, with the introduction of national central banks and treasuries and an increasingly integrated global economy. By the 1860s, most industrialised countries had followed the lead of the United Kingdom and put their currency on to the gold standard. At that point the UK was the primary exporter of manufactured goods and services and over 60% of world trade was invoiced in pound sterling. British banks were also expanding overseas, London was the world centre for insurance and commodity markets and British capital was the leading source of foreign investment around the world; sterling soon became the standard currency used for international commercial transactions. -- from Reserve Currency, WikipediaThe gold standard falls and the US dollar ascends.
By now, those of you still reading (you, dozing off at your monitor! thank you!), are wondering why I'm dragging you through this history lesson and what on earth it has to do with foreign currency reserves and the US dollar. Hang on, we're speeding up now (mostly because there are a lot of economic models and details that I'm outright skipping).
All countries that are on a gold standard fix the prices of their currencies to a specified amount of gold. Therefore, rates of exchange between currencies tied to gold also become fixed, the price levels between those countries move together, and it vastly facilitates international trade. If enacted correctly and "all countries play by the economic rules" then the virtue of the gold standard is that it assures long-term price stability - at the expense of highly unstable prices in the short run and a lack of discretion over monetary policy.
The gold standard may have been a good idea in principle. Unfortunately in practice - particularly through WWI, the great depression and WWII - it didn't work out at all well. Countries and central banks cheated, markets and international payment systems collapsed, people started hoarding gold - all the usual stuff that happens when academic theory collides with real human behavior. It was time to come up with something else. From Wikipedia:
In 1944 in Bretton Woods, New Hampshire, representatives from 44 nations met to develop a new international monetary system that came to be known as the Bretton Woods system. Conference members had hoped that this new system would “ensure exchange rate stability, prevent competitive devaluations, and promote economic growth." It was not until 1958 that the Bretton Woods System became fully operational. Countries now settled their international accounts in dollars that could be converted to gold at a fixed exchange rate of $35 per ounce, which was redeemable by the U.S. government. Thus, the United States was committed to backing every dollar overseas with gold. Other currencies were fixed to the dollar, and the dollar was pegged to gold.The Bretton Woods Agreement* in 1944 established the US dollar as the reserve currency of the world. All other currencies could devalue against the dollar, but only the dollar maintained the backing of gold. This may have seemed appropriate at the time, as the U.S. owned over half the world's official gold reserves and had taken over from Great Britain as the premier economic powerhouse, contributing 35% of world GDP. In the aftermath of WWII, no other country was in a very good position to argue.
*The politics on all sides surrounding this agreement were about as vicious and rife with self-dealing as you can imagine. At times - in hindsight - they are also very, very funny. If you have the time and the interest, you can read about it in Benn Steil's book, The Battle of Bretton Woods.
In 1971, Nixon takes the US off the gold standard, and currencies begin to be "free floating".
By the late 60s the US was no longer the dominant engine of world growth, public debt had increased, its gold supply was falling due to persistently negative balance of payments and the Federal Reserve was inflating the currency, resulting in the dollar becoming increasingly overvalued versus other currencies. Other countries were understandably furious at subsidizing the US spending spree, and threatened to convert their dollar reserves into gold (which the US could not afford to have them do, because it didn't have that much gold left) and exit the Bretton Woods system. West Germany did so in 1971 and promptly saw its currency and economy strengthen. Switzerland followed.
In August, 1971 President Nixon took the US off the gold standard: US dollars were no longer convertible into gold; fixed exchange rates became floating; the dollar devalued against other currencies (and the US fell headlong into stagflation).
Central banks begin to diversify their foreign exchange reserves.
Back to Wikipedia (Get off me. I send them donations every year):
Foreign-exchange reserves (also called forex reserves or FX reserves) are assets held by central banks and monetary authorities, usually in different reserve currencies, mostly the United States dollar, and to a lesser extent the Euro, the Pound sterling, and the Japanese yen, and used to back its liabilities, e.g., the local currency issued, and the various bank reserves deposited with the central bank, by the government or financial institutions.Foreign exchange reserves -> fixed income investment.
