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The World Reserve Currency Debate - Dollar, Euro, Yen or Yuan?

0 2027 Market Intelligence

Alex Carrick

Positions:
Alex Carrick is Chief Economist for CanaData, Reed Construction Data’s Canadian economic forecasting and statistical service.

Economists

Currency markets may be in for a period of some turmoil. The Chinese and Japanese governments are becoming less enamored of holding large amounts of U.S. government debt. There are several reasons why China and Japan might worry about a decline in the value of the greenback that would depreciate the value of Treasury Bill holdings. This report examines why the greenback is at the top of the heap rather than the Euro and why some nations may start to lobby for wider usage of Special Drawing Rights.

Chinese Officials Initiate a Currency Debate

Some recent comments by high-ranking Chinese officials forewarn of some volatility ahead in world currency markets. Premier Wen Jiabao expressed distress over his country/'s very substantial holdings of U.S. debt. This has arisen because the U.S. buys so many goods in China and the dollars accumulated are invested back in the U.S. in Treasury bonds, bills and notes.

The second notification appeared in a discussion paper released by Chinese central bank governor, Zhou Xiaochuan. He is proposing the creation of a new international reserve currency, based on a basket of currencies, to eventually replace the U.S. dollar. His remarks include a not-so-subtle dig that the U.S. might benefit from this arrangement as well in that it would force America to exercise more monetary and fiscal discipline.

Why Now?

This issue is being raised at this time partly to stir things up prior to the imminent meeting of the G20 group of nations in London, England. Another part of the motivation is to provide a smokescreen behind which China can hide with respect to increasing calls for the Peoples Republic to orchestrate an increase in the value of its currency, the Yuan.

What this does highlight is that currency markets may be in for a period of some turmoil. The Chinese and Japanese are becoming less enamored of holding large amounts of U.S. government debt. Both countries have been placed in this position by their traditionally large trade surpluses. Japan is currently suffering through a huge export sales decline, but the Yen has still been one of only a few currencies to stand up in this downturn.

Holding large U.S. debt threatens large losses if and when the value of the U.S. dollar falls. Over the past six to nine months, as the worldwide recession has deepened, the greenback has been the currency of last resort and has therefore maintained more than its value. The greenback is the world/'s reserve currency. It has been a strange twist of fate that the recession has reinforced the greenback/'s status as the world/'s currency of choice.

Problems with the Euro

The U.S. dollar has been the currency of last resort in this crisis. Investors have flocked to the U.S. dollar in a “flight to safety.” Why not to the Euro? By population and combined output level, the European Union is comparable to the number one national economy in the world, the United States. The Swiss franc and Japanese Yen do not have anything like the necessary depth to play the same role in world trade as the U.S. dollar.

One major reason has become clear as the hard times have persisted. Several countries recently admitted into the European Union are flirting with bankruptcy. These are mostly former Soviet satellites and Eastern Bloc nations. Baltic and Balkan states are in the forefront. Richer members of the European Union may be called upon to bail them out.

The Euro has another wrinkle that makes its value hard to assess. When Euro nations need to raise money on capital markets, the co-ordination of financing becomes problematic. The number of countries that have adopted the Euro or tied their currencies to the Euro is now in the high “teens.” Each of these, with their own internal politics and growth rates, brings a different degree of stress to the table when trying to raise money.

Ireland and Greece Pay a Premium

Recently, Ireland and Greece, both Euro nations with serious economic problems, tapped capital markets. They each had to pay substantial premiums versus other Euro nations, in the form of higher interest rates, to achieve their capital-raising goals. Correctly judging the right “risk” mix becomes a tricky business for creditors and borrowers alike.

Reasons to Worry about the Greenback/'s Value?

This leaves the U.S. dollar in charge. However, there are several reasons why China and Japan might worry about a decline in the value of the greenback that would depreciate the value of their Treasury Bill holdings.

(1) The U.S. government is racking up huge debts in its efforts to climb out of recession and purge the financial system of toxic assets. Massive government debt is a sure-fire means to put downward pressure on a nation/'s currency value.

(2) Printing money is a time-honored means to relieve some of the debt problems as outlined in (1). However, this always leads to an inflation problem long term, which again places a declining bias on a nation/'s monetary unit.

(3) U.S. interest rates are at exceptionally low levels. This will reduce the allure for international investors of holding Treasury Bills, bonds and notes once the need for “safety” is deemed to be less pressing.

(4) There are already signs that the “safety” effect may be waning. It appears that investors are preparing to take a little more risk again by way of purchasing other assets. This is apparent in the recent mild recovery in stock markets; in the mild uptick in new and existing home sales; and in private sector firms entering into toxic asset purchases along with the federal government as part of Tim Geithner/'s rescue package.

There is some irony in the fact that as its economy improves, the U.S. dollar may come under pressure again. The Canadian dollar has been showing slight improvement of late, partly due to gentle softening in the value of the greenback and partly due to an increase in world oil prices.

Special Drawing Rights (SDRs)

One solution China is offering to reduce currency-value uncertainty is expanding the use of an instrument called Special Drawing Rights (SDRs). These were devised by the International Monetary Fund about half a century ago. They are based on a basket of currencies.

Widespread use of SDRs never really caught on because the system continued to work fairly well with the greenback at the top of the heap. But now, with greater financial sector regulation in the air and an overhaul of world financial markets likely upcoming, there are starting to be some calls for a re-examination of currency markets as well.

A Topic of Wide-ranging Importance

The question of currency values is far from academic. Over time, they have a huge influence on input costs and returns on foreign sales. Relative stability on foreign exchange markets makes it easier for individuals and businesses to plan and budget.

Cross-border supply chains are important cogs in getting many goods onto store shelves and flowing along automated production lines. The huge expansion of world trade that will inevitably characterize the coming post-recessionary period will need well-functioning exchange markets and easier-to-anticipate currency fluctuations.

Alex Carrick

Find Canadian construction-related economic articles in Canadian Construction Market News and in the Economic Outlook section of Daily Commercial News. Mr. Carrick also has a lifestyle blog that can be reached by clicking here.

by Alex Carrick last update:Apr 23, 2009

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