Only a small portion of the foreign exchange reserves are actually held as bank deposits - that is, in currency form. Instead, most central banks invest their reserves in securities denominated in the targeted foreign currencies. Central banks being necessarily risk averse, these security portfolios are heavily weighted towards sovereign debt, highly rated asset-backed securities and investment grade corporate debt.
The US dollar is still the reserve currency of the world. For now.
FX reserves that are tracked by the IMF (International Monetary Fund) currently total ~$12 trillion, roughly 60% of which is estimated to be held in US dollar assets. A little over half of the countries report the size and allocation by currency of their FX reserves; others - including China, the world's largest single holder of FX reserves - report only the total size. Reliable estimates and limited self-reporting leads most analysts to conclude that the currency breakdown of the ~$5 trillion in unallocated reserves is similar to that of the allocated reserves, and most likely also held 60-70% in US dollars. Historical FX reserve data from the IMF broken down by currency for allocated reserves, plus the unallocated portion, is shown in the graph below.
The benefits of being a reserve currency - not to mention "the" reserve currency - are both tangible and meaningful: lower interest rates, cheaper financing of both public and private debt which results in improved economic growth, ease of international transactions for exports, and the prestige of being a financial world leader and a "safe haven" in times of upheaval. (Now everyone reach out and smack Ted Cruz in the head.)
Why is the US dollar still so dominant?
A clique of international economists have long projected (nee hoped) that the US dollar would lose its status as the reserve currency of the world - or at least be forced to share that status with the Euro, or perhaps China's renminbi. As an example of that faction, some Slovenian economists did an evaluation of foreign currency reserves similar to that in the recent BIS review. Their conclusions in 2007 were that the US dollar was likely to be "dethroned" as the leading reserve currency in favor of the euro. Excerpted from Compositional Analysis of Foreign Currency Reserves in the 1999-2007 Period - The Euro vs. the Dollar as Leading Reserve Currency (edited for brevity, emphasis added):
This article mainly aims to present the currency composition of the foreign currency reserves of central banks in selected countries in the 1999-2007 period and, on this basis, to establish whether the euro stands any real chances of dethroning the US dollar as the global currency. The empirical results ...theoretical and empirical expectations, confirm the hypothesis that in the near future the euro may be regarded as a global reserve currency on a par with the US dollar or it may even become the leading reserve currency.
Given that most raw materials (oil, gold etc.) are these days globally traded in US dollars and that this currency dominates with over more than four-fifths of foreign trade and one-half of global exports, most central banks hold their foreign currency reserves in dollars. Moreover, the United States is at the helm of the world economy in terms of the size of its national economy and it is also the second largest financial center.
In recent times, an opinion has been gaining ground which mirrors the pessimistic scenario for the US currency because in the years to come the dollar is expected to gradually lose its role as the leading global reserve currency (see e.g. Bergsten (1997), Mundell (1998), Wyplosz (2001), Chinn & Frankel (2005)).This is postulated to be a consequence of changes in oil trading as oil-exporting countries will start charging for oil in euros and the latter will accordingly supplant dollars.Editor's note: I'm not sure, so any oil specialists please let me know, but I still don't think there is a meaningful amount of oil being priced in euros at this time.
Similarly, the beginning of the end of the dollar’s role as the leading international monetary currency could also involve the decision announced by China in July 2003 to switch some of its reserves out of dollars and into euros (Sharma et al., 2004). In the past, China tied its currency to the dollar while at present it fixes it against a basket of currencies. This example was followed by some Asian central banks which have diversified some of their reserves into euros.China has certainly diversified some of its fx reserves, but since they do not report their currency breakdown, estimates are that at most 20-25% is held in euros. The euro diversification of allocated reserves stabilized at ~20% of FX reserves and seems not to be rising.
Unfortunately, due to recent events that are once again destabilizing the euro zone, I can't imagine that will contribute to a further FX diversification into euros at this time. It will no doubt happen that the US dollar will share "reserve status" - and eventually be completely supplanted - by another currency or basket of currencies.
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